[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2021 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          

                                       Title 26

                                  Internal Revenue
                               ________________________

                         Part 1 (Sec. Sec.  1.908 to 1.1000)

                         Revised as of April 1, 2021

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2021
                    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........................     893
      Alphabetical List of Agencies Appearing in the CFR......     913
      Table of OMB Control Numbers............................     923
      List of CFR Sections Affected...........................     941

[[Page iv]]





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

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

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

[[Page v]]



                               EXPLANATION

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

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

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

LEGAL STATUS

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

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
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, 2021), 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 
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instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
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 
requirements.

PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
the revision date stated on the cover of each volume are not carried. 
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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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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established by statute and allows Federal agencies to meet the 
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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 
material published in the Federal Register.
    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
process.
    (c) The incorporating document is drafted and submitted for 
publication in accordance with 1 CFR part 51.
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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 
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    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
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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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    The e-CFR is a regularly updated, unofficial editorial compilation 
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available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register.
    April 1, 2021.







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations codified 
under this title by the Internal Revenue Service, Department of the 
Treasury, as of April 1, 2021. The first fifteen volumes comprise part 1 
(Subchapter A--Income Tax) and are arranged by sections as follows: 
Sec. Sec.  1.0-1.60; Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; 
Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; 
Sec. Sec.  1.410-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end of part 1. The sixteenth volume containing parts 2-29, includes the 
remainder of subchapter A and all of Subchapter B--Estate and Gift 
Taxes. The last six volumes contain parts 30-39 (Subchapter C--
Employment Taxes and Collection of Income Tax at Source); parts 40-49; 
parts 50-299 (Subchapter D--Miscellaneous Excise Taxes); parts 300-499 
(Subchapter F--Procedure and Administration); parts 500-599 (Subchapter 
G--Regulations under Tax Conventions); and part 600 to end (Subchapter 
H--Internal Revenue Practice).

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

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

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




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

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

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

[[Page 3]]



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




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


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

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

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

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

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





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



                  Normal Taxes and Surtaxes (Continued)

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

         Earned Income of Citizens or Residents of United States

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

               earned income of citizens of united states

1.912-1 Exclusion of certain cost-of-living allowances.
1.912-2 Exclusion of certain allowances of Foreign Service personnel.
1.921-1T Temporary regulations providing transition rules for DISCs and 
          FSCs.
1.921-2 Foreign Sales Corporation--general rules.
1.927(a)-1T Temporary regulations; definition of export property.
1.927(b)-1T [Reserved]
1.927(d)-1 [Reserved]
1.927(d)-2T Temporary regulations; definitions and special rules 
          relating to Foreign Sales Corporation.

                    possessions of the united states

1.931-1 Exclusion of certain income from sources within Guam, American 
          Samoa, or the Northern Mariana Islands.
1.932-1 Coordination of United States and Virgin Islands income taxes.
1.933-1 Exclusion of certain income from sources within Puerto Rico.
1.934-1 Limitation on reduction in income tax liability incurred to the 
          Virgin Islands.
1.935-1 Coordination of individual income taxes with Guam and the 
          Northern Mariana Islands.
1.936-1 Elections.
1.936-4 Intangible property income in the absence of an election out.
1.936-5 Intangible property income when an election out is made: 
          Product, business presence, and contract manufacturing.
1.936-6 Intangible property income when an election out is made: cost 
          sharing and profit split options; covered intangibles.
1.936-7 Manner of making election under section 936 (h)(5); special 
          election for export sales; revocation of election under 
          section 936(a).
1.936-8T Qualified possession source investment income (temporary). 
          [Reserved]
1.936-9T Source of qualified possession source investment income 
          (temporary). [Reserved]
1.936-10 Qualified investments.
1.936-11 New lines of business prohibited.
1.937-1 Bona fide residency in a possession.
1.937-2 Income from sources within a possession.
1.937-3 Income effectively connected with the conduct of a trade or 
          business in a possession.

                     controlled foreign corporations

1.951-1 Amounts included in gross income of United States shareholders.
1.951-2 [Reserved]
1.951-3 Coordination of subpart F with foreign personal holding company 
          provisions.
1.951A-1 General provisions.
1.951A-2 Tested income and tested loss.
1.951A-3 Qualified business asset investment.
1.951A-4 Tested interest expense and tested interest income.
1.951A-5 Treatment of GILTI inclusion amounts.
1.951A-6 Adjustments related to tested losses.
1.951A-7 Applicability dates.
1.952-1 Subpart F income defined.
1.952-2 Determination of gross income and taxable income of a foreign 
          corporation.
1.953-1 Income from insurance of United States risks.
1.953-2 Actual United States risks.
1.953-3 Risks deemed to be United States risks.
1.953-4 Taxable income to which section 953 applies.

[[Page 6]]

1.953-5 Corporations not qualifying as insurance companies.
1.953-6 Relationship of sections 953 and 954.
1.954-0 Introduction.
1.954-1 Foreign base company income.
1.954-2 Foreign personal holding company income.
1.954-3 Foreign base company sales income.
1.954-4 Foreign base company services income.
1.954-5 Increase in qualified investments in less developed countries; 
          taxable years of controlled foreign corporations beginning 
          before January 1, 1976.
1.954-6 Foreign base company shipping income.
1.954-7 Increase in qualified investments in foreign base company 
          shipping operations.
1.954-8 Foreign base company oil related income.
1.954(c)(6)-1 Certain cases in which section 954(c)(6) exception not 
          available.
1.955-0 Effective dates.
1.955-1 Shareholder's pro rata share of amount of previously excluded 
          subpart F income withdrawn from investment in less developed 
          countries.
1.955-2 Amount of a controlled foreign corporation's qualified 
          investments in less developed countries.
1.955-3 Election as to date of determining qualified investments in less 
          developed countries.
1.955-4 Definition of less developed country.
1.955-5 Definition of less developed country corporation.
1.955-6 Gross income from sources within less developed countries.
1.955A-1 Shareholder's pro rata share of amount of previously excluded 
          subpart F income withdrawn from investment in foreign base 
          company shipping operations.
1.955A-2 Amount of a controlled foreign corporation's qualified 
          investments in foreign base company shipping operations.
1.955A-3 Election as to qualified investments by related persons.
1.955A-4 Election as to date of determining qualified investment in 
          foreign base company shipping operations.
1.956-1 Shareholder's pro rata share of the average of the amounts of 
          United States property held by a controlled foreign 
          corporation.
1.956-1T Shareholder's pro rata share of the average of the amounts of 
          United States property held by a controlled foreign 
          corporation (temporary).
1.956-2 Definition of United States property.
1.956-2T Definition of United States property (temporary).
1.956-3 Certain trade or service receivables acquired from United States 
          persons.
1.956-4 Certain rules applicable to partnerships.
1.957-1 Definition of controlled foreign corporation.
1.957-2 Controlled foreign corporation deriving income from insurance of 
          United States risks.
1.957-3 United States person defined.
1.958-1 Direct and indirect ownership of stock.
1.958-2 Constructive ownership of stock.
1.959-1 Exclusion from gross income of United States persons of 
          previously taxed earning and profits.
1.959-2 Exclusion from gross income of controlled foreign corporations 
          of previously taxed earnings and profits.
1.959-3 Allocation of distributions to earnings and profits of foreign 
          corporations.
1.959-4 Distributions to United States persons not counting as 
          dividends.
1.960-1 Overview, definitions, and computational rules for determining 
          foreign income taxes deemed paid under section 960(a), (b), 
          and (d).
1.960-2 Foreign income taxes deemed paid under sections 960(a) and (d).
1.960-3 Foreign income taxes deemed paid under section 960(b).
1.960-4 Additional foreign tax credit in year of receipt of previously 
          taxed earnings and profits.
1.960-5 Credit for taxable year of inclusion binding for taxable year of 
          exclusion.
1.960-6 Overpayments resulting from increase in limitation for taxable 
          year of exclusion.
1.960-7 Applicability dates.
1.961-1 Increase in basis of stock in controlled foreign corporations 
          and of other property.
1.961-2 Reduction in basis of stock in foreign corporations and of other 
          property.
1.962-1 Limitation of tax for individuals on amounts included in gross 
          income under section 951(a).
1.962-2 Election of limitation of tax for individuals.
1.962-3 Treatment of actual distributions.
1.963-0 Repeal of section 963; effective dates.
1.963-1 [Reserved]
1.963-2 Determination of the amount of the minimum distribution.
1.963-3 Distributions counting toward a minimum distribution.
1.963-4--1.963-5 [Reserved]
1.963-6 Deficiency distribution.
1.964-1 Determination of the earnings and profits of a foreign 
          corporation.
1.964-2 Treatment of blocked earnings and profits.
1.964-3 Records to be provided by United States shareholders.
1.964-4 Verification of certain classes of income.
1.964-5 Effective date of subpart F.
1.965-0 Outline of section 965 regulations.
1.965-1 Overview, general rules, and definitions.

[[Page 7]]

1.965-2 Adjustments to earnings and profits and basis.
1.965-3 Section 965(c) deductions.
1.965-4 Disregard of certain transactions.
1.965-5 Allowance of credit or deduction for foreign income taxes.
1.965-6 Computation of foreign income taxes deemed paid and allocation 
          and apportionment of deductions.
1.965-7 Elections, payment, and other special rules.
1.965-8 Affiliated groups (including consolidated groups).
1.965-9 Applicability dates.

                        Export Trade Corporations

1.970-1 Export trade corporations.
1.970-2 Elections as to date of determining investments in export trade 
          assets.
1.970-3 Effective date of subpart G.
1.971-1 Definitions with respect to export trade corporations.
1.972-1 Consolidation of group of export trade corporations.
1.981-0 Repeal of section 981; effective dates.
1.981-1 Foreign law community income for taxable years beginning after 
          December 31, 1966, and before January 1, 1977.
1.981-2 Foreign law community income for taxable years beginning before 
          January 1, 1967.
1.981-3 Definitions and other special rules.
1.985-0 Outline of regulation.
1.985-1 Functional currency.
1.985-2 Election to use the United States dollar as the functional 
          currency of a QBU.
1.985-3 United States dollar approximate separate transactions method.
1.985-4 Method of accounting.
1.985-5 Adjustments required upon change in functional currency.
1.985-6 Transition rules for a QBU that uses the dollar approximate 
          separate transactions method for its first taxable year 
          beginning in 1987.
1.985-7 Adjustments required in connection with a change to DASTM.
1.985-8 Special rules applicable to the European Monetary Union 
          (conversion to the euro).
1.986(a)-1 Translation of foreign income taxes for purposes of the 
          foreign tax credit.
1.986(c)-1 Coordination with section 965.
1.987-0 Section 987; table of contents.
1.987-1 Scope, definitions, and special rules.
1.987-1T Scope, definitions, and special rules (temporary).
1.987-2 Attribution of items to eligible QBUs; definition of a transfer 
          and related rules.
1.987-3 Determination of section 987 taxable income or loss of an owner 
          of a section 987 QBU.
1.987-3T Determination of section 987 taxable income or loss of an owner 
          of a section 987 QBU (temporary).
1.987-4 Determination of net unrecognized section 987 gain or loss of a 
          section 987 QBU.
1.987-5 Recognition of section 987 gain or loss.
1.987-6 Character and source of section 987 gain or loss.
1.987-6T Character and source of section 987 gain or loss (temporary).
1.987-7 Section 987 aggregate partnerships.
1.987-8 Termination of a section 987 QBU.
1.987-8T Termination of a section 987 QBU (temporary).
1.987-9 Recordkeeping requirements.
1.987-10 Transition rules.
1.987-11 Effective/applicability date.
1.987-12 Deferral of section 987 gain or loss.
1.988-0 Taxation of gain or loss from a section 988 transaction; table 
          of contents.
1.988-1 Certain definitions and special rules.
1.988-1T Certain definitions and special rules (temporary).
1.988-2 Recognition and computation of exchange gain or loss.
1.988-2T Recognition and computation of exchange gain or loss 
          (temporary).
1.988-3 Character of exchange gain or loss.
1.988-4 Source of gain or loss realized on a section 988 transaction.
1.988-5 Section 988(d) hedging transactions.
1.988-6 Nonfunctional currency contingent payment debt instruments.
1.989(a)-1 Definition of a qualified business unit.
1.989(b)-1 Definition of weighted average exchange rate.

                Domestic International Sales Corporations

1.991-1 Taxation of a domestic international sales corporation.
1.992-1 Requirements of a DISC.
1.992-2 Election to be treated as a DISC.
1.992-3 Deficiency distributions to meet qualification requirements.
1.992-4 Coordination with personal holding company provisions in case of 
          certain produced film rents.
1.993-1 Definition of qualified export receipts.
1.993-2 Definition of qualified export assets.
1.993-3 Definition of export property.
1.993-4 Definition of producer's loans.
1.993-5 Definition of related foreign export corporation.
1.993-6 Definition of gross receipts.
1.993-7 Definition of United States.
1.994-1 Inter-company pricing rules for DISC's.
1.994-2 Marginal costing rules.
1.995-1 Taxation of DISC income to shareholders.
1.995-2 Deemed distributions in qualified years.

[[Page 8]]

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

    Authority: 26 U.S.C. 7805.
    Sections 1.909-1 through 1.906-6 also issued under 26 U.S.C. 909(e).
    Section 1.911-7 also issued under 26 U.S.C. 911(d)(9).
    Section 1.931-1 also issued under 26 U.S.C. 7654(e).
    Section 1.932-1 also issued under 26 U.S.C. 7654(e).
    Section 1.934-1 also issued under 26 U.S.C. 934(b)(4).
    Section 1.935-1 also issued under 26 U.S.C. 7654(e).
    Section 1.936-4 also issued under 26 U.S.C. 936(h).
    Section 1.936-5 also issued under 26 U.S.C. 936(h).
    Section 1.936-6 also issued under 26 U.S.C. 863(a) and (b), and 26 
U.S.C. 936(h).
    Section 1.936-7 also issued under 26 U.S.C. 936(h).
    Section 1.936-11 also issued under 26 U.S.C. 936(j).
    Section 1.937-1 also issued under 26 U.S.C. 937(a).
    Section 1.937-1T also issued under 26 U.S.C. 937(a).
    Section 1.937-2 also issued under 26 U.S.C. 937(b).
    Section 1.937-3 also issued under 26 U.S.C. 937(b).
    Section 1.951-1 also issued under 26 U.S.C. 7701(a).
    Section 1.951A-2 also issued under 26 U.S.C. 882(c)(1)(A) and 
954(b)(5).
    Section 1.951A-3 also issued under 26 U.S.C. 951A(d)(4).
    Section 1.951A-5 also issued under 26 U.S.C. 951A(f)(1)(B).
    Section 1.952-11T is also issued under 26 U.S.C. 852(b)(3)(C), 
852(b)(8), and 852(c).
    Section 1.953-2 also issued under 26 U.S.C. 7701(b)(11).
    Section 1.954-0 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-1 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-2 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.956-1 also issued under 26 U.S.C. 245A(g), 956(d), and 
956(e).
    Section 1.956-1T also issued under 26 U.S.C. 956(d) and 956(e).
    Section 1.956-2 also issued under 26 U.S.C. 956(d) and 956(e).
    Section 1.956-3 also issued under 26 U.S.C. 864(d)(8) and 956(e).
    Section 1.956-4 also issued under 26 U.S.C. 956(d) and 956(e).
    Section 1.957-1 also issued under 26 U.S.C. 957.
    Section 1.957-3 also issued under 26 U.S.C. 957(c).
    Section 1.960-1 also issued under 26 U.S.C. 960(f).
    Section 1.960-2 also issued under 26 U.S.C. 960(f).
    Section 1.960-3 also issued under 26 U.S.C. 960(f).
    Section 1.960-4 also issued under 26 U.S.C. 951A(f)(1)(B) and 26 
U.S.C. 960(f).
    Section 1.962-1 also issued under 26 U.S.C. 965(o).
    Section 1.965-1 also issued under 26 U.S.C. 965(c)(3)(B)(iii)(V), 
965(d)(2), 965(o), 989(c), and 7701(a).
    Section 1.965-2 also issued under 26 U.S.C. 965(b)(3)(A)(ii), 
965(o), and 961(a) and (b).
    Section 1.965-3 also issued under 26 U.S.C. 965(c)(3)(D) and 965(o).
    Section 1.965-4 also issued under 26 U.S.C. 965(c)(3)(F) and 965(o).
    Sections 1.965-5 through 1.965-6 also issued under 26 U.S.C. 965(o) 
and 26 U.S.C. 902(c)(8) (as in effect on December 21, 2017).
    Section 1.965-7 also issued under 26 U.S.C. 965(h)(3), 965(h)(5), 
965(i)(2), 965(i)(8)(B), 965(m)(2)(A), 965(n)(3), and 965(o).
    Section 1.965-8 also issued under 26 U.S.C. 965(o).
    Section 1.965-9 also issued under 26 U.S.C. 965(o).
    Sections 1.985-0 through 1.985-5 also issued under 26 U.S.C. 985.
    Section 1.986(a)-1 also issued under 26 U.S.C. 986(a)(1)(C) and 26 
U.S.C. 986(a)(1)(D)(ii).
    Section 1.986(c)-1 also issued under 26 U.S.C. 965(o) and 26 U.S.C. 
989(c).
    Sections 1.987-1 through 1.987-5 also issued under 26 U.S.C. 987.
    Section 1.987-12 is issued under 26 U.S.C. 987 and 989.
    Sections 1.988-0 through 1.988-5 also issued under 26 U.S.C. 988.
    Sections 1.989(a)-0T and 1.989(a)-1T also issued under 26 U.S.C. 
989(c).
    Section 1.989(b)-1 also issued under 26 U.S.C. 989(b).
    Section 1.989-1(c) also issued under 26 U.S.C. 989(c).

[[Page 9]]


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

         Earned Income of Citizens or Residents of United States



Sec. 1.908  [Reserved]



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

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

              Sec. 1.909-1 Definitions and special rules.

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

                  Sec. 1.909-2 Splitter arrangements.

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

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

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

                    Sec. 1.909-4 Coordination rules.

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

           Sec. 1.909-5 2011 and 2012 splitter arrangements.

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

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

    (a) Foreign tax credit splitting event.
    (1) In general.
    (2) Taxes not subject to suspension under section 909.
    (3) Taxes subject to suspension under section 909.
    (b) Pre-2011 splitter arrangements.
    (1) Reverse hybrid structure splitter arrangements.
    (2) Foreign consolidated group splitter arrangements.
    (3) Group relief or other loss-sharing regime splitter arrangements.
    (i) In general.
    (ii) Split taxes and related income.
    (4) Hybrid instrument splitter arrangements.
    (i) In general.
    (ii) U.S. equity hybrid instrument splitter arrangement.
    (iii) U.S. debt hybrid instrument splitter arrangement.
    (c) General rules for applying section 909 to pre-2011 split taxes 
and related income.
    (1) Annual determination.
    (2) Separate categories.
    (d) Special rules regarding related income.
    (1) Annual adjustments.
    (2) Effect of separate limitation losses and deficits.
    (3) Pro rata method for distributions out of earnings and profits 
that include both related income and other income.
    (4) Alternative method for distributions out of earnings and profits 
that include both related income and other income.
    (5) Distributions, deemed distributions, and inclusions out of 
related income.
    (6) Carryover of related income.
    (7) Related income taken into account by a section 902 shareholder.
    (8) Related income taken into account by a payor section 902 
corporation.

[[Page 10]]

    (9) Related income taken into account by an affiliated group of 
corporations that includes a section 902 shareholder.
    (10) Distributions of previously-taxed earnings and profits.
    (e) Special rules regarding pre-2011 split taxes.
    (1) Taxes deemed paid pro rata out of pre-2011 split taxes and other 
taxes.
    (2) Pre-2011 split taxes deemed paid in pre-2011 taxable years.
    (3) Carryover of pre-2011 split taxes.
    (4) Determining when pre-2011 split taxes are no longer treated as 
pre-2011 split taxes.
    (f) Rules relating to partnerships and trusts.
    (1) Taxes paid or accrued by partnerships.
    (2) Section 704(b) allocations.
    (3) Trusts.
    (g) Interaction between section 909 and other Code provisions.
    (1) Section 904(c).
    (2) Section 905(a).
    (3) Section 905(c).
    (4) Other foreign tax credit provisions.
    (h) Effective/applicability date.

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



Sec. 1.909-1  Definitions and special rules.

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

[[Page 11]]

shareholder or beneficiary to whom the related income is allocated.
    (d) Application of section 909 to pre-1987 accumulated profits and 
pre-1987 foreign income taxes. Section 909 and Sec. Sec. 1.909-1 
through 1.909-5 will apply to pre-1987 accumulated profits (as defined 
in Sec. 1.902-1(a)(10)(i)) and pre-1987 foreign income taxes (as 
defined in Sec. 1.902-1(a)(10)(iii)) of a section 902 corporation 
attributable to taxable years beginning on or after January 1, 2012.
    (e) Effective/applicability date. This section applies to taxable 
years ending after February 9, 2015. See 26 CFR 1.909-1T (revised as of 
April 1, 2014) for rules applicable to taxable years beginning on or 
after January 1, 2011, and ending on or before February 9, 2015.

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



Sec. 1.909-2  Splitter arrangements.

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


[[Page 12]]


    Example 1. (i) Facts. USP, a domestic corporation, wholly owns DE, a 
disregarded entity for U.S. federal income tax purposes that is 
organized in country A and treated as a corporation for country A tax 
purposes. DE wholly owns RH, a corporation for U.S. Federal income tax 
purposes that is organized in country A and treated as a fiscally 
transparent entity for country A tax purposes. Country A imposes an 
income tax at the rate of 30% on DE with respect to the items of income 
earned by RH. Prior to year 1, RH had no income for country A purposes 
and had no post-1986 earnings and profits for U.S. Federal income tax 
purposes. In year 1, RH earns 200u of income on which DE pays 60u of 
country A tax. Pursuant to Sec. 1.901-2(f)(4)(ii), USP is treated as 
legally liable for the 60u of country A taxes paid by DE. DE has no 
other income. In year 2, RH earns no income and incurs no losses or 
expenses. At the end of year 2, RH distributes 100u to DE.
    (ii) Result. (A) Split taxes and related income. Pursuant to Sec. 
1.909-2(b)(1)(iv), RH is a reverse hybrid because it is a corporation 
for U.S. Federal income tax purposes and a fiscally transparent entity 
for country A purposes. Pursuant to Sec. 1.909-2(b)(1), RH is a covered 
person with respect to USP because USP wholly owns RH for U.S. Federal 
income tax purposes. Pursuant to Sec. 1.909-2(b)(1)(i), there is a 
splitter arrangement with respect to RH because USP paid country A tax 
with respect to the income of RH. All 60u of taxes paid by USP in year 1 
with respect to the income of RH are split taxes pursuant to Sec. 
1.909-2(b)(1)(ii). The post-1986 earnings and profits of RH are 200u as 
of the end of year 1. Pursuant to Sec. 1.909-2(b)(1)(iii), the related 
income in year 1 is the 200u of RH's earnings and profits that are 
attributable to the activities that gave rise to the split taxes. No 
additional split taxes or related income arise in year 2.
    (B) Distribution. Because DE is a disregarded entity, the 100u 
distribution by RH at the end of year 2 is treated as a dividend to USP. 
Pursuant to Sec. 1.909-6(d)(7) and Sec. 1.909-3(a), 100u of the 200u 
of related income of RH, or 50%, is taken into account by USP by reason 
of the 100u dividend. Accordingly, pursuant to Sec. 1.909-6(e)(4) and 
Sec. 1.909-3(a), a ratable portion of the split taxes, or 30u of taxes 
(50% of 60u), is no longer treated as split taxes and is taken into 
account by USP for U.S. Federal income tax purposes.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that in year 2, RH has a 100u loss for U.S. Federal income tax purposes 
as well as for country A tax purposes. For country A tax purposes, DE 
takes the 100u loss into account in year 2 and may not carry back the 
100u loss to offset its country A taxable income for year 1. At the end 
of year 2, RH distributes 100u to DE.
    (ii) Result. (A) Split taxes and related income. The split taxes and 
related income for year 1 are the same as in Example 1. Pursuant to 
Sec. 1.909-2(b)(1)(iii), Sec. 1.909-6(d)(1) and Sec. 1.909-3(a), the 
total related income of RH is reduced to 100u (200u - 100u) in year 2 
because RH incurred a 100u loss in year 2 attributable to the activities 
that are included in DE's country A tax base.
    (B) Distribution. Because DE is a disregarded entity, the 100u 
distribution by RH at the end of year 2 is treated as a dividend to USP. 
Pursuant to Sec. 1.909-6(d)(7) and Sec. 1.909-3(a), 100u of the 100u 
of related income of RH, or 100%, is taken into account by USP by reason 
of the 100u dividend. Accordingly, pursuant to Sec. 1.909-6(e)(4) and 
Sec. 1.909-3(a), a ratable portion of the split taxes, or 60u of taxes 
(100% of 60u), is no longer treated as split taxes and is taken into 
account by USP for U.S. Federal income tax purposes.

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

[[Page 13]]

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

[[Page 14]]

    (v) Related income from a loss-sharing splitter arrangement. The 
related income with respect to split taxes from a loss-sharing splitter 
arrangement is an amount of income of the individual or corporate member 
of the U.S. combined income group equal to the amount of income under 
foreign tax law of that U.S. combined income group that is offset by the 
usable shared loss of another U.S. combined income group.
    (vi) Foreign group relief or other loss-sharing regime. A foreign 
group relief or other loss-sharing regime exists when an entity may 
surrender its loss to offset the income of one or more other entities. A 
foreign group relief or other loss-sharing regime does not include an 
allocation of loss of an entity that is a partnership or other fiscally 
transparent entity (under the principles of Sec. 1.894-1(d)(3)) for 
foreign tax purposes or regimes in which foreign tax is imposed on 
combined income (such as a foreign consolidated regime), as described in 
Sec. 1.901-2(f)(3).
    (vii) Examples. The following examples illustrate the rules of 
paragraph (b)(2) of this section.

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

[[Page 15]]

one or more of the others. Country B imposes an income tax at the rate 
of 30% on the taxable income of corporations organized in country B. In 
year 1, before any loss sharing, CFC2 has income of 100u, CFC1 and CFC3 
have no income, DE has a loss of 100u, and HP1 has income of 200u. Under 
the provisions of country B's loss-sharing regime, the group decides to 
use DE's 100u loss to offset 100u of HP1's income. After the loss is 
shared, for country B tax purposes, CFC2 has 100u of income on which it 
pays 30u of country B income tax, and HP1 has 100u of income (200u less 
the 100u shared loss) on which it pays 30u of country B income tax. For 
U.S. Federal income tax purposes, the loss sharing with HP1 is not taken 
into account, and, because DE is a disregarded entity, its 100u loss is 
taken into account by CFC2 and reduces CFC2's earnings and profits for 
U.S. Federal income tax purposes. The 200u income of HP1 is allocated 
50/50 to CFC2 and CFC3, as is the 30u of country B income tax paid by 
HP1. Accordingly, before application of section 909, for U.S. Federal 
income tax purposes, CFC2 has earnings and profits of 55u (100u income 
plus 100u share of HP1's income less 100u loss of DE less 30u country B 
income tax paid by CFC2 less 15u share of HP1's country B income tax) 
and the dollar equivalent of 45u of country B income tax to add to its 
post-1986 foreign income taxes pool. CFC3 has earnings and profits of 
85u (100u share of HP1's income less 15u share of HP1's country B income 
taxes) and the dollar equivalent of 15u of country B income tax to add 
to its post-1986 foreign income taxes pool.
    (ii) U.S. combined income groups. Pursuant to Sec. 1.909-
2(b)(2)(ii), because the income and loss of HP1 are combined in part 
with the income and loss of both CFC2 and CFC3, it belongs to both of 
the separate CFC2 and CFC3 U.S. combined income groups. DE is a member 
of the CFC2 U.S. combined income group.
    (iii) Income of the U.S. combined income groups. Pursuant to Sec. 
1.909-2(b)(2)(iii)(A), the income of the CFC2 U.S. combined income group 
is the 200u country B taxable income of the members of the group with 
positive taxable incomes (CFC2's country B taxable income of 100u plus 
50% of HP1's country B taxable income of 200u, or 100u). Because DE does 
not have positive taxable income for country B tax purposes, its 100u 
loss is not included in the income of the CFC2 U.S. combined income 
group. The income of the CFC3 U.S. combined income group is 100u (50% of 
HP1's country B taxable income of 200u, or 100u).
    (iv) Shared loss of the U.S. combined income groups. Pursuant to 
Sec. 1.909-2(b)(2)(iii)(B), the shared loss of the CFC2 U.S. combined 
income group is the 100u loss incurred by DE that is used to offset 100u 
of HP1's income. The CFC3 U.S. combined income group has no shared loss. 
Pursuant to Sec. 1.909-2(b)(2)(i), the usable shared loss of the CFC2 
U.S. combined income group is 100u, the full amount of the group's 100u 
shared loss that could have been used to offset income of the CFC2 U.S. 
combined income group had the loss been used to offset 100u of CFC2's 
country B taxable income.
    (v) Income offset by shared loss. The shared loss of the CFC2 
combined income group is used to offset 100u country B taxable income of 
HP1. Because the taxable income of HP1 is allocated 50/50 between the 
CFC2 and CFC3 U.S. combined income groups, the shared loss is treated as 
offsetting 50u of the CFC2 U.S. combined income group's income and 50u 
of the CFC3 U.S. combined income group's income.
    (vi) Splitter arrangement. There is a splitter arrangement because 
50u of the 100u usable shared loss of the CFC2 U.S. combined income 
group was used to offset income of the CFC3 U.S. combined income group. 
Pursuant to Sec. 1.909-2(b)(2)(iv), the split taxes are the 15u of 
country B income tax paid by CFC2 on 50u of its income, which is equal 
to the amount of the CFC2 U.S. combined income group's usable shared 
loss that was used to offset income of another U.S. combined income 
group. Pursuant to Sec. 1.909-2(b)(2)(v), the related income is the 50u 
of CFC3's income that was offset by the usable shared loss of the CFC2 
U.S. combined income group.

    (3) Hybrid instrument splitter arrangements--(i) U.S. equity hybrid 
instrument splitter arrangement--(A) In general. A U.S. equity hybrid 
instrument is a splitter arrangement if:
    (1) Under the laws of a foreign jurisdiction in which the instrument 
owner is subject to tax, the instrument gives rise to income includible 
in the instrument owner's income and such inclusion results in foreign 
income taxes paid or accrued by the instrument owner;
    (2) Under the laws of a foreign jurisdiction in which the issuer is 
subject to tax, the instrument gives rise to deductions that are 
incurred or otherwise taken into account by the issuer; and
    (3) The events that give rise to income includible in the instrument 
owner's income for foreign tax purposes as described in paragraph 
(b)(3)(i)(A)(1) of this section, and to deductions for the issuer for 
foreign tax purposes as described in paragraph (b)(3)(i)(A)(2) of this 
section, do not result in an inclusion of income for the instrument 
owner for U.S. federal income tax purposes.
    (B) Split taxes from a U.S. equity hybrid instrument splitter 
arrangement. Split

[[Page 16]]

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

[[Page 17]]

    (D) U.S. debt hybrid instrument. The term U.S. debt hybrid 
instrument means an instrument that is treated as equity for foreign tax 
purposes but as indebtedness for U.S. Federal income tax purposes.
    (4) Partnership inter-branch payment splitter arrangements--(i) In 
general. An allocation of foreign income tax paid or accrued by a 
partnership with respect to an inter-branch payment as described in 
Sec. 1.704-1(b)(4)(viii)(d)(3) (revised as of April 1, 2011) (the 
inter-branch payment tax) is a splitter arrangement to the extent the 
inter-branch payment tax is not allocated to the partners in the same 
proportion as the distributive shares of income in the CFTE category to 
which the inter-branch payment tax is or would be assigned under Sec. 
1.704-1(b)(4)(viii)(d) without regard to Sec. 1.704-
1(b)(4)(viii)(d)(3).
    (ii) Split taxes from a partnership inter-branch payment splitter 
arrangement. The split taxes from a partnership inter-branch splitter 
arrangement equal the excess of the amount of the inter-branch payment 
tax allocated to a partner under the partnership agreement over the 
amount of the inter-branch payment tax that would have been allocated to 
the partner if the inter-branch payment tax had been allocated to the 
partners in the same proportion as the distributive shares of income in 
the CFTE category referred to in paragraph (b)(4)(i) of this section.
    (iii) Related income from a partnership inter-branch payment 
splitter arrangement. The related income from a partnership inter-branch 
payment splitter arrangement equals the amount of income allocated to a 
partner that exceeds the amount of income that would have been allocated 
to the partner if income in the CFTE category referred to in paragraph 
(b)(4)(i) of this section in the amount of the inter-branch payment had 
been allocated to the partners in the same proportion as the inter-
branch payment tax was allocated under the partnership agreement.
    (c) Effective/applicability date. This section applies to foreign 
income taxes paid or accrued in taxable years ending after February 9, 
2015. However, a taxpayer may choose to apply the provisions of Sec. 
1.909-2T (as contained in 26 CFR part 1, revised as of April 1, 2014) in 
lieu of this section to foreign income taxes paid or accrued in its 
first taxable year ending after February 9, 2015, and in taxable years 
of foreign corporations with respect to which the taxpayer is a domestic 
shareholder (as defined in Sec. 1.902-1(a)) that end with or within 
that first taxable year. See 26 CFR 1.909-2T (revised as of April 1, 
2014) for rules applicable to foreign income taxes paid or accrued in 
taxable years beginning on or after January 1, 2012, and ending on or 
before February 9, 2015.

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



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

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

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

[[Page 18]]



Sec. 1.909-4  Coordination rules.

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

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



Sec. 1.909-5  2011 and 2012 splitter arrangements.

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

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



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

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

[[Page 19]]

paragraph (b) of this section (pre-2011 split taxes) but that were 
deemed paid under section 902(a) or 960 on or before the last day of the 
section 902 corporation's last pre-2011 taxable year;
    (iii) Any pre-2011 split taxes if either the payor section 902 
corporation took the related income into account in a pre-2011 taxable 
year or a section 902 shareholder (as defined in Sec. 1.909-1(a)(2)) of 
the relevant section 902 corporation took the related income into 
account on or before the last day of the section 902 corporation's last 
pre-2011 taxable year; and
    (iv) Any pre-2011 split taxes paid or accrued by a section 902 
corporation in taxable years of such section 902 corporation beginning 
before January 1, 1997.
    (3) Taxes subject to suspension under section 909. To the extent 
that the section 902 corporation paid or accrued pre-2011 split taxes 
that are not described in paragraph (a)(2) of this section, section 909 
and the regulations under that section will apply to such pre-2011 split 
taxes for purposes of applying sections 902 and 960 in post-2010 taxable 
years of the section 902 corporation. Accordingly, these taxes will be 
removed from the section 902 corporation's pools of post-1986 foreign 
income taxes and suspended under section 909 as of the first day of the 
section 902 corporation's first post-2010 taxable year. There is no 
increase to a section 902 corporation's earnings and profits for the 
amount of any pre-2011 taxes to which section 909 applies that were 
previously deducted in computing earnings and profits in a pre-2011 
taxable year.
    (b) Pre-2011 splitter arrangements. The arrangements set forth in 
this paragraph (b) are pre-2011 splitter arrangements.
    (1) Reverse hybrid structure splitter arrangements. A reverse hybrid 
structure exists when a section 902 corporation owns an interest in a 
reverse hybrid. A reverse hybrid is an entity that is a corporation for 
U.S. Federal income tax purposes but is a pass-through entity or a 
branch under the laws of a foreign country imposing tax on the income of 
the entity. As a result, the owner of the reverse hybrid is subject to 
tax on the income of the entity under foreign law. A pre-2011 splitter 
arrangement involving a reverse hybrid structure exists when pre-2011 
taxes are paid or accrued by a section 902 corporation with respect to 
income of a reverse hybrid that is a covered person with respect to the 
section 902 corporation. A pre-2011 splitter arrangement involving a 
reverse hybrid structure may exist even if the reverse hybrid has a 
deficit in earnings and profits for a particular year (for example, due 
to a timing difference). Such taxes paid or accrued by the section 902 
corporation are pre-2011 split taxes. The related income is the earnings 
and profits (computed for U.S. Federal income tax purposes) of the 
reverse hybrid attributable to the activities of the reverse hybrid that 
gave rise to income included in the foreign tax base with respect to 
which the pre-2011 split taxes were paid or accrued. Accordingly, 
related income of the reverse hybrid would not include any item of 
income or expense attributable to a disregarded entity (as defined in 
Sec. 301.7701-2(c)(2)(i) of this chapter) owned by the reverse hybrid 
if income attributable to the activities of the disregarded entity is 
not included in the foreign tax base.
    (2) Foreign consolidated group splitter arrangements. A foreign 
consolidated group exists when a foreign country imposes tax on the 
combined income of two or more entities. Tax is considered imposed on 
the combined income of two or more entities even if the combined income 
is computed under foreign law by attributing to one such entity the 
income of one or more entities. A foreign consolidated group is a pre-
2011 splitter arrangement to the extent that the taxpayer did not 
allocate the foreign consolidated tax liability among the members of the 
foreign consolidated group based on each member's share of the 
consolidated taxable income included in the foreign tax base under the 
principles of Sec. 1.901-2(f)(3) (revised as of April 1, 2011). A pre-
2011 splitter arrangement involving a foreign consolidated group may 
exist even if one or more members has a deficit in earnings and profits 
for a particular year (for example, due to a timing difference). Pre-
2011 taxes paid or accrued with respect to the income of a foreign

[[Page 20]]

consolidated group are pre-2011 split taxes to the extent that taxes 
paid or accrued by one member of the foreign consolidated group are 
imposed on a covered person's share of the consolidated taxable income 
included in the foreign tax base. The related income is the earnings and 
profits (computed for U.S. Federal income tax purposes) of such other 
member attributable to the activities of that other member that gave 
rise to income included in the foreign tax base with respect to which 
the pre-2011 split taxes were paid or accrued. No inference should be 
drawn from the treatment of foreign consolidated groups under section 
909 as to the determination of the person who paid the foreign income 
tax for U.S. Federal income tax purposes.
    (3) Group relief or other loss-sharing regime splitter 
arrangements--(i) In general. A foreign group relief or other loss-
sharing regime exists when one entity with a loss permits the loss to be 
used to offset the income of one or more entities (shared loss). A pre-
2011 splitter arrangement involving a shared loss exists when the 
following three conditions are met:
    (A) There is an instrument that is treated as indebtedness under the 
laws of the jurisdiction in which the issuer is subject to tax and that 
is disregarded for U.S. Federal income tax purposes (disregarded debt 
instrument). Examples of a disregarded debt instrument include a debt 
obligation between two disregarded entities that are owned by the same 
section 902 corporation, two disregarded entities that are owned by a 
partnership with one or more partners that are section 902 corporations, 
a section 902 corporation and a disregarded entity that is owned by that 
section 902 corporation, or a partnership in which the section 902 
corporation is a partner and a disregarded entity that is owned by such 
partnership.
    (B) The owner of the disregarded debt instrument pays a foreign 
income tax attributable to a payment or accrual on the instrument.
    (C) The payment or accrual on the disregarded debt instrument gives 
rise to a deduction for foreign tax purposes and the issuer of the 
instrument incurs a shared loss that is taken into account under foreign 
law by one or more entities that are covered persons with respect to the 
owner of the instrument.
    (ii) Split taxes and related income. In situations described in 
paragraph (b)(3)(i) of this section, pre-2011 taxes paid or accrued by 
the owner of the disregarded debt instrument with respect to amounts 
paid or accrued on the instrument (up to the amount of the shared loss) 
are pre-2011 split taxes. The related income of a covered person is an 
amount equal to the shared loss, determined without regard to the actual 
amount of the covered person's earnings and profits.
    (4) Hybrid instrument splitter arrangements--(i) In general. A 
hybrid instrument for purposes of this paragraph (b)(4) is an instrument 
that either is treated as equity for U.S. Federal income tax purposes 
but is treated as indebtedness for foreign tax purposes (U.S. equity 
hybrid instrument), or is treated as indebtedness for U.S. Federal 
income tax purposes but is treated as equity for foreign tax purposes 
(U.S. debt hybrid instrument).
    (ii) U.S. equity hybrid instrument splitter arrangement. If the 
issuer of a U.S. equity hybrid instrument is a covered person with 
respect to a section 902 corporation that is the owner of the U.S. 
equity hybrid instrument, there is a pre-2011 splitter arrangement with 
respect to the portion of the pre-2011 taxes paid or accrued by the 
owner section 902 corporation with respect to the amounts on the 
instrument that are deductible by the issuer as interest under the laws 
of a foreign jurisdiction in which the issuer is subject to tax but that 
do not give rise to income for U.S. Federal income tax purposes. Pre-
2011 split taxes paid or accrued by the section 902 corporation equal 
the total amount of pre-2011 taxes paid or accrued by the section 902 
corporation less the amount of pre-2011 taxes that would have been paid 
or accrued had the section 902 corporation not been subject to tax on 
income from the U.S. equity hybrid instrument. The related income of the 
issuer of the U.S. equity hybrid instrument is an amount equal to the 
amounts that are deductible by the issuer for foreign tax purposes, 
determined without regard to the actual

[[Page 21]]

amount of the issuer's earnings and profits.
    (iii) U.S. debt hybrid instrument splitter arrangement. If the owner 
of a U.S. debt hybrid instrument is a covered person with respect to a 
section 902 corporation that is the issuer of the U.S. debt hybrid 
instrument, there is a pre-2011 splitter arrangement with respect to the 
portion of the pre-2011 taxes paid or accrued by the section 902 
corporation on income in an amount equal to the interest (including 
original issue discount) paid or accrued on the instrument that is 
deductible for U.S. Federal income tax purposes but that does not give 
rise to a deduction under the laws of a foreign jurisdiction in which 
the issuer is subject to tax. Pre-2011 split taxes are the pre-2011 
taxes paid or accrued by the section 902 corporation on the income that 
would have been offset by the interest paid or accrued on the U.S. debt 
hybrid instrument had such interest been deductible for foreign tax 
purposes. The related income with respect to a U.S. debt hybrid 
instrument is the gross amount of the interest income recognized for 
U.S. Federal income tax purposes by the owner of the U.S. debt hybrid 
instrument, determined without regard to the actual amount of the 
owner's earnings and profits.
    (c) General rules for applying section 909 to pre-2011 split taxes 
and related income--(1) Annual determination. The determination of 
related income, other income, pre-2011 split taxes, and other taxes, and 
the portion of these amounts that were distributed, deemed paid or 
otherwise transferred or eliminated must be made on an annual basis 
beginning with the first taxable year of the section 902 corporation 
beginning after December 31, 1996 (post-1996 taxable year) in which the 
section 902 corporation paid or accrued a pre-2011 tax with respect to a 
pre-2011 splitter arrangement and ending with the section 902 
corporation's last pre-2011 taxable year. Annual amounts of related 
income and pre-2011 split taxes are aggregated for each separate pre-
2011 splitter arrangement.
    (2) Separate categories. The determination of annual and aggregate 
amounts of related income and pre-2011 split taxes with respect to each 
pre-2011 splitter arrangement must be made for each separate category as 
defined in Sec. 1.904-4(m) of the section 902 corporation, each covered 
person, and any other person that succeeds to the related income and 
pre-2011 split taxes. In the case of a pre-2011 splitter arrangement 
involving a shared loss (as described in paragraph (b)(3) of this 
section), the amount of the related income in each separate category of 
the covered person is equal to the amount of income in that separate 
category that was offset by the shared loss for foreign tax purposes. In 
the case of a pre-2011 splitter arrangement involving a U.S. equity 
hybrid instrument (as described in paragraph (b)(4)(ii) of this 
section), the related income is assigned to the issuer's separate 
categories in the same proportions as the pre-2011 split taxes. Earnings 
and profits, including related income, are assigned to separate 
categories under the rules of Sec. Sec. 1.904-4, 1.904-5, and 1.904-7. 
Foreign income taxes, including pre-2011 split taxes, are assigned to 
separate categories under the rules of Sec. 1.904-6. A section 902 
shareholder must consistently apply methodologies for determining pre-
2011 split taxes and related income with respect to all pre-2011 
splitter arrangements.
    (d) Special rules regarding related income--(1) Annual adjustments. 
In the case of each pre-2011 splitter arrangement involving a reverse 
hybrid or a foreign consolidated group (as described in paragraphs 
(b)(1) and (2) of this section, respectively), a covered person's 
aggregate amount of related income must be adjusted each year by the net 
amount of income and expense attributable to the activities of the 
covered person that give rise to income included in the foreign tax 
base, even if the net amount is negative and regardless of whether the 
section 902 corporation paid or accrued any pre-2011 split taxes in such 
year.
    (2) Effect of separate limitation losses and deficits. Related 
income is determined without regard to the application of Sec. 1.960-
1(i)(4) (relating to the effect of separate limitation losses on 
earnings and profits in another separate category) or section 952(c)(1) 
(relating to certain earnings and profits deficits).

[[Page 22]]

    (3) Pro rata method for distributions out of earnings and profits 
that include both related income and other income. If the earnings and 
profits of a covered person include amounts attributable to both related 
income and other income, including earnings and profits attributable to 
taxable years beginning before January 1, 1997, then distributions, 
deemed distributions, and inclusions out of earnings and profits (for 
example, under sections 301, 304, 367(b), 951(a), 964(e), 1248, or 1293) 
of the covered person are considered made out of related income and 
other income on a pro rata basis. Any reduction of a covered person's 
earnings and profits that results from a payment on stock that is not 
treated as a dividend for U.S. Federal income tax purposes (for example, 
pursuant to section 312(n)(7)) will also reduce related income and other 
income on a pro rata basis.
    (4) Alternative method for distributions out of earnings and profits 
that include both related income and other income. Solely for purposes 
of identifying the amount of pre-2011 split taxes of a section 902 
corporation that are suspended as of the first day of the section 902 
corporation's first post-2010 taxable year, in lieu of the rule set 
forth in paragraph (d)(3) of this section, a section 902 shareholder may 
choose to treat all distributions, deemed distributions, and inclusions 
out of earnings and profits of a covered person as attributable first to 
related income. A section 902 shareholder may choose to use this 
alternative method on a timely filed original income tax return for the 
first post-2010 taxable year in which the shareholder computes an amount 
of foreign income taxes deemed paid with respect to a section 902 
corporation that paid or accrued pre-2011 split taxes. Such choice by a 
section 902 shareholder is evidenced by employing the method on its 
income tax return; the section 902 shareholder need not file a separate 
statement. A section 902 shareholder that chooses this alternative 
method must consistently apply it with respect to all pre-2011 splitter 
arrangements.
    (5) Distributions, deemed distributions, and inclusions of related 
income. Distributions, deemed distributions, and inclusions of related 
income (including indirectly through a partnership) to persons other 
than the payor section 902 corporation retain their character as related 
income with respect to the associated pre-2011 split taxes.
    (6) Carryover of related income. Related income carries over to 
other corporations in the same manner as earnings and profits carry over 
under section 381, Sec. 1.367(b)-7, or similar rules, and retains its 
character as related income with respect to the associated pre-2011 
split taxes.
    (7) Related income taken into account by a section 902 shareholder. 
Related income will be considered taken into account by a section 902 
shareholder to the extent that the related income is recognized as gross 
income by the section 902 shareholder, or by an affiliated corporation 
described in paragraph (d)(9) of this section, upon a distribution, 
deemed distribution, or inclusion (such as under section 951(a)) out of 
the earnings and profits of the covered person attributable to such 
related income.
    (8) Related income taken into account by a payor section 902 
corporation. Related income will be considered taken into account by a 
payor section 902 corporation to the extent that:
    (i) The related income is reflected in the earnings and profits of 
such section 902 corporation for U.S. Federal income tax purposes by 
reason of a distribution, deemed distribution, or inclusion out of the 
earnings and profits of the covered person attributable to such related 
income; or
    (ii) The related income is reflected as a positive adjustment to the 
earnings and profits of such section 902 corporation for U.S. Federal 
income tax purposes by reason of the section 902 corporation and the 
covered person combining in a transaction described in section 381(a)(1) 
or (a)(2).
    (9) Related income taken into account by an affiliated group of 
corporations that includes a section 902 shareholder. A section 902 
shareholder will be considered to have taken related income into account 
if one or more members of an affiliated group of corporations (as 
defined in section 1504) that files a consolidated Federal income tax 
return

[[Page 23]]

that includes the section 902 shareholder takes the related income into 
account.
    (10) Distributions of previously-taxed earnings and profits. 
Distributions and deemed distributions described in paragraph (d) of 
this section (including in the case of a section 902 shareholder that 
has chosen the alternative method described in paragraph (d)(4) of this 
section) do not include distributions of amounts described in section 
959(c)(1) or (c)(2), which are distributed before amounts described in 
section 959(c)(3).
    (e) Special rules regarding pre-2011 split taxes--(1) Taxes deemed 
paid pro-rata out of pre-2011 split taxes and other taxes. If the pre-
2011 taxes of a section 902 corporation include both pre-2011 split 
taxes and other taxes, then foreign income taxes deemed paid under 
section 902 or 960 or otherwise removed from post-1986 foreign income 
taxes in pre-2011 taxable years will be treated as attributable to pre-
2011 split taxes and other taxes on a pro-rata basis.
    (2) Pre-2011 split taxes deemed paid in pre-2011 taxable years. Pre-
2011 split taxes deemed paid in pre-2011 taxable years in connection 
with a dividend paid to a shareholder described in section 902(b) retain 
their character as pre-2011 split taxes. The section 902(b) shareholder 
will be treated as the payor section 902 corporation with respect to 
those pre-2011 split taxes.
    (3) Carryover of pre-2011 split taxes. Pre-2011 split taxes that 
carry over to another foreign corporation, including under section 381, 
Sec. 1.367(b)-7 or similar rules, retain their character as pre-2011 
split taxes. The transferee foreign corporation will be treated as the 
payor section 902 corporation with respect to those pre-2011 split 
taxes.
    (4) Determining when pre-2011 split taxes are no longer treated as 
pre-2011 split taxes. For each pre-2011 splitter arrangement, as related 
income is taken into account by the payor section 902 corporation or a 
section 902 shareholder as provided in paragraph (d) of this section, a 
ratable portion of the associated pre-2011 split taxes will no longer be 
treated as pre-2011 split taxes. In the case of a pre-2011 splitter 
arrangement involving a reverse hybrid or a foreign consolidated group 
(as described in paragraphs (b)(1) and (2) of this section, 
respectively), if aggregate related income is reduced to zero (other 
than as a result of a distribution, deemed distribution, or inclusion 
described in paragraph (d) of this section) or less than zero, pre-2011 
split taxes will retain their character as pre-2011 split taxes until 
the amount of aggregate related income is positive and the related 
income is taken into account by the payor section 902 corporation or a 
section 902 shareholder as provided in paragraph (d) of this section.
    (f) Rules relating to partnerships and trusts--(1) Taxes paid or 
accrued by partnerships. In the case of foreign income taxes paid or 
accrued by a partnership, the taxes will be treated as pre-2011 split 
taxes to the extent such taxes are allocated to one or more section 902 
corporations and would be pre-2011 split taxes if the partner section 
902 corporation had paid or accrued the taxes directly on the date such 
taxes are included by the section 902 corporation under sections 702 and 
706(a). Further, any foreign income taxes subject to section 909 will be 
suspended in the hands of the partner section 902 corporation.
    (2) Section 704(b) allocations. Partnership allocations that satisfy 
the requirements of section 704(b) and the regulations thereunder will 
not constitute pre-2011 splitter arrangements except to the extent the 
arrangement is otherwise described in paragraph (b) of this section (for 
example, a payment or accrual on a disregarded debt instrument that 
gives rise to a shared loss).
    (3) Trusts. Rules similar to the rules of paragraph (f)(1) of this 
section will apply in the case of any trust with one or more 
beneficiaries that is a section 902 corporation.
    (g) Interaction between section 909 and other Code provisions--(1) 
Section 904(c). Section 909 does not apply to excess foreign income 
taxes that were paid or accrued in pre-2011 taxable years and carried 
forward and deemed paid or accrued under section 904(c) in a post-2010 
taxable year.
    (2) Section 905(a). For purposes of determining in post-2010 taxable 
years the allowable deduction for foreign income taxes paid or accrued 
under section 164(a), the carryover of excess foreign income taxes under 
section 904(c),

[[Page 24]]

and the extended period for claiming a credit or refund under section 
6511(d)(3)(A), foreign income taxes to which section 909 applies are 
first taken into account and treated as paid or accrued in the year in 
which the related income is taken into account, and not in the earlier 
year to which the tax relates (determined without regard to section 
909).
    (3) Section 905(c). If a redetermination of foreign income taxes 
claimed as a direct credit under section 901 occurs in a post-2010 
taxable year and the foreign tax redetermination relates to a pre-2011 
taxable year, to the extent such foreign tax redetermination increased 
the amount of foreign income taxes paid or accrued with respect to the 
pre-2011 taxable year (for example, due to an additional assessment of 
foreign tax or a payment of a previously accrued tax not paid within two 
years), section 909 will not apply to such taxes. If a redetermination 
of foreign tax paid or accrued by a section 902 corporation occurs in a 
post-2010 taxable year and increases the amount of foreign income taxes 
paid or accrued by the section 902 corporation with respect to a pre-
2011 taxable year (for example, due to an additional assessment of 
foreign tax or a payment of a previously accrued tax not paid within two 
years), such taxes will be treated as pre-2011 taxes. Section 909 will 
apply to such taxes if they are pre-2011 split taxes and the taxes will 
be suspended in the post-2010 taxable year in which they would otherwise 
be taken into account as a prospective adjustment to the section 902 
corporation's pools of post-1986 foreign income taxes.
    (4) Other foreign tax credit provisions. Section 909 does not affect 
the applicability of other restrictions or limitations on the foreign 
tax credit under existing law, including, for example, the 
substantiation requirements of section 905(b).
    (h) Effective/applicability date. This section applies to foreign 
income taxes paid or accrued by section 902 corporations in pre-2011 
taxable years for purposes of computing foreign income taxes deemed paid 
with respect to distributions or inclusions out of earnings and profits 
of section 902 corporations in taxable years of the section 902 
corporation ending after February 9, 2015. See 26 CFR 1.909-6T (revised 
as of April 1, 2014) for rules applicable to foreign income taxes paid 
or accrued by section 902 corporations in pre-2011 taxable years for 
purposes of computing foreign income taxes deemed paid with respect to 
distributions or inclusions out of earnings and profits of section 902 
corporations in taxable years of the section 902 corporation beginning 
after December 31, 2010, and ending on or before February 9, 2015.

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



Sec. 1.910  [Reserved]



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

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

[[Page 25]]

services performed after December 31, 1981.
    (b) Scope. Section 1.911-2 provides rules for determining whether an 
individual qualifies to make an election under section 911. Section 
1.911-3 provides rules for determining the amount of foreign earned 
income that is excludable under section 911(a)(1). Section 1.911-4 
provides rules for determining the housing cost amount and the portions 
excludable under section 911(a)(2) or deductible under section 
911(c)(3). Section 1.911-5 provides special rules applicable to married 
couples. Section 1.911-6 provides for the disallowance of deductions, 
exclusions, and credits attributable to amounts excluded under section 
911. Section 1.911-7 provides procedural rules for making or revoking an 
election under section 911. Section 1.911-8 provides a reference to 
rules applicable to taxable years beginning before January 1, 1982.

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

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



Sec. 1.911-2  Qualified individuals.

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


If an individual has submitted a statement of nonresidence to the 
authorities of a foreign country the accuracy of which has not been 
resolved as of any date when a determination of the individual's bona 
fide residence is being made, then the individual will

[[Page 26]]

not be considered a bona fide resident of the foreign country as of that 
date.
    (d) Determination of physical presence. For purposes of paragraph 
(a)(2)(ii) of this section, the following rules apply.
    (1) Twelve-month test. A period of twelve consecutive months may 
begin with any day but must end on the day before the corresponding day 
in the twelfth succeeding month. The twelve-month period may begin 
before or after arrival in a foreign country and may end before or after 
departure.
    (2) 330-day test. The 330 full days need not be consecutive but may 
be interrupted by periods during which the individual is not present in 
a foreign country. In computing the minimum 330 full days of presence in 
a foreign country or countries, all separate periods of such presence 
during the period of twelve consecutive months are aggregated. A full 
day is a continuous period of twenty-four hours beginning with midnight 
and ending with the following midnight. An individual who has been 
present in a foreign country and then travels over areas not within any 
foreign country for less than twenty-four hours shall not be deemed 
outside a foreign country during the period of travel. If an individual 
who is in transit between two points outside the United States is 
physically present in the United States for less than twenty-four hours, 
such individual shall not be treated as present in the United States 
during such transit but shall be treated as travelling over areas not 
within any foreign country. For purposes of this paragraph (d)(2), the 
term ``transit between two points outside the United States'' has the 
same meaning that it has when used in section 7701(b)(6)(C).
    (3) Illustrations of the physical presence requirement. The physical 
presence requirement of paragraph (a)(2)(ii) of this section is 
illustrated by the following examples:

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

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

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

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

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

------------------------------------------------------------------------
                                                               Full days
                                                                   in
                                                                foreign
                                                                country
------------------------------------------------------------------------
Jan. 21, 1983 through Aug. 21, 1983..........................        213
Aug. 22, 1983 through Sept. 5, 1983..........................          0
Sept. 6, 1983 through Dec. 31, 1983..........................        117

[[Page 27]]

 
Jan. 1, 1984 through Jan. 20, 1984...........................          0
                                                              ----------
    Total full days..........................................        330
------------------------------------------------------------------------

    (e) Special rules. For purposes only of establishing that an 
individual is a qualified individual under paragraph (a) of this 
section, residence or presence in a foreign country while there employed 
by the U.S. government or any agency or instrumentality of the U.S. 
government counts towards satisfaction of the requirements of Sec. 
1.911-2(a). (But see section 911(b)(1)(B)(ii) and Sec. 1.911-3(c)(3) 
for the rule excluding amounts paid by the U.S. government to an 
employee from the definition of foreign earned income.) Time spent in a 
foreign country prior to January 1, 1982, counts toward satisfaction of 
the bona fide residence and physical presence requirements, even though 
no exclusion or deduction may be allowed under section 911 for income 
attributable to services performed during that time. For purposes or 
paragraph (a)(2)(ii) of this section, the term ``resident of the United 
States'' includes an individual for whom a valid election is in effect 
under section 6013 (g) or (h) for the taxable year or years during which 
the physical presence requirement is satisfied.
    (f) Waiver of period of stay in foreign country due to war or civil 
unrest. Notwithstanding the requirements of paragraph (a) of this 
section, an individual whose tax home is in, a foreign country, and who 
is a bona fide resident of, or present in a foreign country for any 
period, who leaves the foreign country after August 31, 1978, before 
meeting the requirements of paragraph (a) of this section, may as 
provided in this paragraph, qualify to make an election under section 
911(a) and Sec. 1.911-7(a). If the Secretary determines, after 
consultation with the Secretary of State or his delegate, that war, 
civil unrest, or similar adverse conditions existed in a foreign 
country, then the Secretary shall publish the name of the foreign 
country and the dates between which such conditions were deemed to 
exist. In order to qualify to make an election under this paragraph, the 
individual must establish to the satisfaction of the Secretary that the 
individual left a foreign country, the name of which has been published 
by the Secretary, during the period when adverse conditions existed and 
that the individual could reasonably have expected to meet the 
requirements of paragraph (a) of this section but for the adverse 
conditions. The individual shall attach to his return for the taxable 
year a statement that the individual expected to meet the requirements 
of paragraph (a) of this section but for the conditions in the foreign 
country which precluded the normal conduct of business by the 
individual. Such individual shall be treated as a qualified individual, 
but only for the actual period of residence or presence. Thus, in 
determining the number of the individual's qualifying days, only days 
within the period of actual residence or presence shall be counted.
    (g) United States. The term ``United States'' when used in a 
geographical sense includes any territory under the sovereignty of the 
United States. It includes the states, the District of Columbia, the 
possessions and territories of the United States, the territorial waters 
of the United States, the air space over the United States, and the 
seabed and subsoil of those submarine areas which are adjacent to the 
territorial waters of the United States and over which the United States 
has exclusive rights, in accordance with international law, with respect 
to the exploration and exploitation of natural resources.
    (h) Foreign country. The term ``foreign country'' when used in a 
geographical sense includes any territory under the sovereignty of a 
government other than that of the United States. It includes the 
territorial waters of the foreign country (determined in accordance with 
the laws of the United States), the air space over the foreign country, 
and the seabed and subsoil of those submarine areas which are adjacent 
to the territorial waters of the foreign country and over which the 
foreign country has exclusive rights, in accordance with international 
law,

[[Page 28]]

with respect to the exploration and exploitation of natural resources.

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

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



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

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

[[Page 29]]

for reporting any amounts included in gross income.
    (2) Limitation--(i) In general. The term ``section 911(a)(1) 
limitation'' means the amount of foreign earned income for a taxable 
year which may be excluded under section 911(a)(1). The section 
911(a)(1) limitation shall be equal to the lesser of the qualified 
individual's foreign earned income for the taxable year in excess of 
amounts that the individual elected to exclude from gross income under 
section 911(a)(2) or the product of the annual rate for the taxable year 
(as specified in paragraph (d)(2)(ii) of this section) multiplied by the 
following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.137

    (ii) Annual rate for the taxable year. The annual rate for the 
taxable year is the rate set forth in section 911(b)(2)(A).
    (3) Number of qualifying days. For purposes of section 911 and the 
regulations thereunder, the number of qualifying days is the number of 
days in the taxable year within the period during which the individual 
met the tax home requirement and either the bona fide residence 
requirement or the physical presence requirement of Sec. 1.911-2(a). 
Although the period of bona fide residence must include an entire 
taxable year, the entire uninterrupted period of residence may include 
fractional parts of a taxable year. For instance, if an individual who 
was a calendar year taxpayer established a tax home and a residence in a 
foreign country as of November 1, 1982, and maintained the tax home and 
the residence through March 31, 1984, then the uninterrupted period of 
bona fide residence includes fractional parts of the years 1982 and 
1984, and all of 1983. The number of qualifying days in 1982 is sixty-
one. The number of qualifying days in 1983 is 365. The number of 
qualifying days in 1984 is ninety-one. The period during which the 
physical presence requirement of Sec. 1.911-2(a)(2)(ii) is met is any 
twelve consecutive month period during which the individual is 
physically present in one or more foreign countries for 330 days and the 
individual's tax home is in a foreign country during each day of such 
physical presence. Such period may include days when the individual is 
not physically present in a foreign country, and days when the 
individual does not maintain a tax home in a foreign country. Such 
period may include fractional parts of a taxable year. Thus, if an 
individual's period of physical, presence is the twelve-month period 
beginning June 1, 1982, and ending May 31, 1983, the number of 
qualifying days in 1982 is 214 and the number of qualifying days in 1983 
is 151.
    (e) Attribution rules--(1) In general. Foreign earned income is 
considered to be earned in the taxable year in which the individual 
performed the services giving rise to the income. If income is earned in 
one taxable year and received in another taxable year, then, for 
purposes of determining the amount of foreign earned income that the 
individual may exclude under section 911(a), the individual must 
attribute the income to the taxable year in which the services giving 
rise to the income were performed. Thus, any reimbursement would be 
attributable to the taxable year in which the services giving rise to 
the obligation to pay the reimbursement were performed, not the taxable 
year in which the reimbursement was received. For example, tax 
equalization payments are normally received in the year after the year 
in which the services giving rise to the obligation to pay the tax 
equalization payment were performed. Therefore, such payments will 
almost always have to be attributed to the prior year. Foreign earned 
income attributable to services performed in a preceding taxable year 
shall be excludable from gross income in the year of receipt only to the 
extent such amount could have been excluded under paragraph (d)(1) in 
the preceding taxable year, had such amount been received in the 
preceding taxable year. The taxable year to which income is attributable 
will be determined on the basis of all the facts and circumstances.
    (2) Priority of use of the section 911(a)(1) limitation. Foreign 
earned income received in the year in which it is earned shall be 
applied to the section 911(a)(1) limitation for that year before 
applying income earned in that year

[[Page 30]]

that is received in any other year. Foreign earned income that is earned 
in one year and received in another year shall be applied to the section 
911(a)(1) limitation for the year in which it was earned, on a year by 
year basis, in any order that the individual chooses. (But see section 
911(b)(1)(B)(iv)). An individual may not amend his return to change the 
treatment of income with respect to the section 911(a)(1) exclusion 
after the period provided by section 6511(a). The special period of 
limitation provided by section 6511(d)(3) does not apply for this 
purpose. For example, C, a qualified individual, receives an advance 
bonus of $10,000 in 1982, salary of $70,000 in 1983, and a performance 
bonus of $10,000 in 1984, all of which are foreign earned income for 
1983. C has a section 911(a)(1) limitation for 1983 of $80,000, and has 
no housing cost amount exclusion. On his income tax return for 1983, C 
elects to exclude foreign earned income of $70,000 received in 1983. C 
may also exclude his $10,000 advance bonus received in 1982 (by filing 
an amended return for 1982), or he may exclude the $10,000 performance 
bonus received in 1984 on his 1984 income tax return. However, C may not 
exclude part of the 1982 bonus and part of the 1984 bonus.
    (3) Exception for year-end payroll period. Notwithstanding paragraph 
(e)(1) of this section, salary or wage payments of a cash basis taxpayer 
shall be attributed entirely to the year of receipt under the following 
circumstances:
    (i) The period for which the payment is made is a normal payroll 
period of the employer which regularly applies to the employee;
    (ii) The payroll period includes the last day of the employee's 
taxable year;
    (iii) The payroll period does not exceed 16 days; and
    (iv) The payment is part of a normal payroll of the employer that is 
distributed at the same time, in relation to the payroll period, that 
such payroll would normally be distributed, and is distributed before 
the end of the next succeeding payroll period.
    (4) Attribution of bonuses and substantially nonvested property to 
periods in which services were performed--(i) In general. Bonuses and 
substantially nonvested property are attributable to all of the services 
giving rise to the income on the basis of all the facts and 
circumstances. If an individual receives a bonus or substantially 
nonvested property (as defined in Sec. 1.83-3(b)) and it is determined 
to be attributable to services performed in more than one taxable year, 
then, for purposes of determining the amount eligible for exclusion from 
gross income in the year the bonus is received or the property vests, a 
portion of such amount shall be treated as attributable to services 
performed in each taxable year (or portion thereof) during the period 
when services giving rise to the bonus or the substantially nonvested 
property were performed. Such portion shall be determined by dividing 
the amount of the bonus or the excess of the fair market value of the 
vested property over the amount paid, if any, for the vested property, 
by the number of months in the period when services giving rise to such 
amount were performed, and multiplying the quotient by the number of 
months in such period in the taxable year. For purposes of this section, 
the term ``month'' means a calendar month. A fraction of a calendar 
month shall be deemed a month if it includes fifteen or more days.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (e)(4).

    Example 1. A, an employee of M Corporation during all of 1983 and 
1984, worked in the United States from January 1 through April 30, 1983, 
and received $12,000 of salary for that period. A worked in country F 
from May 1, 1983 through the end of 1984, and is a qualified individual 
under Sec. 1.911-2(a) for that period. For the period from May 1 
through December 31, 1983, A received $32,000 of salary. M pays a bonus 
on December 20, 1983 to each of M's employees in an amount equal to 10 
percent of the employee's regular wages or salary for the 1983 calendar 
year. The amount of A's bonus is $4,400 for 1983. The portion of A's 
bonus that is attributable to services performed in country F and is 
foreign earned income for 1983 is $3,200, or $32,000 x 10 percent. The 
remaining $1,200 of A's bonus is attributable to services performed in 
the United States, and is not foreign earned income.
    Example 2. The facts are the same as in example 1, except that M 
determines bonuses

[[Page 31]]

separately for each country based on the productivity of the employees 
in that country. M pays a bonus to employees in country F, in the amount 
of 15 percent of each employee's wages or salary earned in country F. 
A's country F bonus is $4,800 for 1983 ($32,000 x 15 percent), and is 
foreign earned income for 1983. If A also receives a bonus (or if A's 
bonus is increased) for working in the United States during 1983, that 
amount is not foreign earned income.
    Example 3. X corporation offers its employees a bonus of $40,000 if 
the employee accepts employment in a foreign country and remains in a 
foreign country for a period of at least four years. A, an employee of 
X, is a calendar year and cash basis taxpayer. A accepts employment with 
X in foreign country F. A begins work in F on July 1, 1983 and continues 
to work in F for X until June 30, 1987. In 1987 X pays A a $40,000 
bonus. The bonus is attributable to services A performed from July 1, 
1983 through June 30, 1987. The amount of the bonus attributable to 1987 
is $5,000 (($40,000 / 48) x 6). The amount of the bonus attributable to 
1986 is $10,000 (($40,000 / 48) x 12). A may exclude the $10,000 
attributable to 1986 only to the extent that amount could have been 
excluded under section 911(a)(1) had A received it in 1986. The 
remaining $25,000 is attributable to services performed in taxable years 
before 1986. Such amounts may not be excluded under section 911 because 
they are received after the close of the taxable year following the 
taxable year in which the services giving rise to the income were 
performed.

    (iii) Special rule for elections under section 83(b). If an 
individual receives substantially nonvested property and makes an 
election under section 83(b) and Sec. 1.83-2(a) to include in his gross 
income the amount determined under section 83(b)(1)(A) and (B) and Sec. 
1.83-2(a) for the taxable year in which the property is transferred (as 
defined in Sec. 1.83-3(a)), then, for the purpose of determining the 
amount eligible for exclusion in the year of receipt, the individual may 
elect either of the following options:
    (A) Substantially nonvested property may be treated as attributable 
entirely to services performed in the taxable year in which an election 
to include it in income is made. If so treated, then the amount 
otherwise included in gross income as determined under Sec. 1.83-2(a) 
will be excludable under section 911(a) for such year subject to the 
limitation provided in Sec. 1.911-3(d)(2) for such year.
    (B) A portion of the substantially nonvested property may be treated 
as attributable to services performed or to be performed in each taxable 
year during which the substantial risk of forfeiture (as defined in 
section 83(c) and Sec. 1.83-3(c)) exists. The portion treated as 
attributable to services performed or to be performed in each taxable 
year is determined by dividing the amount of the substantially nonvested 
property included in gross income as determined under Sec. 1.83-2(a) by 
the number of months during the period when a substantial risk of 
forfeiture exists. The quotient is multiplied by the total number of 
months in the taxable year during which a substantial risk of forfeiture 
exists. The amount determined to be attributable to services performed 
in the year the election is made shall be excluded from gross income for 
such year as provided in paragraph (d)(2) of this section. Amounts 
treated as attributable to services performed in subsequent taxable 
years shall be excludable in the year of receipt only to the extent such 
amounts could be excluded under paragraph (d)(2) of this section in such 
subsequent years. An individual may obtain such additional exclusion by 
filing an amended return for the taxable year in which the property was 
transferred. The individual may only amend his or her return within the 
period provided by section 6511(a) and the regulations thereunder.
    (5) Moving expense reimbursements--(i) Source of reimbursements. For 
the purpose of determining whether a moving expense reimbursement is 
attributable to services performed within a foreign country or within 
the United States, in the absence of evidence to the contrary, the 
reimbursement shall be attributable to future services to be performed 
at the new principal place of work. Thus, a reimbursement received by an 
employee from his employer for the expenses of a move to a foreign 
country will generally be attributable to services performed in the 
foreign country. A reimbursement received by an employee from his 
employer for the expenses of a move from a foreign country to the United 
States will generally be attributable to services performed in the 
United States. For purposes of this paragraph (e)(5), evidence to the 
contrary includes, but is not

[[Page 32]]

limited to, an agreement, between the employer and the employee, or a 
statement of company policy, which is reduced to writing before the move 
to the foreign country and which is entered into or established to 
induce the employee or employees to move to a foreign country. The 
writing must state that the employer will reimburse the employee for 
moving expenses incurred in returning to the United States regardless of 
whether the employee continues to work for the employer after the 
employee returns to the United States. The writing may contain 
conditions upon which the right to reimbursement is determined as long 
as the conditions set forth standards that are definitely ascertainable 
and the conditions can only be fulfilled prior to, or through completion 
of the employee's return move to the United States that is the subject 
of the writing. In no case will an oral agreement or statement of 
company policy concerning moving expenses be considered evidence to the 
contrary. For the purpose of determining whether a storage expense 
reimbursement is attributable to services performed within a foreign 
country, in the case of storage expenses incurred after December 31, 
1983, the reimbursement shall be attributable to services performed 
during the period of time for which the storage expenses are incurred.
    (ii) Attribution of foreign source reimbursements to taxable years 
in which services are performed--(A) In general. If a reimbursement for 
moving expenses is determined to be from foreign sources under paragraph 
(e)(5)(i) of this section, then for the purpose of determining the 
amount eligible for exclusion in accordance with paragraphs (d)(2) and 
(e)(2) of this section, the reimbursement shall be considered 
attributable to services performed in the year of the move as long as 
the individual is a qualified individual for a period that includes 120 
days in the year of the move. The period that is used in determining the 
number of qualifying days for purposes of the individual's section 
911(a)(1) limitation (under paragraph (d)(2) of this section) must also 
be used in determining whether the individual is a qualified individual 
for a period that includes 120 days in the year of the move. If the 
individual is not a qualified individual for such period, then the 
individual shall treat a portion of the reimbursement as attributable to 
services performed in the year of the move, and a portion as 
attributable to services performed in the succeeding taxable year, if 
the move is from the United States to a foreign country, or to the prior 
taxable year, if the move is from a foreign country to the United 
States. The portion of the reimbursement treated as attributable to 
services performed in the year of the move shall be determined by 
multiplying the total reimbursement by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.138


The remaining portion of the reimbursement shall be treated as 
attributable to services performed in the year succeeding or preceding 
the year of the move. Amounts treated as attributable to services 
performed in a year succeeding or preceding the year of the move shall 
be excludable in the year of receipt only to the extent such amounts 
could be excluded under paragraph (d)(2) of this section in such 
succeeding or preceding year.
    (B) Moves beginning before January 1, 1984. Notwithstanding 
paragraph (e)(5)(ii)(A) of this section, this paragraph (e)(5)(ii)(B) 
shall apply for moves begun before January 1, 1984. If a reimbursement 
for moving expenses is determined to be from foreign sources under 
paragraph (e)(5)(i) of this section, then for the purpose of determining 
the amount eligible for exclusion in accordance with paragraphs

[[Page 33]]

(d)(2) and (e)(2) of this section, the reimbursement shall be considered 
attributable to services performed in the year of the move. However, if 
the individual does not qualify under section 911(d)(1) and Sec. 1.911-
2(a) for the entire taxable year of the move, then the individual shall 
treat a portion of the reimbursement as attributable to services 
performed in the succeeding taxable year, if the move is from the United 
States to a foreign country, or to the prior taxable year, if the move 
is from a foreign country to the United States. The portion of the 
reimbursement treated as attributable to services performed in the year 
succeeding or preceding the move shall be determined by multiplying the 
total reimbursement by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.139


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

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

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

[[Page 34]]

other foreign earned income in 1982 is $58,000. C elects under paragraph 
(e)(4)(iii)(B) of this section to treat the stock as if earned over the 
period of the substantial risk of forfeiture. The number of months in 
the period of the substantial risk of forfeiture is thirty-four. The 
number of months in the taxable year 1982 within the period of foreign 
employment is ten. For purposes of determining C's section 911(a)(1) 
limitation, $4,412 (($15,000/34) x 10) of the amount included in gross 
income under section 83(b) is treated as attributable to services 
performed in 1982, $5,294 is treated as attributable to services to be 
performed in 1983, and $5,294 is treated as attributable to services to 
be performed in 1984. In 1982, C excludes $62,412 under section 
911(a)(1). That is the lesser of foreign earned income for 1982 ($58,000 
+ $4,412) or the annual rate for the taxable year multiplied by a 
fraction the numerator of which is C's qualifying days in the taxable 
year and the denominator of which is the number of days in the taxable 
year ($75,000 x 306/365). C continues to perform services in foreign 
country J throughout 1983 and 1984. C would be able to exclude the 
remaining $5,294 attributable to services performed in 1983 and $5,294 
attributable to services performed in 1984 if those amounts would be 
excludable if they had been received in 1983 or 1984 respectively. If C 
is entitled to exclude the additional amounts, C must claim the 
exclusion by filing an amended return for 1982.
    Example 4. D is a U.S. citizen and a calendar year taxpayer. In 
September, 1984 D moves to a foreign country K. D is physically present 
in K, and D's tax home is in K, from September 15, 1984 through December 
31, 1985. D receives $6,000 in April, 1985 from his employer, as a 
reimbursement for expenses of moving to K, pursuant to a written 
agreement that such moving expenses would be reimbursed to D upon 
successful completion of 6 months employment in K. Under paragraph 
(e)(15)(i) of this section, the reimbursement is attributable to 
services performed in K. Under the physical presence test of Sec. 
1.911-2(a)(2)(ii), among other periods D is a qualified individual for 
the period of August 10, 1984 through August 9, 1985, which includes 144 
days in 1984. Under paragraph (e)(5)(ii)(A) of this section, for the 
purpose of determining the amount eligible for exclusion, the 
reimbursement is considered attributable to services performed in 1984 
(the year of the move) because D is a qualified individual under Sec. 
1.911-2(a) for a period that includes 120 days in 1984. The 
reimbursement may be excluded under paragraphs (d)(2) and (e)(2) of this 
section, to the extent that D's foreign earned income for 1984 that was 
earned and received in 1984 was less than the annual rate for the 
taxable year multiplied by the number of D's qualifying days in the 
taxable year over the number of days in D's taxable year ($80,000 x 144/
366), or $31,475.
    Example 5. The facts are the same as in example 4 except that D is 
not a qualified individual under the physical presence test, but is a 
qualified individual under the bona fide residence test for the period 
of September 15, 1984 through December 31, 1985. Under paragraph 
(e)(5)(ii)(A) of this section, for the purpose of determining the amount 
eligible for exclusion, the reimbursement is considered attributable to 
services performed in 1984 and 1985 because D is not a qualified 
individual for a period that includes 120 days in 1984 (the year of the 
move). The portion of the reimbursement treated as attributable to 
services performed in 1984 is $6,000 x 108/366, or $1,770, and may be 
excluded, subject to D's 1984 section 911(a)(1) limitation. The balance 
of the reimbursement, $4,230, is treated as attributable to services 
performed in 1985, and may be excluded to the extent provided in 
paragraphs (d)(2) and (e)(2) of this section.
    Example 6. The facts are the same as in example 4, with the 
following additions. Before D moved to K, D and his employer signed a 
written agreement that D would perform services for the employer for at 
least one year, primarily in country K, and, if D did not voluntarily 
cease to work for the employer primarily in country K before one year 
had elapsed, the employer would reimburse D for one half of D's 
expenses, up to a maximum of $4,000, of moving back to the United 
States. The agreement also stated that, if D did not voluntarily leave 
the employment in K before two years had elapsed, the employer would 
reimburse D for all of D's reasonable expenses of moving back to the 
United States. The agreement further stated that D's right to 
reimbursement would not be conditioned upon the performance of services 
after D ceased to work in K. D worked in country K for all of 1985. On 
January 1, 1986, D left K and moved to the United States. In February, 
1986 the employer paid D $3,500 as reimbursement for one-half of D's 
expenses of moving to the United States. Although D did not fulfill the 
condition in the agreement to receive full reimbursement, all of the 
conditions in the agreement set forth definitely ascertainable standards 
and no condition could be fulfilled after D moved back to the United 
States. The agreement fulfills the requirements of paragraph (e)(5)(i) 
of this section, and therefore is evidence that the reimbursement should 
not be attributable to future services to be performed at D's new 
principal place of work. Under the facts and circumstances, the 
reimbursement is attributable to services performed in K. Under 
paragraph (e)(5)(ii)(A) of this section, the entire reimbursement is 
attributable to services performed in 1985. The amount attributable to

[[Page 35]]

1985 may be excluded to the extent provided in paragraphs (d)(2) and 
(e)(2) of this section.

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

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



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

    (a) Definition of housing cost amount. The term ``housing cost 
amount'' means an amount equal to the reasonable expenses paid or 
incurred (as defined in section 7701(a)(25)) during the taxable year by 
or on behalf of the individual attributable to housing in a foreign 
country for the individual and any spouse or dependents who reside with 
the individual (or live in a second foreign household described in 
paragraph (b)(5) of this section) less the base housing amount as 
defined in paragraph (c) of this section. The housing cost amount must 
be reduced by the amount of any military or section 912 allowance or 
similar allowance excludable from gross income that is intended to 
compensate the individual or the individual's spouse in whole or in part 
for the expenses of housing during the same period for which the 
individual claims a housing cost amount exclusion or deduction.
    (b) Housing expenses--(1) Included expenses. For purposes of 
paragraph (a) of this section, housing expenses include rent, the fair 
rental value of housing provided in kind by the employer, utilities 
(other than telephone charges), real and personal property insurance, 
occupancy taxes not described in paragraph (b)(2)(v) of this section, 
nonrefundable fees paid for securing a leasehold, rental of furniture 
and accessories, household repairs, and residential parking.
    (2) Excluded expenses. Housing expenses do not include:
    (i) The cost of house purchase, improvements, and other costs that 
are capital expenditures;
    (ii) The cost of purchased furniture or accessories or domestic 
labor (maids, gardeners, etc.);
    (iii) Amortized payments of principal with respect to an evidence of 
indebtedness secured by a mortgage on the taxpayer's housing;
    (iv) Depreciation of housing owned by the taxpayer, or amortization 
or depreciation of capital improvements made to housing leased by the 
taxpayer;
    (v) Interest and taxes deductible under section 163 or 164 or other 
amounts deductible under section 216(a) (relating to deduction of 
interest and taxes by cooperative housing corporation tenant);
    (vi) The expenses of more than one foreign household except as 
provided in paragraph (b)(5) of this section;
    (vii) Expenses excluded from gross income under section 119;
    (viii) Expenses claimed as deductible moving expenses under section 
217; or
    (ix) The cost of a pay television subscription.
    (3) Limitation. Housing expenses are taken into account for purposes 
of this section only to the extent attributable to housing for portions 
of the taxable year within the period during which the individual 
satisfies the requirements of Sec. 1.911-2(a). Housing expenses are not 
taken into account for the period during which the value of the 
individual's housing is excluded from gross income under section 119, 
unless the individual maintains a second foreign household described in 
paragraph (b)(5) of this section. If an individual maintains two foreign 
households, only expenses incurred with respect to the abode which bears 
the closest relationship, not necessarily geographic, with respect to 
the individual's tax home shall be taken into account, unless one of the 
households is a second foreign household.
    (4) Reasonableness. An amount paid for housing shall not be treated 
as reasonable, for purposes of paragraph (a) of this section, to the 
extent that the expense is lavish or extravagant under the 
circumstances.
    (5) Expenses of a second foreign household--(i) In general. The term 
``second foreign household'' means a separate abode maintained by an 
individual outside of the U.S. for his or her spouse or dependents (who, 
if minors, are in the individual's legal custody or the joint custody of 
the individual and the individual's spouse) at a place other than the 
tax home of the individual because of adverse living conditions at the 
individual's tax home. If an individual

[[Page 36]]

maintains a second foreign household the expenses of the second foreign 
household may be included in the individual's housing expenses under 
paragraph (b)(1) of this section. Under no circumstances shall an 
individual be considered to maintain more than one second foreign 
household at the same time.
    (ii) Adverse living conditions. Solely for purposes of paragraph 
(b)(5)(i) of this section, adverse living conditions are living 
conditions which are dangerous, unhealthful, or otherwise adverse. 
Adverse living conditions include a state of warfare or civil 
insurrection in the general area of the individual's tax home. Adverse 
living conditions exist if the individual resides on the business 
premises of the employer for the convenience of the employer and, 
because of the nature of the business (for example, a construction site 
or drilling rig), it is not feasible for the employer to provide housing 
for the individual's spouse or dependents. The criteria used by the 
Department of State in granting a separate maintenance allowance are 
relevant, but not determinative, for purposes of determining whether a 
separate household is provided because of adverse living conditions.
    (c) Base housing amount--(1) In general. The base housing amount is 
equal to the product of 16 percent of the annual salary of an employee 
of the United States who is compensated at a rate equal to the annual 
salary rate paid for step 1 of grade GS-14, multiplied by the following 
fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.140


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

[[Page 37]]

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

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

[[Page 38]]

is attributable to employer provided amounts. C may deduct the lesser of 
her housing cost amount ($5,843) or her foreign earned income in excess 
of amounts excluded under section 911(a) ($35,000-25,479 = $9,521). 
Thus, C's housing cost amount deduction is $5,843.
    Example 5. The facts are the same as in example 4 except that C had 
$30,000 of foreign earned income for 1982, none of which was 
attributable to employer provided amounts. C elects to exclude $25,479 
under Sec. 1.911-3(d)(1). C may only deduct $4,521 of her housing cost 
amount under paragraph (e)(1) of this section because her foreign earned 
income in excess of amounts excluded under section 911(a) is 
$4,521($30,000-25,479). The $1,322 of unused housing cost amount 
deduction may be carried over to the subsequent taxable year.
    Example 6. The facts are the same as in example 4 except that C had 
$15,000 of foreign earned income of 1982, none of which was attributable 
to employer provided amounts. C elects to exclude the entire $15,000 
under Sec. 1.911-3(d)(1). C is not entitled to a housing cost amount 
deduction for 1982 since she has no foreign earned income in excess of 
amounts excluded under section 911(a). C may carry over her entire 
housing cost amount deduction to 1983.
    Example 7. The facts are the same as in example 6. In addition, 
during taxable year 1983 C had $115,000 of foreign earned income, none 
of which was attributable to employer provided amounts, and $40,000 of 
reasonable housing expenses C elects to exclude her foreign earned 
income under Sec. 1.911-3(d)(1). C's section 911(a)(1) limitation is 
the lesser of $115,000 or $80,000 ($80,000 x 365/365). C's housing cost 
amount for 1983 is $33,650 (40,000-(39,689 x .16) x 365/365). Since no 
portion of that amount is attributable to employer provided amounts, C 
may not claim a housing cost amount exclusion. C may deduct the lesser 
of her housing cost amount ($33,650) or her foreign earned income in 
excess of amounts excluded under section 911(a) ($115,000-80,000 = 
35,000). Thus, C may deduct her $33,650 housing cost amount in 1983. In 
addition, C may deduct $1,350 of the housing cost amount deduction 
carried over from taxable year 1982.

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

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

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



Sec. 1.911-5  Special rules for married couples.

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

[[Page 39]]

and W may exclude from gross income a total of $125,000. That amount is 
determined by adding W's section 911(a)(1) limitation, $80,000 (the 
lesser of $80,000 x 365/365 or $100,000), and H's section 911(a)(1) 
limitation, $45,000 (the lesser of $80,000 x 365/365 or $45,000).
    (3) Computation of housing cost amount--(i) Spouses residing 
together. If the spouses reside together, and file a joint return, they 
may compute their housing cost amount either jointly or separately. If 
the spouses reside together and file separate returns, they must compute 
their housing cost amounts separately. If the spouses compute their 
housing cost amounts separately, they may allocate the housing expenses 
to either of them or between them for the purpose of calculating 
separate housing cost amounts, but each spouse claiming a housing cost 
amount exclusion or deduction must use his or her full base housing 
amount in such computation. If the spouses compute their housing cost 
amount jointly, then only one of the spouses may claim the housing cost 
amount exclusion or deduction.


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

[[Page 40]]

more than one second foreign household and the expenses of such 
household may only be claimed by one spouse. For example, if both H and 
W are qualified individuals and H's tax home is in London and W's tax 
home is in Paris, then both H and W may exclude or deduct their housing 
cost amounts; however, H and W must compute these amounts separately 
regardless of whether they file joint or separate returns. If instead of 
living in Paris, W lives in an area where there are adverse living 
conditions and W maintains H's home in London, then W may add those 
housing expenses to her housing expenses and compute one base housing 
amount. In that case H may not claim a housing cost amount exclusion or 
deduction.
    (iii) Housing cost amount attributable to employer provided amounts. 
Each spouse claiming a housing cost amount exclusion or deduction shall 
compute the portion of the housing cost amount that is attributable to 
employer provided amounts separately, based on his or her separate 
foreign earned income, in accordance with Sec. 1.911-4(d)(3).
    (b) Married couples with community income. The amount of excludable 
foreign earned income of a husband and wife with community income is 
determined separately for each spouse in accordance with paragraph (a) 
of this section on the basis of income attributable to that spouse's 
services without regard to community property laws. See sections 879 and 
6013 (g) and (h) for special rules regarding treatment of community 
income of a nonresident alien individual married to a U.S. citizen or 
resident.

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

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



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

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

[[Page 41]]

219(b)(1)), real estate taxes and mortgage interest on a personal 
residence, charitable contributions, alimony payments, and deductions 
for personal exemptions. In addition, for purposes of this section, 
amounts excludable or deductible under section 911 or 119 shall not be 
allocable or chargeable to other amounts excluded under section 911(a). 
Thus, an individual's housing cost amount which is excludable or 
deductible under Sec. 1.911-4(d) for a taxable year is not apportioned 
in part to the individual's foreign earned income which is excluded for 
such year under Sec. 1.911-3(d). Therefore, the entire amount of such 
exclusion or deduction is allowed to the extent provided in Sec. 1.911-
4. This section does not affect the time for claiming any deduction, 
exclusion, or credit that is not allocated or apportioned to excluded 
amounts.
    (b) Moving expenses--(1) In general. No deduction shall be allowed 
for moving expenses under section 217 to the extent the deduction is 
properly allocable to or chargeable against amounts of foreign earned 
income excluded from gross income under section 911(a). If an 
individual's new principal place of work is in a foreign country, 
deductible moving expenses will be allocable to foreign earned income. 
If an individual treats a reimbursement from his employer for the 
expenses of a move from a foreign country to the United States as 
attributable to services performed in a foreign country under Sec. 
1.911-3(e)(5)(i), then deductible moving expenses attributable to that 
move will be allocable to foreign earned income. If the individual is a 
qualified individual who elects to exclude foreign earned income under 
section 911(a), then some or all of such moving expenses must be 
disallowed as a deduction.
    (2) Attribution of moving expense deduction to taxable years in 
which services are performed. If a moving expense deduction is properly 
allocable to foreign earned income, the deduction shall be considered 
attributable to services performed in the year of the move as long as 
the individual is a qualified individual under Sec. 1.911-2(a) for a 
period that includes 120 days in the year of the move. If the individual 
is not a qualified individual for such period, then the individual shall 
treat the deduction as attributable to services performed in both the 
year of the move and the succeeding taxable year, if the move is from 
the United States to the foreign country, or the prior taxable year, if 
the move is from a foreign country to the United States. Notwithstanding 
the preceding two sentences, storage expenses incurred after December 
31, 1983 shall be treated as attributable to services performed in the 
year in which the expenses are incurred.
    (3) Formula for disallowance of moving expense deduction. The 
portion of the moving expense deduction that is disallowed shall be 
determined by multiplying the moving expense deduction by a fraction the 
numerator of which is all amounts excluded under section 911(a) for the 
year or years to which the deduction is attributable (under paragraph 
(b)(2) of this section) and the denominator of which is foreign earned 
income (as defined in Sec. 1.911-3(a)) for that year or years.
    (4) Effect of disallowance based on attribution of deduction to 
subsequent year's income. An individual may claim a moving expense 
deduction in the taxable year in which the amount of the expense is paid 
or incurred even if attributable, in part, to the succeeding year. 
However, at such time as the individual excludes income under section 
911(a) for the year or years to which the deduction is attributable, the 
individual shall either--
    (i) File an amended return for the year in which the deduction was 
claimed that does not claim the portion of the deduction that is 
disallowed because it is chargeable against excluded income, or
    (ii) Include in income for the year following the year in which the 
deduction was claimed an amount equal to the amount of the deduction 
that is disallowed.


Any amount included in income under paragraph (b)(4)(ii) of this section 
is not foreign earned income.
    (5) Moves beginning before January 1, 1984. Notwithstanding 
paragraphs (b)(1) through (3) of this section, the rules of this 
paragraph (b)(5) shall apply for moves beginning before January 1, 1984.

[[Page 42]]

    (i) Individual qualifies for the entire taxable year of the move. If 
the individual is a qualified individual for the entire taxable year of 
the move, then the amount of moving expense disallowed shall be 
determined by multiplying the moving expense deduction otherwise 
allowable by a fraction the numerator of which is the foreign earned 
income excluded under section 911(a) for the taxable year of the move 
and the denominator of which is the foreign earned income for the same 
taxable year.
    (ii) Individual qualifies for less than the entire taxable year of 
the move. If the individual is a qualified individual for less than the 
entire taxable year of the move, then, for the purpose of determining 
the portion of the otherwise allowable moving expense deduction that is 
disallowed, the individual must attribute a portion of the otherwise 
allowable moving expense deduction either to the succeeding taxable 
year, if the move is from the United States to a foreign country, or to 
the prior taxable year, if the move is from a foreign country to the 
United States. The portion of the moving expense deduction treated as 
attributable to services performed in the year of the move shall be 
determined by multiplying the otherwise allowable moving expense 
deduction by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.141


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

[[Page 43]]

year for U.S. tax purposes. Such term includes the portion of any 
foreign taxable year within the individual's U.S. taxable year and 
excludes the portion of any foreign taxable year not within the 
individual's U.S. taxable year.
    (ii) Apportionment of foreign taxes. For purposes of this paragraph 
(c), foreign taxes imposed on foreign earned income shall be deemed to 
accrue, on a pro rata basis, to income as the income is received or 
accrued. The taxes so accrued shall be apportioned to the taxable year 
during which the income is received or accrued. This rule applies for 
all individuals, regardless of their method of accounting.
    (iii) Effect of disallowance. The disallowance of foreign taxes 
under this paragraph (c) shall not affect the time for claiming any 
deduction or credit for foreign taxes paid. Rather, the disallowance 
shall only affect the amount of taxes considered paid or accrued to any 
foreign country.
    (iv) Interest on foreign taxes. Any interest expense incurred on a 
liability for foreign taxes is allocated and apportioned not under this 
paragraph (c) but under paragraph (a) of this section to foreign earned 
income and then to excluded foreign earned income and to that extent 
disallowed as a deduction under paragraph (a). In that regard, see also 
Sec. 1.861-8(e)(2) for the specific rules for allocation and 
apportionment of interest expense.
    (d) Examples. The following examples illustrate the application of 
this section.

    Example 1. In 1982 A, an architect, operates his business as a sole 
proprietorship in which capital is not a material income producing 
factor. A receives $1,000,000 in gross receipts, all of which is foreign 
source earned income, and incurs $500,000 of otherwise deductible 
business expenses definitely related to the foreign earned income. A 
elects to exclude $75,000 under section 911(a)(1). The expenses must be 
apportioned to excluded earned income as follows: $500,000 x $75,000/
1,000,000. Thus, $37,500 of the business expenses are not deductible.
    Example 2. The facts are the same as in example 1, except that 
$100,000 of A's gross receipts is U.S. source earned income and $68,000 
of A's business expenses are attributable to the U.S. source earned 
income. Thus, A has $900,000 of foreign earned income and $432,000 of 
deductions allocated to foreign earned income. The expenses apportioned 
to excluded earned income are $432,000 x $75,000/$900,000, or $36,000, 
which are not deductible.
    Example 3. B is a U.S. citizen, calendar year and cash basis 
taxpayer. B moves to foreign country N and maintains a tax home and is 
physically present there from July 1, 1984 through May 26, 1985. Among 
other possible periods, B is a qualified individual for 219 days in the 
year of the move. B pays $6,000 of otherwise deductible moving expenses 
in 1984. For 1984, B's foreign earned income is $60,000 and B excludes 
$47,869 ($80,000 x 219/366) under section 911(a). Under paragraph (b)(2) 
of this section, B's moving expenses are attributable to services 
performed in 1984. Under paragraph (b)(3) of this section, $6,000 x 
$47,869/$60,000, or $4,789, of B's moving expense deduction is 
disallowed. B may deduct $1,211 of moving expenses on his 1984 return.
    Example 4. The facts are the same as in example 3 except that B 
maintains a tax home and is physically present in foreign country N from 
October 9, 1984 through September 3, 1985. Among other possible periods, 
B is a qualified individual for no more than 119 days in 1984 and 281 
days in 1985. B's foreign earned income for 1984 is $60,000. B's foreign 
earned income for 1985 is $150,000. Because B is a qualified individual 
for less than 120 days in the year of the move, under paragraph (b)(2) 
of this section, B's moving expenses are attributable to services 
performed in 1984 and 1985. At the close of 1984, B may either seek an 
extension of time to file under Sec. 1.911-7(c) or may file an income 
tax return without claiming the exclusions or deduction under section 
911. B does not seek an extension and files without excluding foreign 
earned income; thus B may deduct his moving expenses in full. B later 
amends his 1984 return and excludes foreign earned income for that year. 
B excludes foreign earned income for 1985. B must determine the portion 
of the moving expense deduction that is disallowed. The portion of the 
moving expense deduction that is disallowed is determined by multiplying 
the otherwise allowable moving expense deduction by a fraction. The 
numerator of the fraction is the sum of amounts excluded under section 
911(a) for 1984 and 1985, that is $26,082 or $80,000 x 119/365, plus 
$61,589, or $80,000 x 281/365, which totals $87,671. The denominator of 
the fraction is the sum of foreign earned income for 1984 and 1985, that 
is $60,000 plus $150,000, or $210,000. B's allowable moving expense 
deduction is $3,495, or $6,000-($6,000 x $87,671/$210,000). If B does 
not file an amended 1984 return (and does not exclude foreign earned 
income for 1984), but excludes foreign earned income under section 
911(a) for 1985, a portion of his moving expense deduction is 
disallowed, based on the same formula. The amount disallowed is $6,000 x 
$61,589/$210,000, or $1,760. This amount may be recaptured either by 
filing an amended return for 1984 or

[[Page 44]]

by including it in income for 1985 (in which case it is not foreign 
earned income).
    Example 5. C is a U.S. citizen, a self-employed individual, and a 
cash basis and calendar year taxpayer. For the entire 1982 taxable year 
C maintained his tax home and his bona fide residence in foreign country 
P. During 1982 C earned and received $120,000 of foreign earned income, 
none of which was attributable to employer provided amounts. C paid 
$40,000 of business expenses. C elected to exclude foreign earned income 
under section 911(a)(1) and claimed a housing cost amount deduction of 
$15,000. C received $10,000 of foreign source interest income which was 
included with C's earned income in a single tax base and taxed at 
graduated rates. For 1982, C paid $30,000 in income tax to foreign 
country P. The amount of C's business expenses that is properly 
apportioned to excluded amounts (and therefore, not deductible) equals 
$25,000, which is determined by multiplying the otherwise allowable 
deductions by C's excluded amounts over C's foreign earned income 
($40,000 x 75,000/120,000). The amount of country P tax that is properly 
apportioned to excluded amounts (and therefore, not deductible or 
creditable) equals $20,000, which is determined by multiplying the tax 
of $30,000 by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.142

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

[[Page 45]]

to disallowance because, under paragraph (c)(2)(ii) of this section, the 
only taxes disallowed are those deemed to accrue on income earned and 
received after December 31, 1981, and excluded from gross income. The 
amount of E's taxes paid in 1982 that are attributable to 1981 is 
$50,909, or $70,000 x $120,000/$165,000. E elects to exclude foreign 
earned income for 1982. The amount of E's taxes paid to S in 1982 that 
accrue to 1982 foreign earned income, and are therefore subject to 
disallowance based on excluded income, is $19,091, or $70,000 x $45,000/
$165,000.

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

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



Sec. 1.911-7  Procedural rules.

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

[[Page 46]]

    (ii) Election for 1982 and 1983 taxable years. Solely for purposes 
of paragraph (a)(2)(i)(A) of this section, an income tax return for any 
taxable year beginning before January 1, 1984, shall be considered 
timely filed if it is filed on or before July 23, 1985.
    (3) Housing cost amount deduction. An individual does not have to 
make an election in order to claim the housing cost amount deduction. 
However, such individual must provide the Commissioner with information 
sufficient to determine the individual's correct amount of tax. Such 
information shall include the following: The individual's name, address, 
and social security number; the name of the individual's employer; the 
foreign country in which the individual's tax home was established; the 
status under which the individual claims the deduction; the individual's 
qualifying period of residence or presence; the individual's foreign 
earned income for the taxable year; and the individual's housing 
expenses.
    (4) Effect of immaterial error or omission. An inadvertent error or 
omission of information required to be provided to make an election 
under this paragraph (a) shall not render the election invalid if the 
error or omission is not material in determining whether the individual 
is a qualified individual or whether the individual intends to make the 
election.
    (b) Revocation of election--(1) In general. An individual may revoke 
any election made under paragraph (a) of this section for any taxable 
year. A revocation must be made separately with respect to each 
election. The individual may revoke an election for any taxable year, 
including the first taxable year for which an election was effective, by 
filing a statement that the individual is revoking one or more of the 
previously made elections. The statement must be filed with the income 
tax return, or with an amended return, for the first taxable year of the 
individual for which the revocation is to be effective. A revocation 
once made is effective for that year and all subsequent years. If an 
election is revoked for any taxable year, including the first taxable 
year for which the election was effective, the individual may not, 
without the consent of the Commissioner, again make the same election 
until the sixth taxable year following the taxable year for which the 
revocation was first effective. For example, a qualified individual 
makes an election to exclude foreign earned income under section 
911(a)(1) and files it with his 1982 income tax return. The individual 
files 1983 and 1984 income tax returns on which he excludes his foreign 
earned income. Then, within 3 years after filing his 1982 income tax 
return, the individual files an amended 1982 income tax return with a 
statement revoking his election to exclude foreign earned income under 
section 911(a)(1). The revocation of the election is effective for 
taxable years 1982, 1983, and 1984. The individual may not elect to 
exclude income under section 911(a)(1) for any taxable year before 1988, 
unless he obtains consent to reelect under paragraph (b)(2) of this 
section.
    (2) Reelection before sixth taxable year after revocation. If an 
individual revoked an election under paragraph (b)(1) of this section 
and within five taxable years the individual wishes to reelect the same 
exclusion, then the individual may apply for consent to the reelection. 
The application for consent shall be made by requesting a ruling from 
the Associate Chief Counsel (Technical), National Office, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224. In 
determining whether to consent to reelection the Associate Chief Counsel 
or his delegate shall consider any facts and circumstances that may be 
relevant to the determination. Relevant facts and circumstances may 
include the following: a period of United States residence, a move from 
one foreign country to another foreign country with differing tax rates, 
a substantial change in the tax laws of the foreign country of residence 
or physical presence, and a change of employer.
    (c) Returns and extensions--(1) In general. Any return filed before 
completion of the period necessary to qualify an individual for any 
exclusion of deduction provided by section 911 shall be filed without 
regard to any exclusion or deduction provided by that section. A claim 
for a credit or refund of any

[[Page 47]]

overpayment of tax may be filed, however, if the taxpayer subsequently 
qualifies for any exclusion or deduction under section 911. See section 
6012(c) and Sec. 1.6012-1(a)(3), relating to returns to be filed and 
information to be furnished by individuals who qualify for any exclusion 
or deduction under section 911.
    (d) Declaration of estimated tax. In estimating gross income for the 
purpose of determining whether a declaration of estimated tax must be 
made for any taxable year, an individual is not required to take into 
account income which the individual reasonably believes will be excluded 
from gross income under the provisions of section 911. In computing 
estimated tax, however, the individual must take into account, among 
other things, the denial of the foreign tax credit for foreign taxes 
allocable to the excluded income (see Sec. 1.911-6(c)).
    (e) Effective/applicability date. This section applies to 
applications for extension of time to file returns filed after July 1, 
2008.

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

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



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

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

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

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

               earned income of citizens of united states



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

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



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

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

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



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

    (a) Termination of a DISC--(1) At end of 1984.
    Q-1: What is the effect of the termination on December 31, 1984, of 
a DISC's taxable year?
    A-1: Without regard to the annual accounting period of the DISC, the 
last taxable year of each DISC beginning during 1984 shall be deemed to 
close on December 31, 1984. The corporation's DISC election also shall 
be deemed revoked at the close of business on December 31, 1984. (A DISC 
that does not elect to be an interest charge DISC as of January 1, 1985, 
in addition to a corporation described in section 992(a)(3), shall be 
referred to as a ``former DISC''.) A corporation which wishes to be 
treated as a FSC, a small FSC, or an interest charge DISC must make an 
election as provided under paragraph (b) (Q & A 1) of this section.

[[Page 48]]

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

[[Page 49]]

tests under section 992(c)(1)(A) which is made with respect to the 
DISC's taxable year ending on December 31, 1984, treated?
    A-10: The distribution will not be treated as previously taxed 
income but will be taxed to the shareholder of the former DISC, as 
provided under section 992(c) and 996(a)(2) and the regulations 
thereunder, in the shareholder's taxable year in which the distribution 
is made.
    (9) Deficiency distributions.
    Q-11: With respect to an audit adjustment made after December 31, 
1984, may a deficiency distribution be made, and if so, in what manner 
may it be made?
    A-11: A deficiency distribution may be made notwithstanding the fact 
that after December 31, 1984, the former DISC is a taxable corporation 
under subchapter C, has elected to be treated as an interest charge 
DISC, or has been liquidated, reorganized or is otherwise no longer in 
existence. However, such deficiency distribution shall be treated as 
made out of accumulated DISC income which is not previously taxed income 
because it will be treated as distributed prior to December 31, 1984, to 
the DISC's shareholders.
    Q-11A: Must a former DISC remain in existence in order for a former 
DISC shareholder to take advantage of the spread provided in section 
995(b)(2) with respect to DISC disqualification?
    A-11A: No. With respect to distributions deemed to be received by a 
former DISC shareholder under section 995(b)(2) for taxable years 
beginning after December 31, 1984, if the former DISC shareholder 
elects, the rules of section 995(b)(2)(B) shall apply even though the 
former DISC does not continue in existence. If the former DISC is no 
longer in existence, the former DISC's shareholders will be deemed to 
have received the distribution on the last day of their taxable years 
over the applicable period of time determined under section 995(b)(2) as 
if the former DISC had remained in existence.
    (10) Deemed distribution for 1984.
    Q-12: How is the deemed distribution to a shareholder for the DISC's 
taxable year ending December 31, 1984, taken into account?
    A-12 (i) If the taxable year of the DISC ending on December 31, 
1984, (A) is the first taxable year of the DISC which begins in 1984, 
(B) begins after the date in 1984 on which the taxable year of the 
DISC's shareholder begins, and (C) if the DISC's shareholder makes an 
election under section 805(b)(3) of the Tax Reform Act of 1984, the 
deemed distribution under section 995(b) with respect to income derived 
by the DISC for such taxable year of the DISC shall be treated as 
received by the shareholder in 10 equal installments (unless the 
shareholder elects to be treated as receiving the deemed distribution in 
income over a smaller number of equal installments). The first 
installment shall be treated as received by the shareholder on the last 
day of the shareholder's second taxable year beginning in 1984 (if any), 
or if the shareholder had only one taxable year which began in 1984, on 
the last day of the shareholder's first taxable year beginning in 1985. 
One installment shall be treated as received by the shareholder on the 
last day of each succeeding taxable year of the shareholder until the 
entire amount of the DISC's 1984 deemed distribution has been included 
in the shareholder's taxable income. To make the election under section 
805(b)(3) of the Tax Reform Act of 1984, the DISC shareholder must 
attach a statement to its timely filed tax return (including extensions) 
for its taxable year which includes December 31, 1984, indicating the 
total amount of the shareholder's pro rata share of the DISC's deemed 
distribution for 1984 (determined under section 995(b) of the Code 
without regard to the election under section 805(b)(3) of the Tax Reform 
Act of 1984), and the number of equal installments, if less than 10, 
over which the shareholder wishes to spread its pro rata share of the 
deemed distribution for 1984. If the election under section 805(b)(3) of 
the Tax Reform Act of 1984 is made, it may not be changed or revoked. In 
determining estimated tax payments, the portion of the deemed 
distribution includible in the shareholder's taxable income for any 
taxable year under this subdivision (i) shall be treated as received by 
the shareholder on the last day of such taxable year.

[[Page 50]]

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

[[Page 51]]

taxable year begins before July 1, 1985. Likewise, the election to be a 
FSC (or a small FSC) may be made during the first 90 days of any taxable 
year of a corporation if the corporation had in a prior taxable year 
elected small FSC (or FSC) status and the corporation revokes the small 
FSC (or FSC) election within the 90 day period. A corporation which was 
a DISC for its taxable year ending December 31, 1984, which wishes to be 
treated as an interest charge DISC beginning with its first taxable year 
beginning after December 31, 1984, may make the election to be treated 
as an interest charge DISC by filing Form 4876A on or before July 1, 
1987. Also, if a corporation which has elected FSC, small FSC or 
interest charge DISC status, or a shareholder of that corporation, is 
acquired in a qualified stock purchase under section 338(d)(3), and if 
an election under section 338(a) is effective with regard to that 
corporation, the corporation may re-elect FSC, small FSC or interest 
charge DISC status, (whichever is applicable) not later than the date of 
the election under section 338(a), see section 338(g)(i) and Sec. 
1.338-2(d). This re-election is necessary because the original elections 
are deemed terminated if an election is made under section 338(a). The 
rules contained in Sec. 1.992-2 (a)(1), (b)(1) and (b)(3) shall apply 
to the manner of making the election and the manner and form of 
shareholder consent.
    (2) FSC incorporated in a possession.
    Q-2: Where does a FSC which is incorporated in a U.S. possession 
file its election?
    A-2: The election is filed with the Internal Revenue Service Center, 
Philadelphia, Pennsylvania 19255.
    (3) Information returns.
    Q-3: Must Form 5471 be filed with respect to the organization of a 
FSC pursuant to section 6046 or to provide information with respect to a 
FSC pursuant to section 6038?
    A-3: A Form 5471 required under section 6046 need not be filed with 
respect to the organization of a FSC. The requirements of section 6046 
shall be satisfied by the filing of a Form 8279 dealing with the 
election to be treated as a FSC or small FSC. However, a Form 5471 will 
be required with respect to a reorganization of a FSC (or small FSC) or 
an acquisition of stock of a FSC (or small FSC), as required under 
section 6046 and the regulations thereunder. Provided that a Form 1120 
FSC is filed, a Form 5471 need not be filed to satisfy the requirements 
of section 6038.
    (4) Conformity of accounting period.
    Q-4: Since a FSC, small FSC, and interest charge DISC must use the 
same annual accounting period as the principal shareholder, must such 
corporation delay the beginning of its first taxable year beyond January 
1, 1985 if the principal shareholder (the shareholder with the highest 
percentage of voting power as defined in section 441(h)) is not a 
calendar year taxpayer?
    A-4: No. Where the principal shareholder is not a calendar year 
taxpayer, a corporation may elect to be treated as a FFSC, small FSC, or 
interest charge DISC for a taxable year beginning January 1, 1985. 
However, such corporation must close its first taxable year and adopt 
the annual accounting period of its principal shareholder as of the 
first day of the principal shareholder's first taxable year beginning in 
1985. A FSC, small FSC, or interest charge DISC need not obtain the 
consent of the Commissioner under section 442 to conform its annual 
accounting period to the annual accounting period of its principal 
shareholder.
    (5) Dollar limitations for short taxable years.
    Q-5: If a small FSC or an interest charge DISC has a short taxable 
year, how are the dollar limitations on foreign trading export gross 
receipts and qualified export gross receipts, respectively, determined 
for small FSCs and interest charge DISCs?
    A-5: The dollar limitations are to be prorated on a daily basis. 
Thus, for example, if for its 1985 taxable year a small FSC has a short 
taxable year of 73 days, then in determining exempt foreign trade 
income, any foreign trading gross receipts that exceed $1 million (73/
365 x $5 million) will not be taken into account.
    (6) Change of accounting period.
    Q-6: If the principal shareholder of a FSC, a small FSC, or an 
interest charge DISC (hereinafter referred to as a ``FSC'') changes its 
annual accounting period or is replaced by a new principal shareholder 
during a taxable

[[Page 52]]

year, is it necessary for the FSC to change its annual accounting 
period?
    A-6: If the principal shareholder changes its annual accounting 
period, the FSC must also change its annual accounting period to conform 
to that of its principal shareholder. If the voting power of the 
principal shareholder is reduced by an amount equal to at least 10 
percent of the total shares entitled to vote and such shareholder is no 
longer the principal shareholder, the FSC must conform its accounting 
period to that of its new principal shareholder. However, in determining 
whether a shareholder is a principal shareholder, the voting power of 
the shareholders is determined as of the beginning of the FSC's taxable 
year. Thus, for example, assume that for 1985 a FSC adopts a calendar 
year period as its annual accounting period to conform to that of its 
principal shareholder. Assume further than in March 1985 there is a 10 
percent change in voting power and a different shareholder whose annual 
accounting period begins on July 1 becomes the new principal 
shareholder. The FSC will not be required to adopt the annual accounting 
period of its new principal shareholder until July 1, 1986. The FSC will 
have a short taxable year for the period January 1 to June 30, 1986.
    (7) Transition transfers.
    Q-7. Under what circumstances may a DISC or former DISC transfer its 
assets to a FSC or small FSC without incurring any tax liability on the 
transfer?
    A-7. A DISC or former DISC will recognize no income, gain, or loss 
on a transfer of its qualified assets (as defined in section 993(b)) to 
a FSC or small FSC if all of the following conditions are met:
    (i) The assets transferred were held by the DISC on August 4, 1983, 
and were transferred by the DISC or former DISC to the FSC or small FSC 
in a transfer completed before January 1, 1986; and
    (ii) The assets are transferred in a transaction which would qualify 
for nonrecognition under subchapter C of chapter 1 of the Code, or would 
so qualify but for section 367 of the Code.
    In such case, section 367 shall not apply to the transfer.
    In addition, other provisions of subchapter C will apply to the 
transfer, such as section 358 (basis to shareholders), section 362 
(basis to corporations), and section 381 (carryovers in corporate 
acquisitions). In determining whether a transfer by a DISC to a FSC or 
small FSC qualifies for nonrecognition under subchapter C, a liquidation 
of the assets of the DISC into a parent corporation followed by a 
transfer by the parent of those assets to the FSC or small FSC will be 
treated as a transaction described in section 368(a)(1)(D).
    Notwithstanding the foregoing answer, a taxpayer which transfers a 
right to use its corporate name to a FSC in a transaction described in 
sections 332, 351, 354, 356 and 361 shall not be treated as having sold 
that right under section 367(d) or as having transferred that right to 
an entity that is not a corporation under section 367(a) provided that 
the corporate name is used only by the FSC and is not licensed or 
otherwise made available to others by the FSC.
    (8) Completed contract method.
    Q-8: Under what conditions is a taxpayer using the completed 
contract method of accounting as defined in Sec. 1.451-3(d) exempted 
from satisfying the foreign management and foreign economic process 
requirements of subsections (c) and (d) of section 924?
    A-8: If the taxpayer has entered into a binding contract before 
March 16, 1984, or has on March 15, 1984, and at all times thereafter a 
firm plan, evidenced in writing, to enter the contract and enters into a 
binding contract by December 31, 1984, then the taxpayer will be treated 
as having satisfied the foreign management tests of section 924(c) for 
periods before December 31, 1984, and the foreign economic process tests 
of section 924(d) with respect to costs incurred before December 31, 
1984, with respect to the transaction. The FSC rules will apply to the 
income from the long-term contract if an election is made and the 
general FSC requirements under section 922 are satisfied. However, such 
taxpayer need not satisfy the activities test under section 925(c) for 
activities which occur before January 1, 1985 in order to use the 
transfer pricing rules under section 925.

[[Page 53]]

    (9) Long-term contract--before March 15, 1984.
    Q-9: Under what conditions is a taxpayer who enters into a binding 
long-term contract (i.e., a contract which is not completed in the 
taxable year in which it is entered into) before March 15, 1984, but 
does not use the completed contract method of accounting exempted from 
satisfying the foreign management and economic process requirements of 
subsections (c) and (d) of section 924?
    A-9: If a taxpayer enters into a binding contract before March 15, 
1984, the taxpayer will be treated as having satisfied the foreign 
management tests of section 924(c) for periods before December 31, 1984, 
and the foreign economic process tests of section 924(d) with respect to 
costs incurred before December 31, 1984, but only with respect to income 
attributable to such contracts that is recognized before December 31, 
1986. The FSC rules will apply to the income from the long-term contract 
if an election is made and the general FSC requirements under section 
922 are satisfied. However, such taxpayer need not satisfy the 
activities test under section 925(c) for activities which occur before 
January 1, 1985, in order to use the transfer pricing rules under 
section 925.
    (10) Long-term contract--after March 15, 1984.
    Q-10: Under what conditions is a taxpayer who has a long-term 
contract (i.e., a contract which is not completed in the taxable year in 
which it is entered into) but does not use the completed contract method 
of accounting exempted from satisfying the foreign management and 
economic process requirements of subsections (c) and (d) of section 924 
if such taxpayer enters into a binding contract after March 15, 1984 and 
before January 1, 1985?
    A-10: If a taxpayer enters into a contract after March 15, 1984, and 
before January 1, 1985, the taxpayer will be treated as having satisfied 
the foreign management tests of section 924(c) for periods before 
December 31, 1984, and the foreign economic process tests of section 
924(d) with respect to costs incurred before December 31, 1984, but only 
with respect to income attributable to such contract that is recognized 
before December 31, 1985.
    The FSC rules will apply to the income from the long-term contract 
if an election is made and the general requirements under section 922 
are satisfied. However, such taxpayer need not satisfy the activities 
test under section 925(c) for activities which occur before January 1, 
1985 in order to use the transfer pricing rules under section 925.
    (11) Incomplete transactions.
    Q-11: In computing its foreign trade income, how should a FSC treat 
transfers of export property from a related supplier to a DISC which is 
subsequently resold by a FSC after the DISC's termination?
    A-11: In applying the gross receipts and combined taxable income 
methods under section 925 (a)(1) and (a)(2), the transaction is treated 
as if the transfer of export property were made by the related supplier 
to the FSC except that the foreign management and economic processes 
tests under section 924 and the activities test under section 925(c) 
shall be deemed to be satisfied for purposes of the transaction.
    (12) Pre-effective date costs and activities.
    Q-12: Are costs incurred and activities performed prior to January 
1, 1985 taken into account for purposes of satisfying the foreign 
management and foreign economic processes requirements of subsections 
(c) and (d) of section 924 and the activities test under section 925(c)?
    A-12: For purposes of determining the costs incurred and the 
activities performed to be taken into account with respect to contracts 
entered into after December 31, 1984, only those costs incurred and 
activities performed after December 31, 1984, are taken into 
consideration. Costs incurred and activities performed by a related 
supplier prior to January 1, 1985 (or prior to the effective date of a 
corporation's election to be treated as a FSC if other than January 1, 
1985) with respect to transactions occurring after January 1, 1985 (or 
after the effective date of a corporation's election to be treated as a 
FSC) need not be taken into account for purposes of computing the FSC's 
profit under section 925 but are treated

[[Page 54]]

for section 925(c) purposes as if they were performed on behalf of the 
FSC.
    (13) FSC and interest charge DISC.
    Q-13: Can a FSC and an interest charge DISC be members of the same 
controlled group?
    A-13: A FSC and an interest charge DISC cannot be members of the 
same controlled group. If any controlled group of corporations of which 
an interest charge DISC is a member establishes a FSC, then any interest 
charge DISC which is a member of such group shall be treated as having 
terminated its status as an interest charge DISC.
    (c) Export Trade Corporations--(1) Previously taxed income.
    Q-1: Under what circumstances are earnings of an export trade 
corporation that have not been included in income under section 951 
treated as previously taxed income previously included in the income of 
a U.S. shareholder for purposes of section 959 (and not taxed)?
    A-1: A corporation which qualifies as an export trade corporation 
(ETC) with respect to its last taxable year beginning before January 1, 
1985, and elects to discontinue operations as an ETC for all taxable 
years beginning after December 31, 1984, shall not be required to take 
into income earnings attributable to previously excluded export trade 
income, as defined in Sec. 1.970-1(b), derived with respect to taxable 
years beginning before January 1, 1985. However, any amounts distributed 
by the former ETC (i.e. a corporation which was an ETC for its last 
taxable year beginning before January 1, 1985) shall be treated as being 
made out of current earnings and profits and then out of previously 
taxed income. For purposes of determining the shareholder's basis in the 
ETC stock, distributions of previously excluded export trade income 
shall be treated as if made out of previously taxed income which has 
already been included in gross income under section 951(a)(1)(B). Thus, 
no basis adjustment under section 961 is necessary. In addition, upon 
the sale or exchange of the stock of such corporation in a transaction 
described in section 1248(a), the earnings and profits of the 
corporation attributable to such previously untaxed income shall not be 
subject to section 1248(a).
    (2) Qualification as an ETC for last year.
    Q-2: Must an ETC satisfy all of the tests set forth in section 
971(a)(1) for the ETC's last taxable year beginning before January 1, 
1985?
    A-2: All of the tests in section 971(a)(1) must be satisfied, except 
that for purposes of the working capital requirements set forth in 
section 971(c)(1), the working capital of the ETC at the close of its 
last taxable year beginning before January 1, 1985 shall be deemed 
reasonable.
    (3) Continuation of ETC status.
    Q-3: May a corporation which chooses to remain an ETC after December 
31, 1984, continue to do so?
    A-3: Yes. However, previously untaxed income of such ETC shall not 
be treated as previously taxed income in accordance with Q&A 1 of this 
section.
    (4) Discontinuation of ETC status.
    Q-4: How does an ETC make an election to discontinue its operation 
as an ETC?
    A-4: The United States shareholders (as defined in section 951(b)) 
must file a statement of election on behalf of the ETC indicating the 
intent of the ETC to discontinue operations as an ETC for taxable years 
beginning after December 31, 1984. In addition, the statement of 
election must include the name, address, taxpayer identification number 
and stock interest of each United States shareholder. The statement must 
also indicate that the corporation on behalf of which the shareholders 
are making the election qualified as an ETC for its last taxable year 
beginning before January 1, 1985, and also the amount of earnings 
attributable to previously excluded export trade income. The statement 
must be jointly signed by each United States shareholder with each 
shareholder stating under penalties of perjury that he or she holds the 
stock interest specified for such shareholder in the statement of 
election. A copy of the statement of election must be attached to Form 
5471 (information return with respect to a foreign corporation) filed 
with respect to the ETC's last taxable year beginning before January 1, 
1985.
    (5) Transition transfers.

[[Page 55]]

    Q-5: Under what circumstances may an electing ETC transfer its 
assets to a FSC without incurring any tax liability on the transfer?
    A-5: An electing ETC will recognize no income, gain, or loss on a 
transfer of its assets to a FSC but only if all of the following 
conditions are met:
    (i) The assets transferred were held by the ETC on August 4, 1983, 
and were transferred by the ETC to the FSC in a transfer completed 
before January 1, 1986; and
    (ii) The assets are transferred in a transaction which would qualify 
for nonrecognition under subchapter C of chapter 1 of the Code, or would 
so qualify but for section 367 of the Code.
    In such case, section 367 shall not apply to the transfer. In 
addition, other provisions of subchapter C will apply to the transfer 
such as section 358 (basis to shareholders), section 362 (basis to 
corporation) and section 381 (carryovers in corporate acquisitions). In 
determining whether a transfer by an ETC to a FSC qualifies for 
nonrecognition under subchapter C, a liquidation of the assets of the 
ETC into a parent corporation followed by a transfer by the parent of 
those assets to the FSC will be treated as a transaction described in 
section 368(a)(1)(D).

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

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



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

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


In addition, under section 441(h), the taxable year of a FSC must 
conform to the taxable year of its principal shareholder. See Q&A 4 of 
Sec. 1.921-1T(b)(4).
    Q-2. Does the reference to a DISC under section 922(a)(1)(F) which 
provides that a FSC cannot be a member, at any time during the taxable 
year, of any controlled group of corporations of

[[Page 56]]

which a DISC is a member refer solely to an interest charge DISC?
    A-2. Yes.
    (b) Small FSC.
    Q-3. What is a small FSC?
    A-3. A small FSC is a Foreign Sales Corporation which meets the 
requirements of section 922(a)(1) enumerated in Q&A 1 of this section as 
well as the requirements of section 922(b). Section 922(b) requires that 
a small FSC make a separate election to be treated as a small FSC. See 
Q&A 1 of Sec. 1.921-1T(b) and Sec. 1.927(f)-1. In addition, section 
922(b) requires that the small FSC not be a member, at any time during 
the taxable year, of a controlled group of corporations which includes a 
FSC unless such FSC is a small FSC.
    Q-4. What is the effect of an election as a small FSC?
    A-4. Under section 924(b)(2), a small FSC need not meet the foreign 
management and economic processes tests of section 924(b)(1) in order to 
have foreign trading gross receipts. However, in determining the exempt 
foreign trade income of a small FSC, any foreign trading gross receipts 
for the taxable year in excess of $5 million are not taken into account. 
If the foreign trading gross receipts of a small FSC for the taxable 
year exceed the $5 million limitation, the FSC may select the gross 
receipts to which the limitation is allocated. In order to use the 
administrative pricing rules under section 925(a), a small FSC must 
satisfy the activities test under section 925(c). In addition, under 
section 441(h), the taxable year of a small FSC must conform to the 
taxable year of its principal shareholder (defined in Q&A 4 of Sec. 
1.921-1T(b)(4) as the shareholder with the highest percentage of its 
voting power).
    Q-5. What is the effect on a small FSC (or FSC) (``target'') if it 
is acquired, directly or indirectly, by a corporation if that acquiring 
corporation (``acquiring''), or a member of the acquiring corporation's 
controlled group, is a FSC (or small FSC)?
    A-5. Unless the corporations in the controlled group elect to 
terminate the FSC (or small (FSC) election of the acquiring corporation, 
the target's small FSC's (or FSC's) taxable year and election will 
terminate as of the day preceding the date the target small FSC and 
acquiring FSC became members of the same controlled group. The target 
small FSC will receive FSC benefits for the period prior to termination, 
but the $5 million small FSC limitation will be reduced to the amount 
which bears the same ratio to the $5 million as the number of days in 
the short year created by the termination bears to 365. The due date of 
the income tax return for the short taxable year created by this 
provision will be the date prescribed by section 6072(b), including 
extensions, starting with the last day of the short taxable year. If the 
short taxable year created by this provision ends prior to March 3, 
1987, the filing date of the tax return for the short taxable year will 
be automatically extended until the earlier of May 18, 1987 or the date 
under section 6072 (b) assuming a short taxable year had not been 
created by these regulations.
    (c) Comparison of FSC to DISC.
    Q-6. How does a FSC differ from a DISC?
    A-6. A DISC is a domestic corporation which is not itself taxable 
while a FSC must be created or organized under the laws of a 
jurisdiction which is outside of the United States (including certain 
U.S. possessions) and may be taxable on its income except for its exempt 
foreign trade income. The DISC provisions enable a shareholder to obtain 
a partial deferral of tax on income from export sales and certain 
services, if 95 percent of its receipts and assets are export related. 
The FSC provisions contain no assets test, but a portion of income for 
export sales and certain services is exempt from U.S. taxes if the FSC 
satisfies certain foreign presence, foreign management, and foreign 
economic processes tests.
    (d) Organization of a FSC.
    Q-7. Under the laws of what countries may a FSC be organized?
    A-7. A FSC may not be created or organized under the laws of the 
United States, a state, or other political subdivision. However, a FSC 
may be created or organized under the laws of a possession of the United 
States, including Guam. American Samoa, the Commonwealth of the Northern 
Mariana Islands and the Virgin Islands of the United States, but not 
Puerto Rico. These eligible possessions are located

[[Page 57]]

outside the U.S. customs territory. In addition, a FSC may incorporate 
under the laws of a foreign country that is a party to--
    (i) An exchange of information agreement that meets the standards of 
the Caribbean Basin Economic Recovery Act of 1983 (Code section 
274(h)(6)(C)), or
    (ii) A bilateral income tax treaty with the United States if the 
Secretary certifies that the exchange of information program under the 
treaty carries out the purpose of the exchange of information 
requirements of the FSC legislation as set forth in section 927(e)(3), 
if the company is covered under the exchange of information program 
under subdivision (i) or (ii). The Secretary may terminate the 
certification. Any termination by the Secretary will be effective six 
months after the date of the publication of the notice of such 
termination in the Federal Register.
    (e) Foreign Trade Income.
    Q-8. How is foreign trade income defined?
    A-8. Foreign trade income, defined in section 923(b), is gross 
income of an FSC attributable to foreign trading gross receipts. It 
includes both the profits earned by the FSC itself from exports and 
commissions earned by the FSC from products and services exported by 
others.
    (f) Investment Income and Carrying Charges.
    Q-9. What do the terms ``investment income'' and ``carrying 
charges'' mean?
    A-9.
    (i) Investment income means:
    (A) Dividends,
    (B) Interest,
    (C) Royalties,
    (D) Annuities,
    (E) Rents (other than rents from the lease or rental of export 
property for use by the lessee outside of the United States);
    (F) Gains from the sale of stock or securities,
    (G) Gains from future transactions in any commodity on, or subject 
to the rules of, a board of trade or commodity exchange (other than 
gains which arise out of a bona fide hedging transaction reasonably 
necessary to conduct the business of the FSC in the manner in which such 
business is customarily conducted by others),
    (H) Amounts includable in computing the taxable income of the 
corporation under part I of subchapter J, and
    (I) Gains from the sale or other disposition of any interest in an 
estate or trust.
    (ii) Carrying charges means:
    (A) Charges that are imposed by a FSC or a related supplier and that 
are identified as carrying charges, (``stated carrying charges'') and
    (B)(1) Charges that are considered to be included in the price of 
the property or services sold by an FSC or a related supplier, as 
provided under Q&As 1 and 2 of Sec. 1.927(d)-1, and
    (2) Any other unstated interest.
    Q-10. How are investment income and carrying charges treated?
    A-10. Investment income and carrying charges are not foreign trading 
gross receipts. Investment income and carrying charges are includable in 
the taxable income of an FSC, except in the case of a commission FSC 
where carrying charges are treated as income of the related supplier, 
and are treated as income effectively connected with a trade or business 
conducted through a permanent establishment within the United States. 
The source of investment income and carrying charges is determined under 
sections 861, 862, and 863 of the Code.
    (g) Small Businesses.
    Q-11. What options are available to small businesses engaged in 
exporting?
    A-11. A small business may elect to be treated as either a small FSC 
or an interest charge DISC. See Q&As 3 & 4 of Sec. 1.921-2 relating to 
a small FSC. Rules with respect to interest charge DISCs are the subject 
of another regulations project.

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



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

    (a) General rule. Under section 927(a), except as otherwise provided 
with respect to excluded property in paragraphs (f), (g) and (h) of this 
section and with respect to certain short supply property in paragraph 
(i) of this section, export property is property in the hands of any 
person (whether or not a FSC) (any further reference to a

[[Page 58]]

FSC in this section shall include a small FSC unless indicated 
otherwise)--
    (1) U.S. manufactured, produced, grown or extracted. Manufactured, 
produced, grown, or extracted in the United States by any person or 
persons other than a FSC (see paragraph (c) of this section),
    (2) Foreign use, consumption or disposition. Held primarily for 
sale, lease or rental in the ordinary course of a trade or business by a 
FSC to a FSC or to any other person for direct use, consumption, or 
disposition outside the United States (see paragraph (d) of this 
section),
    (3) Foreign content. Not more than 50 percent of the fair market 
value of which is attributable to articles imported into the United 
States (see paragraph (e) of this section), and
    (4) Non-related FSC purchaser or user. Which is not sold, leased or 
rented by a FSC, or with a FSC as commission agent, to another FSC which 
is a member of the same controlled group (as defined in section 
927(d)(4) and Sec. 1.924(a)-1T(h)) as the FSC.
    (b) Services. For purposes of this section, services (including the 
written communication of services in any form) are not export property. 
Whether an item is property or services shall be determined on the basis 
of the facts and circumstances attending the development and disposition 
of the item. Thus, for example, the preparation of a map of a particular 
construction site would constitute services and not export property, but 
standard maps prepared for sale to customers generally would not 
constitute services and would be export property if the requirements of 
this section were otherwise met.
    (c) Manufacture, production, growth, or extraction of property--(1) 
By a person other than a FSC. Export property may be manufactured, 
produced, grown, or extracted in the United States by any person, 
provided that that person does not qualify as a FSC. Property held by a 
FSC which was manufactured, produced, grown or extracted by it at a time 
when it did not qualify as a FSC is not export property of the FSC. 
Property which sustains further manufacture, production or processing 
outside the United States prior to sale or lease by a person but after 
manufacture, production, processing or extraction in the United States 
will be considered as manufactured, produced, grown or extracted in the 
United States by that person only if the property is reimported into the 
United States for further manufacturing, production or processing prior 
to final export sale. In order to be considered export property, the 
property manufactured, produced, grown or extracted in the United States 
must satisfy all of the provisions of section 927(a) and this section.
    (2) Manufactured, produced or processed. For purposes of this 
section, property which is sold or leased by a person is considered to 
be manufactured, produced or processed by that person or by another 
person pursuant to a contract with that person if the property is 
manufactured or produced, as defined in Sec. 1.954-3(a)(4). For 
purposes of this section, however, in determining if the 20% conversion 
test of Sec. 1.954-3(a)(4)(iii) has been met, conversion costs include 
assembly and packaging costs but do not include the value of parts 
provided pursuant to a services contract as described in Sec. 1.924(a)-
1T(d)(3). In addition, for purposes of this section, the 20% conversion 
test is extended and applied to the export property's adjusted basis 
rather than to its cost of goods sold if it is leased or held for lease.
    (d) Foreign use, consumption or disposition--(1) In general. (i) 
Under paragraph (a)(2) of this section, export property must be held 
primarily for the purpose of sale, lease or rental in the ordinary 
course of a trade or business, by a FSC to a FSC or to any other person, 
and the sale or lease must be for direct use, consumption, or 
disposition outside the United States. Thus, property cannot qualify as 
export property unless it is sold or leased for direct use, consumption, 
or disposition outside the United States. Property is sold or leased for 
direct use, consumption, or disposition outside the United States if the 
sale or lease satisfies the destination test described in subdivision 
(2) of this paragraph, the proof of compliance requirements described in 
subdivision (3) of this paragraph, and the use outside the

[[Page 59]]

United States test described in subdivision (4) of this paragraph.
    (ii) Factors not taken into account. In determining whether property 
which is sold or leased to a FSC is sold or leased for direct use, 
consumption, or disposition outside the United States, the fact that the 
acquiring FSC holds the property in inventory or for lease prior to the 
time it sells or leases it for direct use, consumption, or disposition 
outside the United States will not affect the characterization of the 
property as export property. Fungible export property must be physically 
segregated from non-export property at all times after purchase by or 
rental by a FSC or after the start of the commission relationship 
between the FSC and related supplier with regard to the export property. 
Non-fungible export property need not be physically segregated from non-
export property.
    (2) Destination test. (i) For purposes of paragraph (d)(1) of this 
section, the destination test of this paragraph is satisfied with 
respect to property sold or leased by a seller or lessor only if it is 
delivered by the seller or lessor (or an agent of the seller or lessor) 
regardless of the F.O.B. point or the place at which title passes or 
risk of loss shifts from the seller or lessor--
    (A) Within the United States to a carrier or freight forwarder for 
ultimate delivery outside the United States to a purchaser or lessee (or 
to a subsequent purchaser or sublessee),
    (B) Within the United States to a purchaser or lessee, if the 
property is ultimately delivered outside the United States (including 
delivery to a carrier or freight forwarder for delivery outside the 
United States) by the purchaser or lessee (or a subsequent purchaser or 
sublessee) within 1 year after the sale or lease,
    (C) Within or outside the United States to a purchaser or lessee 
which, at the time of the sale or lease, is a FSC or an interest charge 
DISC and is not a member of the same controlled group as the seller or 
lessor,
    (D) From the United States to the purchaser or lessee (or a 
subsequent purchaser or sublessee) at a point outside the United States 
by means of the seller's or lessor's own ship, aircraft, or other 
delivery vehicle, owned, leased, or chartered by the seller or lessor,
    (E) Outside the United States to a purchaser or lessee from a 
warehouse, storage facility, or assembly site located outside the United 
States, if the property was previously shipped by the seller or lessor 
from the United States, or
    (F) Outside the United States to a purchaser or lessee if the 
property was previously shipped by the seller or lessor from the United 
States and if the property is located outside the United States pursuant 
to a prior lease by the seller or lessor, and either (1) the prior lease 
terminated at the expiration of its term (or by the action of the prior 
lessee acting alone), (2) the sale occurred or the term of the 
subsequent lease began after the time at which the term of the prior 
lease would have expired, or (3) the lessee under the subsequent lease 
is not a related person with respect to the lessor and the prior lease 
was terminated by the action of the lessor (acting alone or together 
with the lessee).
    (ii) For purposes of this paragraph (d)(2) (other than paragraphs 
(d)(2)(i)(C) and (F)(3)), any relationship between the seller or lessor 
and any purchaser, subsequent purchaser, lessee, or sublessee is 
immaterial.
    (iii) In no event is the destination test of this paragraph (d)(2) 
satisfied with respect to property which is subject to any use (other 
than a resale or sublease), manufacture, assembly, or other processing 
(other than packaging) by any person between the time of the sale or 
lease by such seller or lessor and the delivery or ultimate delivery 
outside the United States described in this paragraph (d)(2).
    (iv) If property is located outside the United States at the time it 
is purchased by a person or leased by a person as lessee, such property 
may be export property in the hands of such purchaser or lessee only if 
it is imported into the United States prior to its further sale or lease 
(including a sublease) outside the United States. Paragraphs (a)(3) and 
(e) of this section (relating to the 50 percent foreign content test) 
are applicable in determining whether such property is export property. 
Thus, for

[[Page 60]]

example, if such property is not subjected to manufacturing or 
production (as defined in paragraph (c) of this section) within the 
United States after such importation, it does not qualify as export 
property.
    (3) Proof of compliance with destination test--(i) Delivery outside 
the United States. For purposes of paragraph (d)(2) of this section 
(other than subdivision (i)(C) thereof), a seller or lessor shall 
establish ultimate delivery, use, or consumption of property outside the 
United States by providing--
    (A) A facsimile or carbon copy of the export bill of lading issued 
by the carrier who delivers the property,
    (B) A certificate of an agent or representative of the carrier 
disclosing delivery of the property outside the United States,
    (C) A facsimile or carbon copy of the certificate of lading for the 
property executed by a customs officer of the country to which the 
property is delivered,
    (D) If that country has no customs administration, a written 
statement by the person to whom delivery outside the United States was 
made,
    (E) A facsimile or carbon copy of the Shipper's Export Declaration, 
a monthly shipper's summary declaration filed with the Bureau of 
Customs, or a magnetic tape filed in lieu of the Shipper's Export 
Declaration, covering the property, or
    (F) Any other proof (including evidence as to the nature of the 
property or the nature of the property or the nature of the transaction) 
which establishes to the satisfaction of the Commissioner that the 
property was ultimately delivered, or directly sold, or directly 
consumed outside the United States within 1 year after the sale or 
lease.
    (ii) The requirements of subdivision (i)(A), (B), (C), or (E) of 
this paragraph will be considered satisfied even though the name of the 
ultimate consignee and the price paid for the goods is marked out 
provided that, in the case of a Shipper's Export Declaration or other 
document listed in subdivision (i)(E) of this paragraph or a document 
such as an export bill of lading, such document still indicates the 
country in which delivery to the ultimate consignee is to be made and, 
in the case of a certificate of an agent or representative of the 
carrier, that the document indicates that the property was delivered 
outside the United States.
    (iii) A seller or lessor shall also establish the meeting of the 
requirement of paragraph (d)(2)(i) of this section (other than 
subdivision (i)(C) thereof), that the property was delivered outside the 
United States without further use, manufacture, assembly, or other 
processing within the United States.
    (iv) For purposes of paragraph (d)(2)(i)(C) of this section, a 
purchaser or lessee of property is deemed to qualify as a FSC or an 
interest charge DISC for its taxable year if the seller or lessor 
obtains from the purchaser or lessee a copy of the purchaser's or 
lessee's election to be treated as a FSC or interest charge DISC 
together with the purchaser's or lessee's sworn statement that the 
election has been timely filed with the Internal Revenue Service Center. 
The copy of the election and the sworn statement of the purchaser or 
lessee must be received by the seller or lessor within 6 months after 
the sale or lease. A purchaser or lessee is not treated as a FSC or 
interest charge DISC with respect to a sale or lease during a taxable 
year for which the purchaser or lessee does not qualify as a FSC or 
interest charge DISC if the seller or lessor does not believe or if a 
reasonable person would not believe at the time the sale or lease is 
made that the purchaser or lessee will qualify as a FSC or interest 
charge DISC for the taxable year.
    (v) If a seller or lessor fails to provide proof of compliance with 
the destination test as required by this paragraph (d)(3), the property 
sold or leased is not export property.
    (4) Sales and leases of property for ultimate use in the United 
States--(i) In general. For purposes of paragraph (d)(1) of this 
section, the use test in this paragraph (d)(4) is satisfied with respect 
to property which--
    (A) Under subdivision (4)(ii) through (iv) of this paragraph is not 
sold for ultimate use in the United States, or
    (B) Under subdivision (4)(v) of this paragraph is leased for 
ultimate use outside the United States.

[[Page 61]]

    (ii) Sales of property for ultimate use in the United States. For 
purposes of subdivision (4)(i) of this paragraph, a purchaser of 
property (including components, as defined in subdivision (4)(vii) of 
this paragraph) is deemed to use the property ultimately in the United 
States if any of the following conditions exist:
    (A) The purchaser is a related party with respect to the seller and 
the purchaser ultimately uses the property, or a second product into 
which the property is incorporated as a component, in the United States.
    (B) At the time of the sale, there is an agreement or understanding 
that the property, or a second product into which the property is 
incorporated as a component, will be ultimately used by the purchaser in 
the United States.
    (C) At the time of the sale, a reasonable person would have believed 
that the property or the second product would be ultimately used by the 
purchaser in the United States unless, in the case of a sale of 
components, the fair market value of the components at the time of 
delivery to the purchaser constitutes less than 20 percent of the fair 
market value of the second product into which the components are 
incorporated (determined at the time of completion of the production, 
manufacture, or assembly of the second product).


For purposes of subdivision (4)(ii)(B) of this paragraph, there is an 
agreement or understanding that property will ultimately be used in the 
United States if, for example, a component is sold abroad under an 
express agreement with the foreign purchaser that the component is to be 
incorporated into a product to be sold back to the United States. As a 
further example, there would also be such an agreement or understanding 
if the foreign purchaser indicated at the time of the sale or previously 
that the component is to be incorporated into a product which is 
designed principally for the United States market. However, such an 
agreement or understanding does not result from the mere fact that a 
second product, into which components exported from the United States 
have been incorporated and which is sold on the world market, is sold in 
substantial quantities in the United States.
    (iii) Use in the United States. For purposes of subdivision (4)(ii) 
of this paragraph, property (including components incorporated into a 
second product) is or would be ultimately used in the United States by 
the purchaser if, at any time within 3 years after the purchase of such 
property or components, either the property is or the components (or the 
second product into which the components are incorporated) are resold by 
the purchaser for use by a subsequent purchaser within the United States 
or the purchaser or subsequent purchaser fails, for any period of 365 
consecutive days, to use the property or second product predominantly 
outside the United States (as defined in subdivision (4)(vi) of this 
paragraph).
    (iv) Sales to retailers. For purposes of subdivision (4)(ii)(C) of 
this paragraph, property sold to any person whose principal business 
consists of selling from inventory to retail customers at retail outlets 
outside the United States will be considered to be used predominantly 
outside the United States.
    (v) Leases of property for ultimate use outside the United States. 
For purposes of subdivision (4)(i) of this paragraph, a lessee of 
property is deemed to use property ultimately outside the United States 
during a taxable year of the lessor if the property is used 
predominantly outside the United States (as defined in subdivision 
(4)(vi) of this paragraph) by the lessee during the portion of the 
lessor's taxable year which is included within the term of the lease. A 
determination as to whether the ultimate use of leased property 
satisfies the requirements of this subdivision is made for each taxable 
year of the lessor. Thus, leased property may be used predominantly 
outside the United States for a taxable year of the lessor (and thus, 
constitute export property if the remaining requirements of this section 
are met) even if the property is not used predominantly outside the 
United States in earlier taxable years or later taxable years of the 
lessor.
    (vi) Predominant use outside the United States. For purposes of this 
paragraph (d)(4), property is used predominantly

[[Page 62]]

outside the United States for any period if, during that period, the 
property is located outside the United States more than 50 percent of 
the time. An aircraft, railroad rolling stock, vessel, motor vehicle, 
container, or other property used for transportation purposes is deemed 
to be used predominantly outside the United States for any period if, 
during that period, either the property is located outside the United 
States more than 50 percent of the time or more than 50 percent of the 
miles traversed in the use of the property are traversed outside the 
United States. However, property is deemed to be within the United 
States at all times during which it is engaged in transport between any 
two points within the United States, except where the transport 
constitutes uninterrupted international air transportation within the 
meaning of section 4262(c)(3) and the regulations under that section 
(relating to tax on air transportation of persons). An orbiting 
satellite is deemed to be located outside the United States. For 
purposes of applying section 4262(c)(3) to this subdivision, the term 
``United States'' includes the Commonwealth of Puerto Rico.
    (vii) Component. For purposes of this paragraph (d)(4), a component 
is property which is (or is reasonably expected to be) incorporated into 
a second product by the purchaser of such component by means of 
production, manufacture, or assembly.
    (e) Foreign content of property--(1) The 50 percent test. Under 
paragraph (a)(3) of this section, no more than 50 percent of the fair 
market value of export property may be attributable to the fair market 
value of articles which were imported into the United States. For 
purposes of this paragraph (e), articles imported into the United States 
are referred to as ``foreign content.'' The fair market value of the 
foreign content of export property is computed in accordance with 
paragraph (e)(4) of this section. The fair market value of export 
property which is sold to a person who is not a related person with 
respect to the seller is the sale price for such property (not including 
interest, finance or carrying charges, or similar charges.)
    (2) Application of 50 percent test. The 50 percent test is applied 
on an item-by-item basis. If, however, a person sells or leases a large 
volume of substantially identical export property in a taxable year and 
if all of that property contains substantially identical foreign content 
in substantially the same proportion, the person may determine the 
portion of foreign content contained in that property on an aggregate 
basis.
    (3) Parts and services. If, at the time property is sold or leased 
the seller or lessor agrees to furnish parts pursuant to a services 
contract (as provided in Sec. 1.924(a)-1T(d)(3)) and the price for the 
parts is not separately stated, the 50 percent test is applied on an 
aggregate basis to the property and parts. If the price for the parts is 
separately stated, the 50 percent test is applied separately to the 
property and to the parts.
    (4) Computation of foreign content--(i) Valuation. For purposes of 
applying the 50 percent test, it is necessary to determine the fair 
market value of all articles which constitutes foreign content of the 
property being tested to determine if it is export property. The fair 
market value of the imported articles is determined as of the time the 
articles are imported into the United States.
    (A) General rule. Except as provided in paragraph (e)(4)(i)(B), the 
fair market value of the imported articles which constitutes foreign 
content is their appraised value, as determined under section 403 of the 
Tariff Act of 1930 (19 U.S.C. 1401a) in connection with their 
importation. The appraised value of the articles is the full dutiable 
value of the articles, determined, however, without regard to any 
special provision in the United States tariff laws which would result in 
a lower dutiable value.
    (B) Special election. If all or a portion of the imported article 
was originally manufactured, produced, grown, or extracted in the United 
States, the taxpayer may elect to determine the fair market value of the 
imported articles which constitutes foreign content under the provisions 
of this paragraph (e)(4)(i)(B) if the property is subjected to 
manufacturing or production (as defined in paragraph (c) of this 
section)

[[Page 63]]

within the United States after importation. A taxpayer making the 
election under this paragraph may determine the fair market value of the 
imported articles which constitutes foreign content to be the fair 
market value of the imported articles reduced by the fair market value 
at the time of the initial export of the portion of the property that 
was manufactured, produced, grown, or extracted in the United States. 
The taxpayer must establish the fair market value of the imported 
articles and of the portion of the property manufactured, produced, 
grown, or extracted in the United States at the time of the initial 
export in accordance with subdivision (4)(ii)(B) of this paragraph.
    (ii) Evidence of fair market value--(A) General rule. For purposes 
of subdivision (4)(i)(A) of this paragraph, the fair market value of the 
imported articles is their appraised value, which may be evidenced by 
the customs invoice issued on the importation of such articles into the 
United States. If the holder of the articles is not the importer (or a 
related person with respect to the importer), the appraised value of the 
articles may be evidenced by a certificate based upon information 
contained in the customs invoice and furnished to the holder by the 
person from whom the articles (or property incorporating the articles) 
were purchased. If a customs invoice or certificate described in the 
preceding sentences is not available to a person purchasing property, 
the person shall establish that no more than 50 percent of the fair 
market value of such property is attributable to the fair market value 
of articles which were imported into the United States.
    (B) Special election. For purposes of the special election set forth 
in subdivision (4)(i)(B) of this paragraph, if the initial export is 
made to a controlled person within the meaning of section 482, the fair 
market value of the imported articles and of the portion of the articles 
that are manufactured, produced, grown, or extracted within the United 
States shall be established by the taxpayer in accordance with the rules 
under section 482 and the regulations under that section. If the initial 
export is not made to a controlled person, the fair market value must be 
established by the taxpayer under the facts and circumstances.
    (iii) Interchangeable component articles. (A) If identical or 
similar component articles can be incorporated interchangeably into 
property and a person acquires component articles that are imported into 
the United States and other component articles that are not imported 
into the United States, the determination whether imported component 
articles were incorporated in the property that is exported from the 
United States shall be made on a substitution basis as in the case of 
the rules relating to drawback accounts under the customs laws. See 
section 313(b) of the Tariff Act of 1930, as amended (19 U.S.C. 
1313(b)).
    (B) The provisions of subdivision (4)(iii)(A) of this paragraph may 
be illustrated by the following example:

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

    (f) Excluded property--(1) In general. Notwithstanding any other 
provision of this section, the following property is not export 
property--
    (i) Property described in subdivision (2) of this paragraph 
(relating to property leased to a member of controlled group),

[[Page 64]]

    (ii) Property described in subdivision (3) of this paragraph 
(relating to certain types of intangible property),
    (iii) Products described in paragraph (g) of this section (relating 
to oil and gas products), and
    (iv) Products described in paragraph (h) of this section (relating 
to certain export controlled products).
    (2) Property leased to member of controlled group--(i) In general. 
Property leased to a person (whether or not a FSC) which is a member of 
the same controlled group as the lessor constitutes export property for 
any period of time only if during the period--
    (A) The property is held for sublease, or is subleased, by the 
person to a third person for the ultimate use of the third person;
    (B) The third person is not a member of the same controlled group; 
and
    (C) The property is used predominantly outside the United States by 
the third person.
    (ii) Predominant use. The provisions of paragraph (d)(4)(vi) of this 
section apply in determining under subdivision (2)(i)(C) of this 
paragraph whether the property is used predominantly outside the United 
States by the third person.
    (iii) Leasing rule. For purposes of this paragraph (f)(2), leased 
property is deemed to be ultimately used by a member of the same 
controlled group as the lessor if such property is leased to a person 
which is not a member of the controlled group but which subleases the 
property to a person which is a member of the controlled group. Thus, 
for example, if X, a FSC for the taxable year, leases a movie film to Y, 
a foreign corporation which is not a member of the same controlled group 
as X, and Y then subleases the film to persons which are members of the 
controlled group for showing to the general public, the film is not 
export property. On the other hand, if X, a FSC for the taxable year, 
leases a movie film to Z, a foreign corporation which is a member of the 
same controlled group as X, and Z then subleases the film to Y, another 
foreign corporation, which is not a member of the same controlled group 
for showing to the general public, the film is not disqualified from 
being export property.
    (iv) Certain copyrights. With respect to a copyright which is not 
excluded by subdivision (3) of this paragraph from being export 
property, the ultimate use of the property is the sale or exhibition of 
the property to the general public. Thus, if A, a FSC for the taxable 
year, leases recording tapes to B, a foreign corporation which is a 
member of the same controlled group as A, and if B makes records from 
the recording tape and sells the records to C, another foreign 
corporation, which is not a member of the same controlled group, for 
sale by C to the general public, the recording tape is not disqualified 
under this paragraph from being export property, notwithstanding the 
leasing of the recording tape by A to a member of the same controlled 
group, since the ultimate use of the tape is the sale of the records 
(i.e., property produced from the recording tape).
    (3) Intangible property. Export property does not include any 
patent, invention, model, design, formula, or process, whether or not 
patented, or any copyright (other than films, tapes, records, or similar 
reproductions, for commercial or home use), goodwill, trademark, 
tradebrand, franchise, or other like property. Although a copyright such 
as a copyright on a book or computer software does not constitute export 
property, a copyrighted article (such as a book or standardized, mass 
marketed computer software) if not accompanied by a right to reproduce 
for external use is export property if the requirements of this section 
are otherwise satisfied. Computer software referred to in the preceding 
sentence may be on any medium, including, but not limited to, magnetic 
tape, punched cards, disks, semi-conductor chips and circuit boards. A 
license of a master recording tape for reproduction outside the United 
States is not disqualified under this paragraph from being export 
property.
    (g) Oil and gas--(1) In general. Under section 927(a)(2)(C), export 
property does not include oil or gas (or any primary product thereof).
    (2) Primary product from oil or gas. A primary product from oil or 
gas is not export property. For purposes of this paragraph--

[[Page 65]]

    (i) Primary product from oil. The term ``primary product from oil'' 
means crude oil and all products derived from the destructive 
distillation of crude oil, including--
    (A) Volatile products,
    (B) Light oils such as motor fuel and kerosene,
    (C) Distillates such as naphtha,
    (D) Lubricating oils,
    (E) Greases and waxes, and
    (F) Residues such as fuel oil.


For purposes of this paragraph, a product or commodity derived from 
shale oil which would be a primary product from oil if derived from 
crude oil is considered a primary product from oil.
    (ii) Primary product from gas. The term ``primary product from gas'' 
means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the lease or upon further processing, 
including--
    (A) Natural gas,
    (B) Condensates,
    (C) Liquefied petroleum gases such as ethane, propane, and butane, 
and
    (D) Liquid products such as natural gasoline.
    (iii) Primary products and changing technology. The primary products 
from oil or gas described in subdivisions (2)(i) and (ii) of this 
paragraph and the processes described in those subdivisions are not 
intended to represent either the only primary products from oil or gas, 
or the only processes from which primary products may be derived under 
existing and future technologies. For example, petroleum coke, although 
not derived from the destructive distillation of crude oil, is a primary 
product from oil derived from an existing technology.
    (iv) Non-primary products. For purposes of this paragraph, 
petrochemicals, medicinal products, insecticides and alcohols are not 
considered primary products from oil or gas.
    (h) Export controlled products--(1) In general. Section 927(a)(2)(D) 
provides that an export controlled product is not export property. A 
product or commodity may be an export controlled product at one time but 
not an export controlled product at another time. For purposes of this 
paragraph, a product or commodity is an ``export controlled product'' at 
a particular time if at that time the export of such product or 
commodity is prohibited or curtailed under section 7(a) of the Export 
Administration Act of 1979, to effectuate the policy relating to the 
protection of the domestic economy set forth in paragraph (2)(C) of 
section 3 of the Export Administration Act of 1979. That policy is to 
use export controls to the extent necessary to protect the domestic 
economy from the excessive drain of scarce materials and to reduce the 
serious inflationary impact of foreign demand.
    (2) Products considered export controlled products--(i) In general. 
For purposes of this paragraph, an export controlled product is a 
product or commodity, which is subject to short supply export controls 
under 15 CFR part 377. A product or commodity is considered an export 
controlled product for the duration of each control period which applies 
to such product or commodity. A control period of a product or commodity 
begins on and includes the initial control date (as defined in 
subdivision (2)(ii) of this paragraph) and ends on and includes the 
final control date (as defined in subdivision (2)(iii) of this 
paragraph).
    (ii) Initial control date. The initial control date of a product or 
commodity which is subject to short supply export controls is the 
effective date stated in the regulations to 15 CFR part 377 which 
subjects the product or commodity to short supply export controls. If 
there is no effective date stated in these regulations, the initial 
control date of the product or commodity will be thirty days after the 
effective date of the regulations which subject the product or commodity 
to short supply export controls.
    (iii) Final control date. The final control date of a product or 
commodity is the effective date stated in the regulations to 15 CFR part 
377 which removes the product or commodity from short supply export 
controls. If there is no effective date stated in those regulations, the 
final control date of the product or commodity is the date which is 
thirty days after the effective date of the regulations which remove the 
product or commodity from short supply export control.

[[Page 66]]

    (iv) Expiration of Export Administration Act. An initial control 
date and final control date cannot occur after the expiration date of 
the Export Administration Act under the authority of which the short 
supply export controls were issued.
    (3) Effective dates--(i) Products controlled on January 1, 1985. If 
a product or commodity was subject to short supply export controls on 
January 1, 1985, this paragraph shall apply to all sales, exchanges, 
other dispositions, or leases of the product or commodity made after 
January 1, 1985, by the FSC or by the FSC's related supplier if the FSC 
is the commission agent on the transaction.
    (ii) Products first controlled after January 1, 1985. If a product 
or commodity becomes subject to short supply export controls after 
January 1, 1985, this paragraph applies to sales, exchanges, other 
dispositions, or leases of such product or commodity made on or after 
the initial control date of such product or commodity, and to owning 
such product or commodity on or after such date.
    (iii) Date of sales, exchange, lease, or other disposition. For 
purposes of this paragraph (h)(3), the date of sale, exchange, or other 
disposition of a product or commodity is the date as of which title to 
such product or commodity passes. The date of a lease is the date as of 
which the lessee takes possession of a product or commodity. The 
accounting method of a person is not determinative of the date of sale, 
exchange, other disposition, or lease.
    (i) Property in short supply. If the President determines that the 
supply of any property which is otherwise export property as defined in 
this section is insufficient to meet the requirements of the domestic 
economy, he may by Executive Order designate such property as in short 
supply. Any property so designated will be treated under section 
927(a)(3) as property which is not export property during the period 
beginning with the date specified in such Executive Order and ending 
with the date specified in an Executive Order setting forth the 
President's determination that such property is no longer in short 
supply.

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



Sec. 1.927(b)-1T  [Reserved]



Sec. 1.927(d)-1  [Reserved]



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

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

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

                    possessions of the united states



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

    (a) General rule. (1) An individual (whether a United States citizen 
or an alien), who is a bona fide resident of a section 931 possession 
during the entire taxable year, will exclude from gross income the 
income derived from sources within any section 931 possession and the 
income effectively connected with the conduct of a trade or business by 
such individual within any section 931 possession, except amounts 
received for services performed as an employee of the United States or 
any agency thereof. For purposes of section 931(d) and this section, an 
employee of

[[Page 67]]

the government of a section 931 possession will not be considered an 
employee of the United States or of an agency of the United States.
    (2) The following example illustrates the application of the general 
rule in paragraph (a)(1) of this section:

    Example. D, a United States citizen, files returns on a calendar 
year basis. In April 2008, D moves to American Samoa, where he purchases 
a house and accepts a permanent position with a local employer. For the 
remainder of the year and for the following three taxable years, D 
continues to live and work in American Samoa and has a closer connection 
to American Samoa than to the United States or any foreign country. 
Assuming that D otherwise meets the requirements under section 937(a) 
and Sec. 1.937-1(b) and (f)(1) (year-of-move exception), D is 
considered a bona fide resident of American Samoa for 2008. Accordingly, 
under section 931 and paragraph (a)(1) of this section, D should exclude 
from his 2008 Federal gross income any income from sources within 
American Samoa and any income that is effectively connected with the 
conduct of a trade or business within American Samoa, as determined 
under section 937(b) and Sec. Sec. 1.937-2 and 1.937-3, as applicable.

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

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



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

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

[[Page 68]]

a trade or business within the Virgin Islands.
    (b) U.S. individuals with Virgin Islands income--(1) Dual filing 
requirement. Subject to paragraph (d) of this section, an individual 
described in paragraph (a)(2)(ii) of this section must make an income 
tax return for the taxable year to the United States and file a copy of 
such return with the Virgin Islands. Such individuals must also attach 
Form 8689, ``Allocation of Individual Income Tax to the U.S. Virgin 
Islands,'' to the U.S. income tax return and to the income tax return 
filed with the Virgin Islands.
    (2) Tax payments. (i) Each individual to whom this paragraph (b) 
applies for the taxable year must pay the applicable percentage of the 
taxes imposed by this chapter for such taxable year (determined without 
regard to paragraph (b)(2)(ii) of this section) to the Virgin Islands.
    (ii) A credit against the tax imposed by this chapter for the 
taxable year will be allowed in an amount equal to the taxes that are 
required to be paid to the Virgin Islands under paragraph (b)(2)(i) of 
this section and are so paid. Such taxes will be considered creditable 
in the same manner as taxes paid to the United States (for example, 
under section 31) and not as taxes paid to a foreign government (for 
example, under sections 27 and 901).
    (iii) For purposes of this paragraph (b)(2)--
    (A) The term applicable percentage means the percentage that Virgin 
Islands adjusted gross income bears to adjusted gross income;
    (B) The term Virgin Islands adjusted gross income means adjusted 
gross income determined by taking into account only income derived from 
sources within the Virgin Islands and deductions properly apportioned or 
allocable to such income. For purposes of the preceding sentence, the 
rules of Sec. 1.861-8 will apply; and
    (C) Pursuant to Sec. 1.937-2(a), the rules of Sec. 1.937-
2(c)(1)(ii) and (c)(2) do not apply.
    (c) Bona fide residents of the Virgin Islands. Subject to paragraph 
(d) of this section, an individual described in paragraph (a)(2)(i) of 
this section will be subject to the following income tax return filing 
requirements:
    (1) Virgin Islands filing requirements. An individual to whom this 
paragraph (c) applies must file an income tax return for the taxable 
year with the Virgin Islands. On this return, the individual must report 
income from all sources and identify the source of each item of income 
shown on the return.
    (2) U.S. filing requirements. (i) For purposes of calculating the 
income tax liability to the United States of an individual to whom this 
paragraph (c) applies, gross income will not include any amount included 
in gross income on the return filed with the Virgin Islands pursuant to 
paragraph (c)(1) of this section, and deductions and credits allocable 
to such income will not be taken into account, provided that--
    (A) The individual fully satisfied the reporting requirements of 
paragraph (c)(1) of this section; and
    (B) The individual fully paid the tax liability referred to in 
section 934(a) to the Virgin Islands with respect to such income.
    (ii) For purposes of the U.S. statute of limitations under section 
6501(a), an income tax return filed with the Virgin Islands by an 
individual who takes the position that he or she is a bona fide resident 
of the Virgin Islands described in paragraph (a)(2)(i) of this section 
(or an individual who files a joint return with such an individual under 
paragraph (d) of this section) will be deemed to be a U.S. income tax 
return, provided that the United States and the Virgin Islands have 
entered into an agreement for the routine exchange of income tax 
information satisfying the requirements of the Commissioner. The working 
arrangement announced in Notice 2007-31 satisfies the condition of the 
preceding sentence. See Notice 2007-31 (2007-16 IRB 971) (applicable to 
taxable years ending on or after December 31, 2006, unless and until 
arrangement terminates). In the absence of such an agreement, 
individuals to whom this paragraph (c) applies generally must file an 
income tax return for the taxable year with the United States to begin 
the period of limitations for Federal income tax purposes as provided in 
section 6501(a), and in such circumstances the Commissioner

[[Page 69]]

may by revenue procedure, notice, or other administrative pronouncement 
specify U.S. filing and other information reporting requirements for 
such individuals. For taxable years ending before December 31, 2006, the 
rules provided in section 3 of Notice 2007-19 (2007-11 IRB 689) will 
apply. See Sec. 601.601(d)(2)(ii)(b).
    (3) U.S. tax payments. In the case of an individual who is required 
to file an income tax return with the United States as a consequence of 
failing to satisfy the requirements of paragraphs (c)(2)(i)(A) or (B) of 
this section, there will be allowed as a credit against the tax imposed 
by this chapter for the taxable year an amount equal to the amount of 
the tax liability referred to in section 934(a) to the extent paid to 
the Virgin Islands. Such taxes shall be considered creditable in the 
same manner as taxes paid to the United States (for example, under 
section 31) and not as taxes paid to a foreign government (for example, 
under sections 27 and 901).
    (d) Joint returns. In the case of married persons, if one or both 
spouses is an individual described in paragraph (a)(2) of this section 
and they file a joint return of income tax, the spouses must file their 
joint return with, and pay the tax due on such return to, the 
jurisdiction (or jurisdictions) where the spouse who has the greater 
adjusted gross income for the taxable year would be required under 
paragraph (b) or (c) of this section to file a return if separate 
returns were filed and all of their income were the income of such 
spouse. For this purpose, adjusted gross income of each spouse is 
determined under section 62 and the regulations under that section but 
without regard to community property laws; and, if one of the spouses 
dies, the taxable year of the surviving spouse will be treated as ending 
on the date of such death.
    (e) Place for filing returns--(1) U.S. returns. Except as otherwise 
provided for returns filed under paragraph (c)(2)(ii) of this section, a 
return required under the rules of paragraphs (b) and (c) of this 
section to be filed with the United States must be filed as directed in 
the applicable forms and instructions.
    (2) Virgin Islands returns. A return required under the rules of 
paragraphs (b) and (c) of this section to be filed with the Virgin 
Islands must be filed as directed in the applicable forms and 
instructions.
    (f) Tax accounting standards--(1) In general. A dual filing taxpayer 
must use the same tax accounting standards on the returns filed with the 
United States and the Virgin Islands. A taxpayer who has filed a return 
only with the United States or only with the Virgin Islands as a single 
filing taxpayer for a prior taxable year and is required to file a 
return only with the other jurisdiction as a single filing taxpayer for 
a later taxable year may not, for such later taxable year, use different 
tax accounting standards unless the second jurisdiction consents to such 
change. However, such change will not be effective for returns filed 
thereafter with the first jurisdiction unless before such later date of 
filing the taxpayer also obtains the consent of the first jurisdiction 
to make such change. Any request for consent to make a change pursuant 
to this paragraph (f) must be made to the office where the return is 
required to be filed under paragraph (e) of this section and in 
sufficient time to permit a copy of the consent to be attached to the 
return for the taxable year.
    (2) Definitions. For purposes of this paragraph (f), the terms--
    (i) Dual filing taxpayer means a taxpayer who is required to file 
returns with the United States and the Virgin Islands for the same 
taxable year under the rules of paragraph (b) or (c) of this section;
    (ii) Single filing taxpayer means a taxpayer who is required to file 
a return only with the United States (because the individual is not 
described in paragraph (a)(2) of this section) or only with the Virgin 
Islands (because the individual is described in paragraph (a)(2)(i) of 
this section and satisfies the conditions of paragraphs (c)(2)(i) and 
(ii) of this section) for the taxable year; and
    (iii) Tax accounting standards includes the taxpayer's accounting 
period, methods of accounting, and any election to which the taxpayer is 
bound

[[Page 70]]

with respect to the reporting of taxable income.
    (g) Extension of territory--(1) Section 932(a) taxpayers--(i) 
General rule. With respect to an individual to whom section 932(a) 
applies for a taxable year, for purposes of taxes imposed by Chapter 1 
of the Internal Revenue Code (Code), the United States generally will be 
treated, in a geographical and governmental sense, as including the 
Virgin Islands. The purpose of this rule is to facilitate the 
coordination of the tax systems of the United States and the Virgin 
Islands. Accordingly, the rule will have no effect where it is 
manifestly inapplicable or its application would be incompatible with 
the intent of any provision of the Code.
    (ii) Application of general rule. Contexts in which the general rule 
of paragraph (g)(1)(i) of this section apply include--
    (A) The characterization of taxes paid to the Virgin Islands. An 
individual to whom section 932(a) applies may take income tax required 
to be paid to the Virgin Islands under section 932(b) into account under 
sections 31, 6315, and 6402(b) as payments to the United States. Taxes 
paid to the Virgin Islands and otherwise satisfying the requirements of 
section 164(a) will be allowed as a deduction under that section, but 
income taxes required to be paid to the Virgin Islands under section 
932(b) will be disallowed as a deduction under section 275(a);
    (B) The determination of the source of income for purposes of the 
foreign tax credit (for example, sections 901 through 904). Thus, for 
example, after an individual to whom section 932(a) applies determines 
which items of income constitute income from sources within the Virgin 
Islands under the rules of section 937(b), such income will be treated 
as income from sources within the United States for purposes of section 
904;
    (C) The eligibility of a corporation to make a subchapter S election 
(sections 1361 through 1379). Thus, for example, for purposes of 
determining whether a corporation created or organized in the Virgin 
Islands may make an election under section 1362(a) to be a subchapter S 
corporation, it will be treated as a domestic corporation and a 
shareholder to whom section 932(a) applies will not be treated as a 
nonresident alien individual with respect to such corporation. While 
such an election is in effect, the corporation will be treated as a 
domestic corporation for all purposes of the Internal Revenue Code. For 
the consistency requirement with respect to entity status elections, see 
paragraph (h) of this section;
    (D) The treatment of items carried over from other taxable years. 
Thus, for example, if an individual to whom section 932(a) applies has 
for a taxable year a net operating loss carryback or carryover under 
section 172, a foreign tax credit carryback or carryover under section 
904, a business credit carryback or carryover under section 39, a 
capital loss carryover under section 1212, or a charitable contributions 
carryover under section 170, the carryback or carryover will be reported 
on the return filed in accordance with paragraph (b)(1) of this section, 
even though the return of the taxpayer for the taxable year giving rise 
to the carryback or carryover was required to be filed with the Virgin 
Islands under section 932(c); and
    (E) The treatment of property exchanged for property of a like kind 
(section 1031). Thus, for example, if an individual to whom section 
932(a) applies exchanges real property located in the United States for 
real property located in the Virgin Islands, notwithstanding the 
provisions of section 1031(h), such exchange may qualify as a like-kind 
exchange under section 1031 (provided that all the other requirements of 
section 1031 are satisfied).
    (iii) Nonapplication of the general rule. Contexts in which the 
general rule of paragraph (g)(1)(i) of this section does not apply 
include--
    (A) The application of any rules or regulations that explicitly 
treat the United States and any (or all) of its possessions as separate 
jurisdictions (for example, sections 931 through 937, 7651, and 7654).
    (B) The determination of any aspect of an individual's residency 
(for example, sections 937(a) and 7701(b)). Thus,

[[Page 71]]

for example, an individual whose principal place of abode is in the 
Virgin Islands is not considered to have a principal place of abode in 
the United States for purposes of section 32(c);
    (C) The characterization of a corporation for purposes other than 
subchapter S (for example, sections 367, 951 through 964, 1291 through 
1298, 6038, and 6038B). Thus, for example, if an individual to whom 
section 932(a) applies transfers appreciated tangible property to a 
corporation created or organized in the Virgin Islands in a transaction 
described in section 351, he or she must recognize gain unless an 
exception under section 367(a) applies. Also, if a corporation created 
or organized in the Virgin Islands qualifies as a passive foreign 
investment company under sections 1297 and 1298 with respect to an 
individual to whom section 932(a) applies, a dividend paid to such 
shareholder does not constitute qualified dividend income under section 
1(h)(11)(B).
    (2) Section 932(c) taxpayers--(i) General rule. With respect to an 
individual to whom section 932(c) applies for a taxable year, for 
purposes of the territorial income tax of the Virgin Islands (that is, 
mirrored sections of the Code), the Virgin Islands generally will be 
treated, in a geographical and governmental sense, as including the 
United States. The purpose of this rule is to facilitate the 
coordination of the tax systems of the United States and the Virgin 
Islands. Accordingly, the rule will have no effect where it is 
manifestly inapplicable or its application would be incompatible with 
the intent of any provision of the Code.
    (ii) Application of general rule. Contexts in which the general rule 
of paragraph (g)(2)(i) of this section apply include--
    (A) The characterization of taxes paid to the United States. A 
taxpayer described in section 932(c)(1) may take income tax paid to the 
United States into account under mirrored sections 31, 6315, and 6402(b) 
as payments to the Virgin Islands;
    (B) The determination of the source of income for purposes of the 
foreign tax credit (for example, mirrored sections 901 through 904). 
Thus, for example, any item of income that constitutes income from 
sources within the United States under the rules of sections 861 through 
865 will be treated as income from sources within the Virgin Islands for 
purposes of mirrored section 904;
    (C) The eligibility of a corporation to make a subchapter S election 
(mirrored sections 1361 through 1379). Thus, for example, for purposes 
of determining whether a corporation created or organized in the United 
States may make an election under mirrored section 1362(a) to be a 
subchapter S corporation, it will be treated as a domestic corporation 
and a shareholder to whom section 932(c) applies will not be treated as 
a nonresident alien individual with respect to such corporation. While 
such an election is in effect, the corporation will be treated as a 
domestic corporation for all purposes of the territorial income tax. For 
the consistency requirement with respect to entity status elections, see 
paragraph (h) of this section;
    (D) The treatment of items carried over from other taxable years. 
Thus, for example, if an individual to whom section 932(c) applies has 
for a taxable year a net operating loss carryback or carryover under 
mirrored section 172, a foreign tax credit carryback or carryover under 
mirrored section 904, a business credit carryback or carryover under 
mirrored section 39, a capital loss carryover under mirrored section 
1212, or a charitable contributions carryover under mirrored section 
170, the carryback or carryover will be reported on the return filed in 
accordance with paragraph (c)(1) of this section, even though the return 
of the taxpayer for the taxable year giving rise to the carryback or 
carryover was required to be filed with the United States; and
    (E) The treatment of property exchanged for property of a like kind 
(mirrored section 1031). Thus, for example, if an individual to whom 
section 932(c) applies exchanges real property located in the United 
States for real property located in the Virgin Islands, notwithstanding 
the provisions of mirrored section 1031(h), such exchange may qualify as 
a like-kind exchange under mirrored section 1031 (provided that all the 
other requirements of mirrored section 1031 are satisfied).

[[Page 72]]

    (iii) Nonapplication of general rule. Contexts in which the general 
rule of paragraph (g)(2)(i) of this section does not apply include--
    (A) The determination of any aspect of an individual's residency 
(for example, mirrored section 7701(b)). Thus, for example, an 
individual whose principal place of abode is in the United States is not 
considered to have a principal place of abode in the Virgin Islands for 
purposes of mirrored section 32(c).
    (B) The determination of the source of income for purposes other 
than the foreign tax credit (for example, sections 932(a) and (b), 
934(b), and 937). Thus, for example, compensation for services performed 
in the United States and rentals or royalties from property located in 
the United States do not constitute income from sources within the 
Virgin Islands for purposes of section 934(b); and
    (C) The definition of wages (mirrored section 3401). Thus, for 
example, services performed by an employee for an employer in the United 
States do not constitute services performed in the Virgin Islands under 
mirrored section 3401(a)(8).
    (h) Entity status consistency requirement--(1) In general. Taxpayers 
should make consistent entity status elections (as defined in paragraph 
(h)(3) of this section), where applicable, in both the United States and 
the Virgin Islands. In the case of a business entity to which this 
paragraph (h) applies--
    (i) If an entity status election is filed with the Internal Revenue 
Service (IRS) but not with the Virgin Islands Bureau of Internal Revenue 
(BIR), the Director of the BIR or his delegate, at his discretion, may 
deem the election also to have been made for Virgin Islands tax 
purposes;
    (ii) If an entity status election is filed with the BIR but not with 
the IRS, the Commissioner, at his discretion, may deem the election also 
to have been made for Federal tax purposes; and
    (iii) If inconsistent entity status elections are filed with the BIR 
and the IRS, both the Commissioner and the Director of the BIR or his 
delegate may, at their individual discretion, treat the elections they 
each received as invalid and may deem the election filed in the other 
jurisdiction to have been made also for tax purposes in their own 
jurisdiction. See Rev. Proc. 2006-23 (2006-1 CB 900) (see Sec. 
601.601(d)(2)(ii)(b) of this chapter) for procedures for requesting the 
assistance of the IRS when a taxpayer is or may be subject to 
inconsistent tax treatment by the IRS and a U.S. possession tax agency.
    (2) Scope. This paragraph (h) applies to the following business 
entities:
    (i) A business entity (as defined in Sec. 301.7701-2(a) of this 
chapter) that is domestic (as defined in Sec. 301.7701-5 of this 
chapter), or otherwise treated as domestic for purposes of the Code, and 
that is owned in whole or in part by any person who is either a bona 
fide resident of the Virgin Islands or a business entity created or 
organized in the Virgin Islands.
    (ii) A business entity that is created or organized in the Virgin 
Islands and that is owned in whole or in part by any U.S. person (other 
than a bona fide resident of the Virgin Islands).
    (3) Definition. For purposes of this section, the term entity status 
election includes an election under Sec. 301.7701-3(c) of this chapter, 
an election under section 1362(a), and any other similar elections.
    (4) Default status. Solely for the purpose of determining 
classification of an eligible entity under Sec. 301.7701-3(b) of this 
chapter and under that section as mirrored in the Virgin Islands, an 
eligible entity subject to this paragraph (h) will be classified for 
both Federal and Virgin Islands tax purposes using the rule that applies 
to domestic eligible entities.
    (5) Transition rules. (i) In the case of an election filed prior to 
April 11, 2005, except as provided in paragraph (h)(5)(ii) of this 
section, the rules of paragraph (h)(1) of this section will apply as of 
the first day of the first taxable year of the entity beginning after 
April 11, 2005.
    (ii) In the unlikely circumstance that inconsistent elections 
described in paragraph (h)(1)(iii) of this section are filed prior to 
April 11, 2005, and the entity cannot change its classification to 
achieve consistency because of the sixty-month limitation described in 
Sec. 301.7701-3(c)(1)(iv) of this chapter,

[[Page 73]]

then the entity may nevertheless request permission from the 
Commissioner or the Director of the BIR or his delegate to change such 
election to avoid inconsistent treatment by the Commissioner and the 
Director of the BIR or his delegate.
    (iii) Except as provided in paragraphs (h)(5)(i) and (h)(5)(ii) of 
this section, in the case of an election filed with respect to an entity 
before it became an entity described in paragraph (h)(2) of this 
section, the rules of paragraph (h)(1) of this section will apply as of 
the first day that such entity is described in paragraph (h)(2) of this 
section.
    (iv) In the case of an entity created or organized prior to April 
11, 2005, paragraph (h)(4) of this section will take effect for Federal 
income tax purposes (or Virgin Islands income tax purposes, as the case 
may be) as of the first day of the first taxable year of the entity 
beginning after April 11, 2005.
    (i) Examples. The rules of this section are illustrated by the 
following examples:

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

[[Page 74]]

the portion of their Federal income tax liability required to be paid to 
the Virgin Islands. H and W attach a Form 8689, ``Allocation of 
Individual Income Tax to the U.S. Virgin Islands,'' to their joint Form 
1040 filed with the IRS and to the copy filed with the Virgin Islands.
    Example 5. N, a U.S. citizen and calendar year taxpayer, takes the 
position that he is a bona fide resident of the Virgin Islands for the 
2007 taxable year. On April 15, 2008, N files a Form 1040, ``U.S. 
Individual Income Tax Return,'' with the Virgin Islands for his 2007 
taxable year. N does not file a Form 1040 with the IRS. Because there is 
an agreement in force between the United States and the Virgin Islands 
for the routine exchange of income tax information, under paragraph 
(c)(2)(ii) of this section, the Federal 3-year period of limitations 
under section 6501(a) will expire on April 15, 2011, and the IRS will 
make no further assessment of income tax after that date for N's 2007 
taxable year except as otherwise authorized by section 6501.
    Example 6. (i) J is a U.S. citizen and a bona fide resident of the 
Virgin Islands. In 2008, J receives compensation for services performed 
as an employee in the Virgin Islands in the amount of $40x. J files with 
the Virgin Islands a Form 1040, ``U.S. Individual Income Tax Return,'' 
reporting gross income of only $30x. Based on these facts, J has not 
satisfied the conditions of section 932(c)(4) and paragraph (c) of this 
section for an exclusion from gross income for Federal income tax 
purposes.
    (ii) The facts are the same as in paragraph (i) of this Example 6 
except that on or before the last day prescribed for filing an income 
tax return for J's 2008 taxable year, J files with the Virgin Islands an 
amended Form 1040 for 2008, correctly reporting the full $40x of 
compensation. Provided that J otherwise fully satisfies the reporting 
requirements of paragraph (c)(1) of this section and fully pays the tax 
liability referred to in section 934(a), J will have no Federal income 
tax filing requirement or liability under paragraphs (c)(2) and (3) of 
this section.
    Example 7. (i) N is a U.S. citizen and a bona fide resident of the 
Virgin Islands. In 2008, N receives compensation for services performed 
in Country M. N files with the Virgin Islands a Form 1040, ``U.S. 
Individual Income Tax Return,'' reporting the compensation as income 
effectively connected with the conduct of a trade or business in the 
Virgin Islands. N claims a special credit against the tax on this 
compensation pursuant to a Virgin Islands law enacted within the limits 
of its authority under section 934.
    (ii) Under the principles of section 864(c)(4) as applied pursuant 
to section 937(b)(1) and Sec. 1.937-3(b), compensation for services 
performed outside the Virgin Islands may not be treated as income 
effectively connected with the conduct of a trade or business in the 
Virgin Islands for purposes of section 934(b). Consequently, N is not 
entitled to claim the special credit under Virgin Islands law with 
respect to N's income from services performed in Country M. Because N 
has not fully paid his tax liability referred to in section 934(a), he 
has not satisfied the conditions of section 932(c)(4) and paragraph (c) 
of this section for an exclusion from gross income for Federal income 
tax purposes. Therefore, income reported on the Form 1040 as filed with 
the Virgin Islands must be included in N's Federal gross income. Under 
paragraph (c)(3) of this section, the amount of tax paid to the Virgin 
Islands on such income will be allowed as a credit against N's Federal 
income tax liability.

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

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



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

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

    Example. E, a United States citizen, files returns on a calendar 
year basis. In April 2008, E moves to Puerto Rico, where he purchases a 
house and accepts a permanent position with a local employer. For the 
remainder of the year and for the following three taxable years, E 
continues to live and work in Puerto Rico and has a closer connection to 
Puerto Rico than to the United States or any foreign country. Assuming 
that E otherwise meets the requirements under section 937(a) and Sec. 
1.937-1(b) and (f)(1) (year-of-move

[[Page 75]]

exception), E is considered a bona fide resident of Puerto Rico for 
2008. Accordingly, under section 933(1) and paragraph (a)(1) of this 
section, E should exclude from his 2008 Federal gross income any income 
from sources within Puerto Rico, as determined under section 937(b) and 
Sec. 1.937-2.

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

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



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

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

[[Page 76]]

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

[[Page 77]]

whether income is from sources outside the United States or effectively 
connected with the conduct of a trade or business within the United 
States.
    (ii) Conduit arrangements. Income will be considered to be from 
sources within the United States for purposes of paragraph (c)(1) of 
this section if, pursuant to a plan or arrangement--
    (A) The income is received in exchange for consideration provided to 
another person; and
    (B) Such person (or another person) provides the same consideration 
(or consideration of a like kind) to a third person in exchange for one 
or more payments constituting income from sources within the United 
States.
    (d) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. (i) S is a U.S. citizen and a bona fide resident of the 
Virgin Islands. For 2008, S files a Form 1040INFO, ``Non-Virgin Islands 
Source Income of Virgin Islands Residents,'' with the Virgin Islands on 
which S reports total gross income as follows:

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

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

[[Page 78]]

who are bona fide residents of the Virgin Islands. During 2008, A Corp 
had $50x in gross income from sources within the Virgin Islands (as 
determined under section 937(b) and Sec. 1.937-2) that is not 
effectively connected with the conduct of a trade or business in the 
United States; $20x in gross income from sources in Country H that is 
effectively connected with the conduct of A Corp's trade or business in 
the United States; and $10x in gross income from sources in Country R 
that is not effectively connected with the conduct of A Corp's trade or 
business in the United States.
    (ii) Section 934(b)(3) permits the Virgin Islands to reduce or remit 
the income tax liability of a qualified foreign corporation arising 
under the Code as applicable in the Virgin Islands (mirror code) with 
respect to income that is derived from sources outside the United States 
and that is not effectively connected with the conduct of a trade or 
business in the United States. A foreign corporation constitutes a 
``qualified foreign corporation'' under section 934(b)(3)(B) if less 
than 10 percent of the total voting power and value of the stock of the 
corporation is owned or treated as owned (within the meaning of section 
958) by one or more United States persons. A U.S. citizen is a ``United 
States person'' as defined in section 7701(a)(30)(A). Given that 10 
percent or more of the voting power and value of its stock is owned by 
U.S. citizens, A Corp does not constitute a ``qualified foreign 
corporation'' under section 934(b)(3)(B). Accordingly, the Virgin 
Islands may only reduce or remit A Corp's mirror code income tax 
liability with respect to its $50x in gross income from sources within 
the Virgin Islands.
    Example 5. (i) The facts are the same as in Example 4, except that 
the outstanding stock of A Corp is owned by the following individuals:
U.S. citizens who are bona fide residents of the Virgin Islands--5%
U.S. citizens who are not bona fide residents of the Virgin Islands--3%
Nonresident aliens who are bona fide residents of the Virgin Islands--
42%
Nonresident aliens who are not bona fide residents of the Virgin 
Islands--50%

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

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

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



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

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

[[Page 79]]

    (A) With respect to an individual described in paragraph (a)(2)(i) 
of this section, the section 935 possession of which such individual is 
a bona fide resident;
    (B) With respect to an individual described in paragraph (a)(2)(ii) 
of this section, the section 935 possession of which such individual is 
a citizen; and
    (C) With respect to an individual described in paragraph (a)(2)(iii) 
of this section, the section 935 possession from which such individual 
derives income.
    (iii) The rules of Sec. 1.937-1 will apply for determining whether 
an individual is a bona fide resident of a section 935 possession.
    (iv) The rules of Sec. 1.937-2 generally will apply for determining 
whether income is from sources within a section 935 possession. Pursuant 
to Sec. 1.937-2(a), however, the rules of Sec. 1.937-2(c)(1)(ii) and 
(c)(2) do not apply for purposes of section 935(a)(3) (as in effect 
before the effective date of its repeal) and paragraph (a)(2)(iii) of 
this section.
    (v) The term citizen of the United States means any individual who 
is a citizen within the meaning of Sec. 1.1-1(c), except that the term 
does not include an individual who is a citizen of a section 935 
possession but not otherwise a citizen of the United States. The term 
citizen of a section 935 possession but not otherwise a citizen of the 
United States means any individual who has become a citizen of the 
United States by birth or naturalization in the section 935 possession.
    (vi) With respect to the United States, the term resident means an 
individual who is a citizen (as defined in Sec. 1.1-1(c)) or resident 
alien (as defined in section 7701(b)) and who does not have a tax home 
(as defined in section 911(d)(3)) in a foreign country during the entire 
taxable year. The term does not include an individual who is a bona fide 
resident of a section 935 possession.
    (vii) The term U.S. taxpayer means an individual described in 
paragraph (b)(1)(i) or (iii)(B) of this section.
    (b) Filing requirement--(1) Tax jurisdiction. An individual 
described in paragraph (a)(2) of this section must file an income tax 
return for the taxable year--
    (i) With the United States if such individual is a resident of the 
United States;
    (ii) With the relevant possession if such individual is described in 
paragraph (a)(2)(i) of this section; or
    (iii) If neither paragraph (b)(1)(i) nor paragraph (b)(1)(ii) of 
this section applies--
    (A) With the relevant possession if such individual is described in 
paragraph (a)(2)(ii) of this section; or
    (B) With the United States if such individual is a citizen of the 
United States, as defined in paragraph (a)(3) of this section.
    (2) Joint returns. In the case of married persons, if one or both 
spouses is an individual described in paragraph (a)(2) of this section 
and they file a joint return of income tax, the spouses shall file their 
joint return with, and pay the tax due on such return to, the 
jurisdiction where the spouse who has the greater adjusted gross income 
for the taxable year would be required under subparagraph (1) of this 
paragraph to file his return if separate returns were filed. For this 
purpose, adjusted gross income of each spouse is determined under 
section 62 and the regulations thereunder but without regard to 
community property laws; and, if one of the spouses dies, the taxable 
year of the surviving spouse shall be treated as ending on the date of 
such death.
    (3) Place for filing returns--(i) U.S. returns. A return required 
under this paragraph (b) to be filed with the United States must be 
filed as directed in the applicable forms and instructions.
    (ii) Guam returns. A return required under this paragraph (b) to be 
filed with Guam must be filed as directed in the applicable forms and 
instructions.
    (iii) NMI returns. A return required under this paragraph (b) to be 
filed with the Northern Mariana Islands must be filed as directed in the 
applicable forms and instructions.
    (4) Tax accounting standards. A taxpayer who has filed his return 
with one of the jurisdictions named in subparagraph (1) of this 
paragraph for a prior taxable year and is required to file his return 
for a later taxable year with the other such jurisdiction may not, for

[[Page 80]]

such later taxable year, change his accounting period, method of 
accounting, or any election to which he is bound with respect to his 
reporting of taxable income to the first jurisdiction unless he obtains 
the consent of the second jurisdiction to make such change. However, 
such change will not be effective for returns filed thereafter with the 
first jurisdiction unless before such later date of filing he also 
obtains the consent of the first jurisdiction to make such change. Any 
request for consent to make a change pursuant to this subparagraph must 
be made to the office where the return is required to be filed under 
subparagraph (3) of this paragraph and in sufficient time to permit a 
copy of the consent to be attached to the return for the taxable year.
    (5) Tax payments. The tax shown on the return must be paid to the 
jurisdiction with which such return is required to be filed and must be 
determined by taking into account any credit under section 31 for tax 
withheld by the relevant possession or the United States on wages, any 
credit under section 6402(b) for an overpayment of income tax to the 
relevant possession or the United States, and any payments under section 
6315 of estimated income tax paid to the relevant possession or the 
United States.
    (6) Liability to other jurisdiction--(i) Filing with the relevant 
possession. In the case of an individual who is required under paragraph 
(b)(1) of this section to file a return with the relevant possession for 
a taxable year, if such individual properly files such return and fully 
pays his or her income tax liability to the relevant possession, such 
individual is relieved of liability to file an income tax return with, 
and to pay an income tax to, the United States for the taxable year.
    (ii) Filing with the United States. In the case of an individual who 
is required under paragraph (b)(1) of this section to file a return with 
the United States for a taxable year, such individual is relieved of 
liability to file an income tax return with, and to pay an income tax 
to, the relevant possession for the taxable year.
    (7) [Reserved]
    (c) Extension of territory--(1) U.S. taxpayers--(i) General rule. 
With respect to a U.S. taxpayer, for purposes of taxes imposed by 
Chapter 1 of the Internal Revenue Code (Code), the United States 
generally will be treated, in a geographical and governmental sense, as 
including the relevant possession. The purpose of this rule is to 
facilitate the coordination of the tax systems of the United States and 
the relevant possession. Accordingly, the rule will have no effect where 
it is manifestly inapplicable or its application would be incompatible 
with the intent of any provision of the Code.
    (ii) Application of general rule. Contexts in which the general rule 
of paragraph (c)(1)(i) of this section apply include--
    (A) The characterization of taxes paid to the relevant possession. 
Income tax paid to the relevant possession may be taken into account 
under sections 31, 6315, and 6402(b) as payments to the United States. 
Taxes paid to the relevant possession and otherwise satisfying the 
requirements of section 164(a) will be allowed as a deduction under that 
section, but income taxes paid to the relevant possession will be 
disallowed as a deduction under section 275(a);
    (B) The determination of the source of income for purposes of the 
foreign tax credit (for example, sections 901 through 904). Thus, for 
example, after a U.S. taxpayer determines which items of income 
constitute income from sources within the relevant possession under the 
rules of section 937(b), such income will be treated as income from 
sources within the United States for purposes of section 904;
    (C) The eligibility of a corporation to make a subchapter S election 
(sections 1361 through 1379). Thus, for example, for purposes of 
determining whether a corporation created or organized in the relevant 
possession may make an election under section 1362(a) to be a subchapter 
S corporation, it will be treated as a domestic corporation and a U.S. 
taxpayer shareholder will not be treated as a nonresident alien 
individual with respect to such corporation. While such an election is 
in effect, the corporation will be treated as a domestic corporation for 
all purposes of the

[[Page 81]]

Code. For the consistency requirement with respect to entity status 
elections, see paragraph (e) of this section;
    (D) The treatment of items carried over from other taxable years. 
Thus, for example, if a U.S. taxpayer has for a taxable year a net 
operating loss carryback or carryover under section 172, a foreign tax 
credit carryback or carryover under section 904, a business credit 
carryback or carryover under section 39, a capital loss carryover under 
section 1212, or a charitable contributions carryover under section 170, 
the carryback or carryover will be reported on the return filed with the 
United States in accordance with paragraph (b)(1)(i) or (b)(1)(iii)(B) 
of this section, even though the return of the taxpayer for the taxable 
year giving rise to the carryback or carryover was required to be filed 
with a section 935 possession; and
    (E) The treatment of property exchanged for property of a like kind 
(section 1031). Thus for example, if a U.S. taxpayer exchanges real 
property located in the United States for real property located in the 
relevant possession, notwithstanding the provisions of section 1031(h), 
such exchange may qualify as a like-kind exchange under section 1031 
(provided that all the other requirements of section 1031 are 
satisfied).
    (iii) Nonapplication of general rule. Contexts in which the general 
rule of paragraph (c)(1)(i) of this section does not apply include--
    (A) The application of any rules or regulations that explicitly 
treat the United States and any (or all) of its possessions as separate 
jurisdictions (for example, sections 931 through 937, 7651, and 7654);
    (B) The determination of any aspect of an individual's residency 
(for example, sections 937(a) and 7701(b)). Thus, for example, an 
individual whose principal place of abode is in the relevant possession 
is not considered to have a principal place of abode in the United 
States for purposes of section 32(c);
    (C) The determination of the source of income for purposes other 
than the foreign tax credit (for example, sections 935, 937, and 7654). 
Thus, for example, income determined to be derived from sources within 
the relevant possession under section 937(b) will not be considered 
income from sources within the United States for purposes of Form 5074, 
``Allocation of Individual Income Tax to Guam or the Commonwealth of the 
Northern Mariana Islands (CNMI)'';
    (D) The definition of wages (section 3401). Thus, for example, 
services performed by an employee for an employer in the relevant 
possession do not constitute services performed in the United States 
under section 3401(a)(8); and
    (E) The characterization of a corporation for purposes other than 
subchapter S (for example, sections 367, 951 through 964, 1291 through 
1298, 6038, and 6038B). Thus, for example, if a U.S. taxpayer transfers 
appreciated tangible property to a corporation created or organized in 
the relevant possession in a transaction described in section 351, he or 
she must recognize gain unless an exception under section 367(a) 
applies. Also, if a corporation created or organized in the relevant 
possession qualifies as a passive foreign investment company under 
sections 1297 and 1298 with respect to a U.S. taxpayer, a dividend paid 
to such shareholder does not constitute qualified dividend income under 
section 1(h)(11)(B).
    (2) Application in relevant possession. In applying the territorial 
income tax of the relevant possession, such possession generally will be 
treated, in a geographical and governmental sense, as including the 
United States. Thus, for example, income tax paid to the United States 
may be taken into account under sections 31, 6315, and 6402(b) as 
payments to the relevant possession. Moreover, a citizen of the United 
States (as defined in paragraph (a)(3) of this section) not a resident 
of the relevant possession will not be treated as a nonresident alien 
individual for purposes of the territorial income tax of the relevant 
possession. Thus, for example, a citizen of the United States (as so 
defined), or a resident of the United States, will not be treated as a 
nonresident alien individual for purposes of section 1361(b)(1)(C) of 
the Guam territorial income tax.
    (d) Special rules for estimated income tax--(1) In general. An 
individual must make each payment of estimated income tax (and any 
amendment to the

[[Page 82]]

estimated tax payment) to the jurisdiction with which the individual 
reasonably believes, as of the date of that payment (or amendment), that 
he or she will be required to file a return for the taxable year under 
paragraph (b)(1) of this section. In determining the amount of such 
estimated income tax, income tax paid to the relevant possession may be 
taken into account under sections 31 and 6402(b) as payments to the 
United States, and vice versa. For other rules relating to estimated 
income tax, see section 6654.
    (2) Joint estimated income tax. In the case of married persons 
making a joint payment of estimated income tax, the taxpayers must make 
each payment of estimated income tax (and any amendment to the estimated 
tax payment) to the jurisdiction where the spouse who has the greater 
estimated adjusted gross income for the taxable year would be required 
under paragraph (d)(1) of this section to pay estimated income tax if 
separate payments were made. For this purpose, estimated adjusted gross 
income of each spouse for the taxable year is determined without regard 
to community property laws.
    (3) Erroneous payment. If the individual or spouses erroneously pay 
estimated income tax to the United States instead of the relevant 
possession or vice versa, only subsequent payments or amendments of the 
payments are required to be made pursuant to paragraph (d)(1) or (d)(2) 
of this section with the other jurisdiction.
    (4) Place for payment. Estimated income tax required under this 
paragraph (d) to be paid to Guam or the Northern Mariana Islands must be 
paid as directed in the applicable forms and instructions issued by the 
relevant possession. Estimated income tax required under paragraph 
(d)(1) of this section to be paid to the United States must be paid as 
directed in the applicable forms and instructions.
    (5) Liability to other jurisdiction--(i) Filing with Guam or the 
Northern Mariana Islands. Subject to paragraph (d)(6) of this section, 
an individual required under this paragraph (d) to pay estimated income 
tax (and amendments thereof) to Guam or the Northern Mariana Islands is 
relieved of liability to pay estimated income tax (and amendments 
thereof) to the United States.
    (ii) Filing with the United States. Subject to paragraph (d)(6) of 
this section, an individual required under this paragraph (d) to pay 
estimated income tax (and amendments thereof) to the United States is 
relieved of liability to pay estimated income tax (and amendments 
thereof) to the relevant possession.
    (6) Underpayments. The liability of an individual described in 
paragraph (a)(2) of this section for underpayments of estimated income 
tax for a taxable year, as determined under section 6654, will be to the 
jurisdiction with which the individual is required under paragraph (b) 
of this section to file his or her return for the taxable year.
    (e) Entity status consistency requirement--(1) In general. Taxpayers 
should make consistent entity status elections (as defined in paragraph 
(e)(3)(ii) of this section), when applicable, in both the United States 
and section 935 possessions. In the case of a business entity to which 
this paragraph (e) applies--
    (i) If an entity status election is filed with the Internal Revenue 
Service (IRS) but not with the relevant possession, the appropriate tax 
authority of the relevant possession, at his discretion, may deem the 
election also to have been made for the relevant possession tax 
purposes;
    (ii) If an entity status election filed with the relevant possession 
but not with the IRS, the Commissioner, at his discretion, may deem the 
election also to have been made for Federal tax purposes; and
    (iii) If inconsistent entity status elections are filed with the 
relevant possession and the IRS, both the Commissioner and the 
appropriate tax authority of the relevant possession may, at their 
individual discretion, treat the elections they each received as invalid 
and may deem the election filed in the other jurisdiction to have been 
made also for tax purposes in their own jurisdiction. See Rev. Proc. 
2006-23 (2006-1 C.B. 900) (see Sec. 601.601(d)(2)(ii)(b) of this 
chapter) for procedures for requesting

[[Page 83]]

the assistance of the IRS when a taxpayer is or may be subject to 
inconsistent tax treatment by the IRS and a U.S. possession tax agency.)
    (2) Scope. This paragraph (e) applies to the following business 
entities:
    (i) A business entity (as defined in Sec. 301.7701-2(a) of this 
chapter) that is domestic (as defined in Sec. 301.7701-5 of this 
chapter), or otherwise treated as domestic for purposes of the Code, and 
that is owned in whole or in part by any person who is either a bona 
fide resident of a section 935 possession or a business entity created 
or organized in a section 935 possession.
    (ii) A business entity that is created or organized in a section 935 
possession and that is owned in whole or in part by any U.S. person 
(other than a bona fide resident of such possession).
    (3) Definitions. For purposes of this section--
    (i) The term appropriate tax authority of the relevant possession 
means the individual responsible for tax administration in such 
possession or his delegate; and
    (ii) The term entity status election includes an election under 
Sec. 301.7701-3(c) of this chapter, an election under section 1362(a), 
and any other similar elections.
    (4) Default status. Solely for the purpose of determining 
classification of an eligible entity under Sec. 301.7701-3(b) of this 
chapter and under that section as mirrored in the relevant possession, 
an eligible entity subject to this paragraph (e) will be classified for 
both Federal and the relevant possession tax purposes using the rule 
that applies to domestic eligible entities.
    (5) Transition rules--(i) In the case of an election filed prior to 
April 11, 2005, except as provided in paragraph (e)(5)(ii) of this 
section, the rules of paragraph (e)(1) of this section will apply as of 
the first day of the first taxable year of the entity beginning after 
April 11, 2005.
    (ii) In the unlikely circumstance that inconsistent elections 
described in paragraph (e)(1)(iii) of this section are filed prior to 
April 11, 2005, and the entity cannot change its classification to 
achieve consistency because of the sixty-month limitation described in 
Sec. 301.7701-3(c)(1)(iv) of this chapter, then the entity may 
nevertheless request permission from the Commissioner or appropriate tax 
authority of the relevant possession to change such election to avoid 
inconsistent treatment by the Commissioner and the appropriate tax 
authority of the relevant possession.
    (iii) Except as provided in paragraphs (e)(5)(i) and (e)(5)(ii) of 
this section, in the case of an election filed with respect to an entity 
before it became an entity described in paragraph (e)(2) of this 
section, the rules of paragraph (e)(1) of this section will apply as of 
the first day that such entity is described in paragraph (e)(2) of this 
section.
    (iv) In the case of an entity created or organized prior to April 
11, 2005, paragraph (e)(4) of this section will take effect for Federal 
income tax purposes (or the relevant possession income tax purposes, as 
the case may be) as of the first day of the first taxable year of the 
entity beginning after April 11, 2005.
    (f) Examples. The application of this section is illustrated by the 
following examples:

    Example 1. (i) B, a United States citizen, files returns on a 
calendar year basis. In November 2008, B moves to Possession G, a 
section 935 possession; purchases a house; and accepts a permanent 
position with a local employer. For the remainder of the year and 
throughout 2009, B continues to live and work in Possession G and has a 
closer connection to Possession G than to the United States or any 
foreign country. As a consequence of his employment in Possession G, B 
earns income from the performance of services in Possession G during 
2008 and 2009.
    (ii) For 2008, B does not qualify as a bona fide resident of 
Possession G under section 937(a) and Sec. 1.937-1(b) and (f)(1). 
Therefore, B is subject to the rules applicable to individuals described 
in paragraph (a)(2)(iii) of this section for 2008 because he has income 
derived from sources within Possession G as determined under the rules 
of section 937(b) and Sec. 1.937-2.
    (iii) For 2009, assuming that B otherwise satisfies the requirements 
of section 937(a) and Sec. 1.937-1(b), B qualifies as a bona fide 
resident of Possession G. Therefore, section 935(b)(1)(B) and paragraph 
(b)(1)(ii) of this section apply to B for 2009, and he must file his 
income tax return with Possession G under paragraph (b)(1) of this 
section. Provided that B properly files such return and pays his income 
tax liability to Possession G, B is relieved of liability to file an 
income

[[Page 84]]

tax return with, and to pay an income tax to, the United States for 2009 
under paragraph (b)(6) of this section.
    Example 2. (i) The facts are the same as in Example 1 except that 
B's employment terminates in June 2011. B properly pays his April 2008 
estimated tax to the United States, continues to pay estimated tax for 
the 2008 taxable year to the United States under paragraph (d) of this 
section, and properly files his 2008 return with the United States.
    (ii)(A) On the date of each payment of estimated tax in 2009, B 
reasonably believes that he would be required to file his return for 
2009 with Possession G under paragraph (b)(1) of this section.
    (B) In August 2009, B determines that he has overpaid tax for the 
previous year in the amount of $1000. B properly pays all estimated 
taxes to Possession G for 2009, subtracting the $1000 overpayment from 
his estimated tax payments pursuant to section 6402(b), and properly 
files his tax return with Possession G.
    (iii) In April 2010, B reasonably believes that he would be 
returning to the United States in the Fall of 2010, and properly pays 
estimated tax to the United States. By June 2010, B reasonably believes 
that he would not be moving from Possession G and would be a bona fide 
resident of Possession G for the entire taxable year. B makes his 
remaining estimated tax payments to Possession G. On his 2010 tax return 
filed with Possession G, pursuant to section 6315, B properly takes into 
account payments made to both the United States and Possession G as 
estimated taxes.
    (iv) In April 2011, B reasonably believes that he would be a bona 
fide resident of Possession G for the entire taxable year 2011 and 
properly pays estimated taxes to Possession G. By the time B pays his 
estimated taxes for June 2011, B's employment terminates and he moves to 
State H. B properly makes his remaining estimated tax payments to the 
United States. On his return for 2011, properly filed with the United 
States, B determines that he has underpaid estimated taxes throughout 
2011 in an amount subject to penalty under section 6654. B owes the 
United States an estimated tax penalty under section 6654.

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

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

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



Sec. 1.936-1  Elections.

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


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

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

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



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

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e), where applicable.
    Q. 1: If a possessions corporation and its affiliates do not make an 
election under either the cost sharing or 50/50 profit split option, 
what rules will govern the treatment of income attributable to 
intangible property owned or leased by the possessions corporation?
    A. 1: Intangible property income will be allocated to the 
possessions corporation's U.S. shareholders with the proration of income 
based on shareholdings.

[[Page 85]]

If a shareholder of the possessions corporation is a foreign person or a 
tax-exempt person, the possessions corporation will be taxable on that 
shareholder's pro rata amount of the intangible property income. If any 
class of the stock of a possessions corporation is regularly traded on 
an established securities market, then the intangible property income 
will be taxable to the possessions corporation rather than the 
corporation's U.S. shareholders. For these purposes, a United States 
shareholder includes any shareholder who is a United States person as 
described under section 7701(a)(30). The term ``intangible property 
income'' means the gross income of a possessions corporation 
attributable to any intangible property other than intangible property 
which has been licensed to such corporation since prior to 1948 and 
which was in use by such corporation on September 3, 1982.
    Q. 2: What is the source of the intangible property income described 
in question 1?
    A. 2: The intangible property income is U.S. source, whether taxed 
to U.S. shareholders or taxed to the possessions corporation. Such 
intangible property income, if treated as income of the possessions 
corporation, does not enter into the calculation of the 80-percent 
possessions source test or the 65-percent active trade or business test 
of section 936(a)(2)(A) and (B).
    Q. 3: How will the amount of income attributable to intangible 
property be measured?
    A. 3: Income attributable to intangible property includes the amount 
received by a possessions corporation from the sale, exchange, or other 
disposition of any product or from the rendering of a service which is 
in excess of the reasonable costs it incurs in manufacturing the product 
or rendering the service (other than costs incurred in connection with 
intangibles) plus a reasonable profit margin. A reasonable profit margin 
shall be computed with respect to direct and indirect costs other than 
(i) costs incurred in connection with intangibles, (ii) interest 
expense, and (iii) the cost of materials which are subject to processing 
or which are components in a product manufactured by the possessions 
corporation. Notwithstanding the above, certain taxpayers who have been 
permitted by the Internal Revenue Service in taxable years beginning 
before January 1, 1983, to use the cost-plus method of pricing without 
reflecting a return from intangibles, but including the cost of 
materials in the cost base, will not be precluded from doing so. (Sec. 
3.02(3), Rev. Proc. 63-10, 1963-1 C.B. 490.) Thus, the Internal Revenue 
Service may continue in appropriate cases to permit such taxpayers to 
continue to report their income as they have been under existing 
procedures described in the previous sentence if it is appropriate under 
all the facts and circumstances and does not distort the income of the 
taxpayer.
    Q. 4: If there is no intangible property related to a product 
produced in whole or in part by a possessions corporation, what method 
may the possessions corporation use to compute its income?
    A. 4: The taxpayer may compute its income using the appropriate 
method as provided under section 482 and the regulations thereunder. The 
taxpayer may also elect the cost sharing or profit split method.

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



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

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

[[Page 86]]

936(h)(5). An integrated product is a product which is not subject to 
any further processing before sale to an unrelated party and which 
includes all component products from which it is produced. An end-
product form is a product which--
    (1) Is not subject to any further processing before sale to an 
unrelated party;
    (2) Is produced from a component product or products; and
    (3) Is treated as not including certain component products for all 
purposes of section 936(h)(5).


A possessions corporation may treat a component product, integrated 
product, or end-product form as its possession product even though the 
final stage or stages of production occur outside the possession. 
Further processing includes transformation, incorporation, assembly, or 
packaging.
    Q. 2: If a possessions corporation produces both a component product 
and an integrated product (which by definition includes the end-product 
form), may the possessions corporation use the options under section 
936(h)(5) to compute its income with respect to either the component 
product, the integrated product or the end-product form?
    A. 2: Yes. The possessions corporation may choose to treat the 
component product, the integrated product, or the end-product form as 
the product for purposes of determining whether the possessions 
corporation satisfies the significant business presence test. The 
possessions corporation must treat the same item of property as its 
product (the possession product) for all purposes of section 936(h)(5) 
for that taxable year, including the significant business presence test 
under section 936(h)(5)(B)(ii), the possessions sales calculation under 
section 936(h)(5)(C)(i)(I), the determination of income under section 
936(h)(5)(C)(i)(II), and the combined taxable income computations under 
section 936(h)(5)(C)(ii). Although the possessions corporation must 
treat the same item of property as its product for all purposes of 
section 936(h)(5) in a particular taxable year, its choice of the 
component product, integrated product or end-product form may be 
different from year to year. The possessions corporation must specify 
the possession product on a statement attached to its return (Schedule P 
of Form 5735). The possessions corporation may specify its choice by 
either listing the components that are included in the possession 
product or the components that are excluded from the possession product. 
The possessions corporation must file a separate Schedule P with respect 
to each possession product. The possessions corporation must attach to 
each Schedule P detailed computations indicating how the significant 
business presence test is satisfied with respect to the possession 
product identified in that Schedule P.
    Q. 3: A possessions corporation produces a product that is sometimes 
sold to unrelated parties without further processing and is sometimes 
sold to unrelated parties after further processing. May the possessions 
corporation choose to treat the same item of property as the possession 
product even though in some cases it is an integrated product and in 
some cases it is a component product?
    A. 3: Yes. Except as provided in questions and answers 4 and 5, the 
possessions corporation must designate a single possession product even 
though it is sometimes a component product and sometimes an integrated 
product.
    Q. 4: A possessions corporation produces a product that is sometimes 
sold without further processing by any member of the affiliated group to 
unrelated parties or to related parties for their own consumption and is 
sometimes sold after further processing by any member of the affiliated 
group to unrelated parties or to related parties for their own 
consumption. May the possessions corporation designate two products as 
possession products?
    A. 4: The possessions corporation may designate two or more 
possession products. The possessions corporation must use a consistent 
definition of the possession product for all items of property that are 
sold to unrelated parties or consumed by related parties at the same 
stage in the production process. The significant business presence test 
shall apply separately to each product designated by the possessions

[[Page 87]]

corporation. The possessions corporation shall compute its income 
separately with respect to each product.
    Q. 5: A possessions corporation produces a product in one taxable 
year and does not sell all of the units that it produced. In the next 
taxable year the possessions corporation produces a product which 
includes the product produced in the prior year. The possessions 
corporation could not have satisfied the significant business presence 
test with respect to the units produced the first taxable year if the 
larger possession product had been designated. May the possessions 
corporation designate two possession products in the second year?
    A. 5: Yes. The possessions corporation may designate two possession 
products. However, once a product has been designated for a particular 
year all sales of units produced in that year must be defined in the 
same manner. In addition, the taxpayer must maintain a significant 
business presence in a possession with respect to that product. Sales 
shall be deemed made first out of the current year's production. If all 
of the current year's production is sold and some inventory is 
liquidated, then the taxpayer's method of inventory accounting shall be 
applied to determine what year's layer of inventory is liquidated.

    Example 1. A possessions corporation S, manufactures a bulk 
pharmaceutical in a possession. S transfers the bulk pharmaceutical to 
its U.S. parent, P, for encapsulation and sale by P to customers. S 
satisifes the significant business presence test with respect to the 
bulk pharmaceutical (the component product) and the combination of the 
bulk pharmaceutical and the capsule (the integrated product). S may use 
the cost sharing or profit split method to compute its income with 
respect to either the component product or the integrated product.
    Example 2. The facts are the same as in example 1 except that S does 
not satisfy the significant business presence test with respect to the 
integrated product. S may use the cost sharing or profit split method to 
compute its income only with respect to the component product. However, 
if in a later taxable year S satisfies the significant business presence 
test with respect to the integrated product, then S may use the cost 
sharing or profit split method to compute its income with respect to 
that integrated product for that later taxable year.
    Example 3. P, a domestic corporation, produces in bulk form in the 
United States the active ingredient for a pharmaceutical product, P 
transfers the bulk form to S, a wholly owned possessions corporation. S 
uses the bulk form to produce in Puerto Rico the finished dosage form 
drug. S transfers the drug in finished dosage form to P, which sells the 
drug to unrelated customers in the U.S. The direct labor costs incurred 
in Puerto Rico by S during its taxable year in formulating, filling and 
finishing the dosage form are at least 65 percent of the total direct 
labor costs incurred by the affiliated group in producing the bulk and 
finished forms during that period. S manufactures (within the meaning of 
section 954(d)(1)(A)) the finished dosage form. S has elected out under 
section 936(h)(5) under the profit split option for the drug product 
area (SIC 283). P and S may treat the bulk and finished dosage forms as 
parts of an integrated product. Since S satisfies the significant 
business presence requirement with respect to the integrated product, it 
is entitled to 50 percent of the combined taxable income on the 
integrated product.
    Example 4. A possessions corporation, S. produces the keyboard of an 
electric typewriter and incorporates the keyboard with components 
acquired from a related corporation into finished typewriters. S does 
not satisfy the significant business presence test with respect to the 
typewriters (the integrated product). Therefore, S may use the cost 
sharing or profit split method to compute its income only with respect 
to a component product or end-product form. For taxable year 1983, S 
specifies on a statement attached to its return (Schedule P of Form 
5735) that the possession product is the end-product form. The statement 
indentifies the components--for example, the keyboard structure and 
frame--which are included in the possession product. S's definition of 
the possession product will apply to all units of the electric 
typewriters which S produces in whole or in part in the possession and 
which are sold in 1983. Thus, all units of a given component 
incorporated into such typewriters will be treated in the same way. For 
example, all keyboards and all frames will be included in the possession 
product, and all electric drive mechanisms and rollers will be excluded 
from the possession product.
    Example 5. Possessions corporation A produces printed circuit boards 
in a possession. The printed circuit boards are sold to unrelated 
parties. A also uses the boards to produce personal computers in the 
possession. A may designate two possession products: printed circuit 
boards and personal computers. The significant business presence test 
applies separately with respect to each of these products. Thus, for 
those printed

[[Page 88]]

circuit boards that are sold to unrelated parties, only the costs of the 
possessions corporation and the other members of the affiliated group 
that are incurred with respect to units of the printed circuit boards 
which are produced in whole or in part in the possessions and sold to 
third parties shall be taken into account. Conversely, with respect to 
personal computers, only the costs incurred with respect to the personal 
computers shall be taken into account. This would include the costs with 
respect to printed circuit boards that are incorporated into personal 
computers but not the costs incurred with respect to printed circuit 
boards that are sold without further processing to unrelated parties.
    Example 6. Possessions corporation S produces integrated circuits in 
a possession. P, an affilate of S, produces circuit boards in the United 
States. P transfers the circuit boards to S. S assembles the integrated 
circuits and the circuit boards. S sells some of the loaded circuit 
boards to third parties. S retains some of the loaded circuit boards and 
incorporates them into central processing units. The central processing 
units are then sold to third parties. S may designate two possession 
products. S must use a consistent definition of the possession product 
for all units that are sold at the same stage in the production process. 
Thus, with respect to those units sold after assembly of the integrated 
circuits and the printed circuits boards, if S cannot satisfy the 
significant business presence test with respect to all the loaded 
circuit boards (the integrated product), then S must designate a lesser 
product, either the integrated circuit (the component product) or the 
loaded circuit board less the printed circuit board (the end-product 
form) as its possession product. With respect to the central processing 
units sold the same rule would apply. Thus, if S cannot satisfy the 
significant business presence test with respect to the entire central 
processing unit for all of the central processing units sold, S must 
designate some lesser product as its possession product.
    Example 7. S is a possession corporation. In 1985, S produced 100 
units of product X. Those units were finished into product Y in 1985 by 
affiliates of S. Product X is a component of product Y. In 1985, S 
satisfies the direct labor test with respect to product X but not with 
respect to product Y. S designates the component product X as its 
possession product. In 1986 S produces 100 units of product X and 
finishes those units into product Y. S would have satisfied the 
significant business presence test with respect to product X if S had 
designated product X as its possession product in 1986. In addition, in 
1986 S satisfies the significant business presence test with respect to 
the integrated product Y. In 1986, S sells 150 units of Y. One hundred 
of those units would be deemed to be produced in 1986. With respect to 
those units S may designate the integrated product Y as its possession 
product. Under S's method of inventory accounting the remaining 50 units 
were determined to have been produced in 1985. With respect to those 
units S must define its possession product as it did for the taxable 
year in which those units were produced. Thus, S's possession product 
would be the component product X.

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

    Example 1. The following are examples of possession products the 
processes of production of which are sufficiently similar that

[[Page 89]]

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


Groupings (D) and (E) do not include any solutions which are delivered 
through the equipment described therein.
    Example 2. A possessions corporation produces in Puerto Rico non-
programmable, interactive cathode ray tube computer terminals that vary 
in price. These terminals all interact with a computer or controller to 
perform their functions of data entry, graphics word processing, and 
program development. The terminals can be purchased with options that 
include a built-in printer, different language keyboards, specialized 
cathode ray tubes, and different power supply features. All terminals 
are produced in one integrated process requiring the same skills and 
operations. The differences in the production of the terminals include 
differences in the number of printed circuit boards incorporated in each 
terminal, the use of unique keyboards, and the installation and testing 
of the built-in printer. Some difference in direct labor time to 
manufacture the terminals occurs, primarily due to the differing number 
and complexity of printed circuit boards incorporated into each 
terminal. Different model numbers are assigned to various computer 
terminals. A grouping by the taxpayer of all of the terminals as one 
product will be respected by the Service, unless the Service establishes 
that substantial distortion results. This grouping is proper because the 
processes of producing each of the terminals are similar.
    Example 3. A possessions corporation, S produces several models of 
serial matrix impact printers and teleprinters. These products have 
differing performance standards based on such factors as speed (in 
characters per second), numbers of columns, and cost. The production 
process for all types of printers involves production of three basic 
elements: electronic circuitry, the printing head, and the mechanical 
parts. The process of producing all the printers is similar. Thus, all 
printers could be grouped and treated as a single product. S purchases 
electronic circuitry and mechanical parts from a U.S. affiliate. S 
performs manufacturing functions relative to the printing head and 
assembles and tests the finished printers. S does not satisfy the 
significant business presence test with respect to the integrated 
products. S therefore specifies on a statement attached to its return 
(Schedule P of Form 5735) that the possession product for both the 
serial matrix printers and the teleprinters is the end-product form. The 
statement identifies the components which are included in each 
possession product. S may group and treat as a single product the serial 
matrix printers and the teleprinters if both end-product forms include 
and exclude similar components. Thus, if the end-product form for both 
the serial matrix printers and the teleprinters includes the mechanical 
parts and excludes the electronic circuitry, then S may group and treat 
as a single product the two end-product forms. If, however, the end-
product forms for the two items of property contain components that are 
not similar and as a result of this definition of the end-product forms 
the production processes involved in producing the two end-product forms 
are not similar, then S may not group the end-product forms.

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

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


[[Page 90]]


    Q. 8: What factors should be disregarded in determining whether a 
particular grouping of similar items of property is reasonable?
    A. 8: In general, differences in the following factors will be 
disregarded in determining whether a particular grouping of items of 
property is reasonable:
    (1) Differences in testing requirements (e.g., some products sold 
for military use may require more extensive or different testing than 
products sold for commercial use);
    (2) Differences in the product specifications that are designed to 
accommodate the product to its area of use or for conditions under which 
used (e.g., electrical products designed for ultimate use in the United 
States differ from electrical products designed for ultimate use in 
Europe);
    (3) Differences in packaging or labeling (e.g., differences in the 
number of units of the items shipped in one package); and
    (4) Minor differences in the operations of the items of property.
    Q. 9: What rules apply for purposes of determining whether 
pharmaceutical products are properly grouped and treated as a single 
product?
    A. 9: The rules contained in questions and answers 6 through 8 of 
this section shall apply. Thus, an affiliated group may establish 
reasonable groupings based on similarities in the production processes 
of two or more possession products. In establishing a group the 
affiliated group may only compare the production processes involved in 
producing the possession products. The fact that two pharmaceutical 
products contain different active or inert ingredients is not relevant 
to the determination of whether the pharmaceutical products may be 
grouped. For example, if the possession products are bulk chemicals and 
the production processes involved in producing the bulk chemicals are 
similar, those bulk chemicals may be grouped and treated as a single 
product even though they contain different active or inert ingredients. 
The affiliated group may also group and treat as a single product the 
finished dosage form drug as long as the production processes involved 
in producing the finished dosage forms are similar. For these purposes, 
the production processes involved in producing the following classes of 
items shall be considered to be sufficiently similar that possession 
products delivered in a form described in one of the categories may be 
grouped with other possession products delivered in a form described in 
the same category.
    The categories are:
    (1) Capsules, tablets, and pills;
    (2) Liquids, ointments, and creams; or
    (3) Injectable and intravenous preparations.


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

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

    Q. 10: Will the fact that a manufacturer of a drug must submit a New

[[Page 91]]

Drug Application (``NDA'') or a supplemental NDA to the Food and Drug 
Administration have any effect on the definition or grouping of a 
product?
    A. 10: No.
    Q. 11: A possessions corporation which produced a product or 
rendered a type of service in a possession on or before September 3, 
1982, is not required to meet the significant business presence test in 
a possession with respect to such product or type of service for its 
taxable years beginning before January 1, 1986 (the interim period). 
During such interim period, how will the term ``product'' be defined for 
purposes of allocating income under the cost sharing or profit split 
methods?
    A. 11: During the interim period the product will be determined 
based on the activities performed by the possessions corporation within 
a possession on September 3, 1982. During the interim period the 
possessions corporation may compute its income under the cost sharing or 
profit split method only with respect to the product that is produced or 
manufactured within the meaning of section 954(d)(1)(A) within the 
possession. If the product is manufactured from a component or 
components produced by an affiliated corporation or a contract 
manufacturer, then the product will not be treated as including such 
component or components for purposes of the computation of income under 
the cost sharing or profit split methods. Thus, the possessions 
corporation is not entitled to any return on the intangibles associated 
with the component or components. Notwithstanding the preceding 
sentences, for taxable years beginning before January 1, 1986, a 
possessions corporation may compute its income under the cost sharing or 
profit split method with respect to a product which includes a component 
or components produced by an affiliated corporation or contract 
manufacturer if the possessions corporation satisfies with respect to 
such product the significant business presence test described in section 
936(h)(5)(B)(ii) and the regulations thereunder.

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


[[Page 92]]


    Q. 12: On September 3, 1982, a possessions corporation, S was 
engaged in the manufacture (within the meaning of section 954(d)(1)(A)) 
of X in a possession. During the interim period, after September 3, 
1982, but before January 1, 1986, S produced Y, which differs from X in 
terms of minor design features. S did not produce Y in a possession on 
September 3, 1982. Will S be considered to have commenced production of 
a new product after September 3, 1982, for purposes of the application 
of the significant business presence test for the interim period?
    A. 12: No. X and Y will be considered to be a single product, and 
therefore S will not be required to satisfy the business presence test 
separately with respect to Y during the interim period. In all cases in 
which the items of property produced on or before September 3, 1982 and 
the items of property produced after that date could have been grouped 
together under the guidelines provided in Sec. 1.936-5(a) questions and 
answers 6 through 10, the possessions corporation will not be considered 
to manufacture a new product after September 3, 1982.
    Q. 13: May the term ``product'' be defined differently for export 
sales than for domestic sales?
    A. 13: Yes. For rules concerning the application of the separate 
election for export sales see Sec. 1.936-7(b).
    (b) Requirement of significant business presence--(1) General rules.
    Q. 1: In general, a possessions corporation may compute its income 
under the cost sharing or profit split methods with respect to a product 
only if the possessions corporation has a significant business presence 
in a possession with respect to that product. When will a possession 
corporation be considered to have a significant business presence in a 
possession?
    A. 1: For purposes of the cost sharing method, the significant 
business presence test is met if the possessions corporation satisfies 
either a value added test or a direct labor test. For purposes of the 
profit split method, the significant business presence test is met if 
the possessions corporation satisfies either a value added test or a 
direct labor test and also manufactures the product in the possession 
within the meaning of section 954(d)(1)(A).
    Q. 2: How may a possessions corporation satisfy the direct labor 
test with respect to a product?
    A. 2: The possessions corporation will satisfy the direct labor test 
with respect to a product if the direct labor costs incurred by the 
possessions corporation as compensation for services performed in a 
possession are greater than or equal to 65 percent of the direct labor 
costs of the affiliated group for units of the possession product 
produced during the taxable year in whole or in part by the possessions 
corporation.
    Q. 3: How may a possessions corporation satisfy the value added 
test?
    A. 3: In order to satisfy the value added test, the production costs 
of the possessions corporation incurred in the possession with respect 
to units of the possession product produced in whole or in part by the 
possessions corporation in the possession and sold or otherwise disposed 
of during the taxable year by the affiliated group to unrelated parties 
must be greater than or equal to twenty-five percent of the difference 
between gross receipts from such sales or other dispositions and the 
direct material costs of the affilated group for materials purchased for 
such units from unrelated parties.
    Q. 4: Must the significant business presence test be met with 
respect to all units of the product produced during the taxable year by 
the affiliated group?
    A. 4: No. The significant business presence test must be met with 
respect to only those units of the product produced during the taxable 
year in whole or in part by the possessions corporation in a possession.
    Q. 5: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test, how shall the 
possessions corporation treat the cost of components transferred to the 
possessions corporation by a member of the affiliated group?
    A. 5: The treatment of the cost of components transferred from an 
affiliate depends on whether the possession product is treated as 
including the components for purposes of section

[[Page 93]]

936(h). If it is, then for purposes of the value added test, the 
production costs associated with the component shall be treated as 
production costs of the affiliated group that are not incurred by the 
possessions corporation. Those production costs, other than the cost of 
materials, shall not be treated as a cost of materials. For purposes of 
the direct labor test and the alternative significant business presence 
test, the direct labor costs associated with such components shall be 
treated as direct labor costs of the affiliated group that are not 
incurred by the possessions corporation. If the possession product is 
treated as not including such component for purposes of section 936(h), 
then, solely for purposes of determining whether the possessions 
corporation satisfies the value added test, the cost of the component 
shall not be treated as either a cost of materials or as a production 
cost. For purposes of the direct labor test and the alternative 
significant business presence test, the direct labor costs associated 
with such component shall not be treated as direct labor costs of the 
affiliated group. If the possession product is treated as not including 
such component, then the possessions corporation shall not be entitled 
to any return on the intangibles associated with the manufacturing or 
marketing of the component.
    Q. 6: May two or more related possessions corporations aggregate 
their production or direct labor costs for purposes of determining 
whether they satisfy the significant business presence test with respect 
to a single product?
    A. 6: No.
    Q. 7: A possessions corporation, S, purchases raw materials and 
components from an unrelated corporation which conducts business outside 
of a possession. The unrelated corporation is not a contract 
manufacturer. What is the treatment of such raw materials and components 
for purposes of the significant business presence test?
    A. 7: Where Company S purchases raw materials or components from an 
unrelated corporation which is not a contract manufacturer, the raw 
materials and components are treated as materials, and the costs related 
thereto are treated as a cost of materials.
    (2) Direct labor costs.
    Q. 1: How is the term ``direct labor costs'' to be defined?
    A. 1: The term ``direct labor costs'' has the same meaning which it 
has for purposes of Sec. 1.471-11(b)(2)(i). Thus, direct labor costs 
include the cost of labor which can be identified or associated with 
particular units or groups of units of a specific product. The elements 
of direct labor include such items as basic compensation, overtime pay, 
vacation and holiday pay, sick leave pay (other than payments pursuant 
to a wage continuation plan under section 105(d)), shift differential, 
payroll taxes, and payments to a supplemental unemployment benefit plan 
paid or incurred on behalf of employees engaged in direct labor.
    Q. 2: May a taxpayer treat a cost as a direct labor cost if it is 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: No. A cost may be treated as a direct labor cost only if it is 
included in inventoriable costs. However, a cost may be considered a 
direct labor cost even though the activity to which it relates would not 
constitute manufacturing under section 954(d)(1)(A) as long as the cost 
is included in inventoriable costs.
    Q. 3: May the members of the affiliated group include as direct 
labor costs the labor element in indirect production costs?
    A. 3: No. The labor element of indirect production costs may not be 
considered as part of direct labor costs.
    Q. 4: Do direct labor costs include the costs which can be 
identified or associated with particular units or groups of units of a 
specific product if those costs could also be described as quality 
control and inspection?
    A. 4: Yes. Direct labor costs include costs which can be identified 
or associated with particular units or groups of units of a specific 
product. Thus, if quality control and inspection is an integral part of 
the production process, then the labor associated with that quality 
control and inspection shall be considered direct labor. For example, 
integrated circuits are soldered to printed circuit boards by passing 
the boards over liquid solder. Employees inspect each of the boards and 
repair

[[Page 94]]

any imperfectly soldered joints discovered on that inspection. The labor 
associated with this process is direct labor. However, if a person 
performs random inspections on limited numbers of products, then that 
labor associated with those inspections shall be considered quality 
control and therefore indirect labor.
    Q. 5: Do direct labor costs of the possessions corporation include 
only the costs which were actually incurred or do they take into 
account, in addition, any labor savings which result because the 
activities were performed in a possession rather than in the United 
States?
    A. 5: Direct labor costs include only the costs which were actually 
incurred.
    Q. 6: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test for a taxable year with 
respect to a product, how shall the possessions corporation compute its 
direct labor costs of units of the product?
    A. 6: The direct labor test shall be applied separately to products 
produced in whole or in part by the possessions corporation in the 
possession during each taxable year. Sales shall be deemed to be made 
first out of the current year's production. If sales are made only out 
of the current year's production, then the direct labor costs of 
producing those units that are sold shall be the pro rata portion of the 
total direct labor costs of producing all the units that are produced in 
whole or in part in the possession by the possessions corporation during 
the current year. If all of the current year's production is sold and 
some inventory is liquidated, then the direct labor test shall be 
applied separately to the current year's production and the liquidated 
inventory. The direct labor costs of producing the liquidated inventory 
shall be the pro rata portion of the total direct labor costs that were 
incurred in producing all the units that were produced in whole or in 
part by the possessions corporation in the possessions in the layer of 
liquidated inventory determined under the member's method of inventory 
accounting.

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

    Q. 7: What is the result if in a particular taxable year the 
possessions corporation satisfies the significant business presence test 
with respect to units of the product produced in one year and fails the 
significant business with respect to units produced in another year?
    A. 7: For those units of the product with respect to which the 
possession corporation satisfies the significant business presence test, 
the possessions corporation may compute its income under the provisions 
of section 936(h)(5). For those units of the product with respect to 
which the possessions corporations fails the significant business 
presence test, the possessions corporation must compute its income under 
section 936(h)(1) through (4).
    Q. 8: Do direct labor costs include costs incurred in a prior 
taxable year with respect to units of the possession product that are 
finished in a later taxable year?
    A. 8: Yes.
    (3) Direct material costs.
    Q. 1: How is the term ``direct material costs'' to be defined?
    A. 1: Direct material costs include the cost of those materials 
which become an integral part of the specific product and those 
materials which are consumed in the ordinary course of manufacturing and 
can be identified or associated with particular units or groups of units 
of that product. See

[[Page 95]]

Sec. 1.471-3 for the elements of direct material costs.
    Q. 2: May a taxpayer treat a cost as a direct material cost if it is 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: A taxpayer may not treat such costs as direct material costs.
    (4) Production costs.
    Q. 1: How is the term ``production costs'' defined?
    A. 1: The term ``production costs'' has the same meaning which it 
has for purposes of Sec. 1.471-11(b) except that the term does not 
include direct material costs and interest. Thus, production costs 
include direct labor costs and fixed and variable indirect production 
costs (other than interest).
    Q. 2: With respect to indirect production costs described in Sec. 
1.471-11(c)(2) (ii) and (iii), may a possessions corporation include 
these costs in production costs for purposes of section 936, if they are 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: No. A possessions corporation may include these costs only if 
they are included for purposes of section 471 and the regulations 
thereunder. If a possessions corporation and the other members of the 
affiliated group include and exclude different indirect production costs 
in their inventoriable costs, then, for purposes of the significant 
business presence test, the possessions corporation shall compute its 
production costs and the production costs of the other members of the 
affiliated group by subtracting from the production costs of each member 
all indirect costs included by that member that are not included in 
production costs by all other members of the affiliated group.
    Q. 3: Does a change in a taxpayer's method of accounting for 
purposes of section 471 affect the taxpayer's computation of production 
costs for purposes of section 936?
    A. 3: Yes. If a taxpayer changes its method of accounting for 
purposes of section 471, then the same change shall apply for purposes 
of section 936.
    Q. 4: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test for a taxable year with 
respect to a product, how shall the possessions corporation compute its 
costs of producing units of the product sold or otherwise disposed to 
unrelated parties during the taxable year?
    A. 4: All members of the affiliated group may elect to use their 
current year production costs regardless of whether the members use the 
FIFO or LIFO method of inventory accounting. If some or all of the 
current year's production of a product is sold, then the production 
costs of producing those units sold shall be the pro rata portion of the 
total production costs of producing all the units produced in the 
current year. If all of the current year's production of a product is 
sold and some inventory is liquidated, then the production costs of 
producing the liquidated inventory shall be the pro rata portion of the 
production costs incurred in producing the layer of liquidated inventory 
as determined under the member's method of inventory accounting.
    Q. 5: How should the members of the affiliated group determine the 
portion of their production costs that is allocable to units of the 
product sold or otherwise disposed of during the taxable year?
    A. 5: The members of the affiliated group may use either standard 
production costs (so long as variances are not material), average 
production costs, or FIFO production costs to determine the production 
costs that will be considered to be attributable to units of the product 
sold or otherwise disposed of during the taxable year. However, all 
members of the affiliated group must use the same method.
    Q. 6: When is the quality control and inspection of a product 
considered to be part of the production activity for that product?
    A. 6: Quality control and inspection of a manufactured product 
before its sale or other disposition by the manufacturer, or before its 
incorporation into other products, is considered to be part of the 
indirect production activity for that initial product. Subsequent 
testing of a product to ensure that the product is compatible with other 
products is not a part of the production activity for the initial 
product.


[[Page 96]]



When a component is incorporated into an end-product form and the end-
product form is then tested, the latter testing will be considered to be 
a part of the indirect production activity for the end-product form and 
will not be considered to be a part of the production activity for the 
component.
    Q. 7: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, what is the treatment 
of the cost of installation of a product?
    A. 7: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, product installation 
costs need not be taken into account as costs incurred in the 
manufacture of that product, if the taxpayer keeps such permanent books 
of account or records as are sufficient to establish the fair market 
price of the uninstalled product. In such a case, the cost of 
installation materials, the cost of the labor for installation, and a 
reasonable profit for installation will not be included in the costs and 
income associated with the possession product. If the taxpayer does not 
keep such permanent books of account or records, then the cost of 
installation materials and the cost of labor for installation shall be 
treated as costs associated with the possession product and income will 
be allocated to the possessions corporation and its affiliates under the 
rules provided in these regulations.
    Q. 8: For purposes of the significant business presence test and the 
allocation of income to a product or service, what is the treatment of 
the cost of servicing and maintaining a possession product that is sold 
to an unrelated party?
    A. 8: The cost of servicing and maintaining a possession product 
after it is sold is not associated with the production of that product.
    Q. 9: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, what is the treatment 
of the cost of samples?
    A. 9: The cost of producing samples will be treated as a marketing 
expense and not as inventoriable costs for these purposes. However, for 
taxable years beginning prior to January 1, 1986, the cost of producing 
samples may be treated as either a marketing expense or as inventoriable 
costs.
    (5) Gross receipts.
    Q. 1: How shall the affiliated group determine gross receipts from 
sales or other dispositions by the affiliated group to unrelated parties 
of the possession product?
    A. 1: Gross receipts shall be determined in the same manner as 
possession sales under the rules contained in Sec. 1.936-6(a)(2).
    (6) Manufacturing within the meaning of section 954(d)(1)(A).
    Q. 1: What is the test for determining, within the meaning of 
section 954(d)(1)(A), whether a product is manufactured or produced by a 
possessions corporation in a possession?
    A. 1: A product is considered to have been manufactured or produced 
by a possessions corporation in a possession within the meaning of 
section 954(d)(1)(A) and Sec. 1.954-3(a)(4) if--
    (i) The property has been substantially transformed by the 
possessions corporation in the possession;
    (ii) The operations conducted by the possessions corporation in the 
possession in connection with the property are substantial in nature and 
are generally considered to constitute the manufacture or production of 
property; or
    (iii) The conversion costs sustained by the possessions corporation 
in the possession, including direct labor, factory burden, testing of 
components before incorporation into an end product and testing of the 
manufactured product before sales account for 20 percent or more of the 
total cost of goods sold of the possessions corporation.


In no event, however, will packaging, repackaging, labeling, or minor 
assembly operations constitute manufacture or production of property. 
See particularly examples 2 and 3 of Sec. 1.954-3(a)(4)(iii).
    Q. 2: Does the requirement that a possession product be produced or 
manufactured in a possession within the meaning of section 954(d)(1)(A) 
apply to taxable years beginning before January 1, 1986?
    A. 2: A possessions corporation must satisfy this requirement for 
taxable

[[Page 97]]

years beginning before January 1, 1986, in the following cases:
    (i) If the possessions corporation makes a separate election under 
section 936(h)(5)(F)(iv)(II) with respect to export sales;
    (ii) If the possessions corporation is electing as its possession 
product a product that is subject to the interim period rules of Sec. 
1.936-5(a) question and answer (10); or
    (iii) If the possessions corporation is electing as its possession 
product a product that is not subject to the interim period rules of 
Sec. 1.936-5 (a) question and answer (10) and the possessions 
corporation computes its income under the profit split method with 
respect to that product.


For rules concerning products first produced in a possession after 
September 3, 1982, see Sec. 1.936-5(b)(7) question and answer (2).
    (7) Start-up operations.
    Q. 1: With respect to products not produced (and types of services 
not rendered) in the possession on or before September 3, 1982, when 
must a possessions corporation first satisfy the 25 percent value added 
test or the 65 percent direct labor test?
    A. 1: A transitional period is established such that a possessions 
corporation engaged in start-up operations with respect to a product or 
service need not satisfy the 25 percent value added test or the 65 
percent labor test until the third taxable year following the taxable 
year in which such product is first sold by the possessions corporation 
or such service is first rendered by the possessions corporation. During 
the transitional period, the applicable percentages for these tests will 
be as follows:

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

    Q. 2: Does the requirement that a possession product be produced or 
manufactured in a possessions within the meaning of section 954(d)(1)(A) 
apply to a product if the possessions corporation is engaged in start-up 
operations with respect to that product?
    A. 2: The possessions corporation must produce or manufacture the 
possessions product within the meaning of section 954(d)(1)(A) if the 
possessions corporation computes its income with respect to that product 
under the profit split method.
    Q. 3: When will a possessions corporation be considered to be 
engaged in start-up operations?
    A. 3: A possessions corporation is engaged in start-up operations if 
it begins operations in a possession with respect to a product or type 
of service after September 3, 1982. Subject to the further provisions of 
this answer, a possessions corporation will be considered to begin 
operations with respect to a product if, under the rules of Sec. 1.936-
5(a) questions and answers (6) through (10), such product could not be 
grouped with any other item of property manufactured in whole or in part 
in the possessions by any member of the affiliated group in any 
preceding taxable year. Any improvement or other change in a possession 
product which does not substantially change the production process would 
not be deemed to create a new product. A change in the division of 
manufacturing activity between the possessions corporation and its 
affiliates with respect to an item of property will not give rise to a 
new product. If a possessions corporation was producing a possession 
product that was either a component product or an end-product form and 
the possessions corporation expands its operations in the same 
possession so that it is now producing a product that includes the 
earlier possession product, the possessions corporation will not be 
entitled to use the start-up significant business presence test unless 
the production costs incurred by the possessions corporation in the 
possession in producing a unit of its new possession product are at 
least double the production costs incurred by the possessions 
corporation in the possession in producing a unit of the earlier 
possession product. If any member of an affiliated group actually groups 
two or more items of property then, solely for the purposes of 
determining whether any item of property in that group is a new product, 
that grouping shall be respected. However, the fact that an affiliated 
group does

[[Page 98]]

not actually group two or more items of property shall be disregarded in 
determining whether any item of property is a new product. 
Notwithstanding the above, if a possessions corporation is producing a 
possession product in one possession and such corporation or a member of 
its affiliated group begins operations in a different possession, 
regardless of whether the items of property could be grouped, the 
affiliated group may treat the units of the item of property produced at 
the new site of operations in the different possession as a new product.
    (8) Alternative significant business presence test.
    Q. 1: Will the Secretary adopt a significant business presence test 
other than those set forth in section 936(h)(5)(B)(ii)?
    A. 1: Yes. The following significant business presence test is 
adopted both for the transitional period and thereafter. A possessions 
corporation will have a significant business presence in a possession 
for a taxable year with respect to a product or type of service if--
    (i) No less than 50 percent of the direct labor costs of the 
affiliated group for units of the product produced, in whole or in part, 
during the taxable year by the possessions corporation or for the type 
of service rendered by the possessions corporation during the taxable 
year are incurred by the possessions corporation as compensation for 
services performed in the possession; and
    (ii) The direct labor costs of the possessions corporation for units 
of the product produced or the type of service rendered plus the base 
period construction costs are no less than 70 percent of the sum of such 
base period construction costs and the direct labor costs of the 
affiliated group for such units of the product produced or the type of 
service rendered.


Notwithstanding satisfaction of the above test, for purposes of 
determining whether a possessions corporation may compute its income 
under the profit split method, a possessions corporation will not be 
treated as having a significant business presence in a possession with 
respect to a product unless the possessions corporation manufactures the 
product in the possession within the meaning of section 954(d)(1)(A).
    Q. 2: How is the term ``base period construction costs'' defined?
    A. 2: The term ``base period construction costs'' means the average 
construction costs incurred by or on behalf of the possessions 
corporation for services in the possession during the taxable year and 
the preceding four taxable years for section 1250 property (as defined 
in section 1250(c) and the regulations thereunder) that is used for the 
production of the product or the rendering of the service in the 
possession, and which represents the original use of the section 1250 
property. For purposes of the preceding sentence, if the possessions 
corporation was not in existence during one or more of the four 
preceding taxable years, its construction costs for that year or years 
shall be deemed to be zero. Construction costs include architects' and 
engineers' fees, labor costs, and overhead and profit (if the 
construction is performed by a person that is not a member of the 
affiliated group).
    (c) Definition and treatment of contract manufacturing.
    Q. 1: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test with respect to a 
product, the costs incurred by the possessions corporation or by any of 
its affiliates in connection with contract manufacturing which is 
related to that product and is performed outside the possession shall be 
treated as direct labor costs of the affiliated group and shall not be 
treated as production costs of the possessions corporation or as 
material costs. How is the term ``contract manufacturing'' to be 
defined?
    A. 1: The term ``contract manufacturing'' includes any arrangement 
between a possessions corporation (or another member of the affiliated 
group) and an unrelated person if the unrelated person:
    (1) Performs work on inventory owned by a member of the affiliated 
group for a fee without the passage of title;
    (2) Performs production activities (including manufacturing, 
assembling,

[[Page 99]]

finishing, or packaging) under the direct supervision and control of a 
member of the affiliated group; or
    (3) Does not undertake any significant risk in manufacturing its 
product (e.g., it is paid by the hour).
    Q. 2: Does an arrangement between a member of the affiliated group 
and an unrelated party constitute contract manufacturing if the 
unrelated party uses an intangible owned or licensed by a member of the 
affiliated group?
    A. 2: Such an arrangement will be treated as contract manufacturing 
if the unrelated party makes use of a patent owned or licensed by a 
member of the affiliated group in producing the product which becomes 
part of the possession product of the possessions corporation. In 
addition, such use of manufacturing intangibles other than patents may 
be treated as contract manufacturing if it is established that the 
arrangement has the effect of materially distorting the application of 
the significant business presence test. However, the preceding sentence 
shall not apply if the possessions corporation establishes that the 
arrangement was entered into for a substantial business purpose (e.g., 
to obtain the benefit of special expertise of the manufacturer or 
economies of scale). These rules shall not apply to such contract 
manufacturing performed in taxable years beginning before January 1, 
1986, nor shall the rules apply to binding contracts for the performance 
of such contract manufacturing entered into before June 13, 1986.
    Q. 3: For purposes of the significant business presence test, how 
shall a possessions corporation treat the cost of contract manufacturing 
performed within a possession?
    A. 3: If the possessions corporation uses the value added test, it 
will be permitted to treat the cost of the contract manufacturing 
performed in a possession, not including material costs, as a production 
cost of the possessions corporation. If it uses the direct labor test or 
the alternative significant business presence test set forth in Sec. 
1.936-5(b)(8), it is permitted to treat the direct labor costs of the 
contract manufacturer associated with such contract manufacturing as a 
cost of direct labor of the possessions corporation. The allowable 
amount of the direct labor cost shall be determined in accordance with 
question and answer 4 below.
    Q. 4: How are the amounts paid by a possessions corporation to a 
contract manufacturer for services rendered in a possession to be 
treated by the possessions corporation in computing the direct labor 
cost of the product to which such contract manufacturing relates?
    A. 4: If the possessions corporation can establish the contract 
manufacturer's direct labor cost which was incurred in the possession, 
such cost will be treated as incurred by the possessions corporation as 
compensation for services performed in the possession. If the 
possessions corporation cannot establish such cost, then 50 percent of 
the amount paid to such contract manufacturer may be treated as incurred 
by the possessions corporation as compensation for services performed in 
the possession: provided, that not more than 50 percent of the fair 
market value of the product manufactured by the contract manufacturer is 
attributable to articles shipped into the possession, and the 
possessions corporation receives a statement from the contract 
manufacturer that this test has been satisfied. If this fair market 
value test is not satisfied, then the cost of contract manufacturing 
performed within a possession shall not be treated as a production cost 
or a direct labor cost of either the possessions corporation or the 
affiliated group.
    Q. 5: For purposes of the significant business presence test, what 
is the treatment of costs which are incurred by a member of the 
affiliated group (including the possessions corporation) for contract 
manufacturing performed outside of the possession with respect to an 
item of property which is a component of the possession product?
    A. 5: If the possession product is treated as including such 
component, the cost of the contract manufacturing shall be treated as a 
direct labor cost of members of the affiliated group other than the 
possessions corporation for purposes of the direct labor test and the 
alternative significant business presence test, and shall not be treated 
as a production cost of the possessions corporation or as a cost of 
materials

[[Page 100]]

for purposes of the value added test. If the possession product is 
treated as not including such component, the cost of the contract 
manufacturing shall not be treated as a direct labor cost of any member 
of the affiliated group for purposes of the direct labor test and the 
alternative significant business presence test, and shall not be treated 
as a production cost of the possessions corporation or as a cost of 
materials for purposes of the value added test.

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



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

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e) where applicable.
    (a) Cost sharing option--(1) Product area research.
    Q. 1: Cost sharing payments are based on research undertaken by the 
affiliated group in the ``product area'' which includes the possession 
product. The term ``product area'' is defined by reference to the three-
digit classification under the Standard Industrial Classification (SIC) 
code. Which governmental agency has jurisdiction to decide the proper 
SIC category for any specfic product?
    A. 1: Solely for the purpose of determining the tax consequences of 
operating in a possession, the Secretary or his delegate has exclusive 
jurisdiction to decide the proper SIC category under which a product is 
classified. For this purpose, the product area under which a product is 
classified will be determined according to the 1972 edition of the SIC 
code. From time to time and in appropriate cases, the Secretary may 
prescribe regulations or issue rulings determining the proper SIC 
category under which a particular product is to be classified, and may 
prescribe regulations for aggregating two or more three-digit 
classifications of the SIC code and for classifying product areas 
according to a system other than under the SIC code.
    Q. 2: How is the term ``affiliated group'' defined for purposes of 
the cost sharing option?
    A. 2: For purposes of the cost sharing option, the term ``affiliated 
group'' means the possessions corporation and all other organizations, 
trades or businesses (whether or not incorporated, whether or not 
organized in the United States, and whether or not affiliated) owned or 
controlled directly or indirectly by the same interests, within the 
meaning of section 482.
    Q. 3: Are research and development expenditures that are included in 
product area research limited to research and development expenditures 
that are deductible under section 174 or that are incurred by U.S. 
affiliates?
    A. 3: No, product area research is not limited to product area 
research expenditures deductible under section 174 or to expenses 
incurred by U.S. affiliates. Product area research also includes 
deductions permitted under section 168 with respect to research property 
which are not deductible under section 174; qualified research expenses 
within the meaning of section 30(b); payments (such as royalities) for 
the use of, or right to use, a patent, invention, formula, process, 
design, pattern or know-how; and a proper allowance for amounts incurred 
in the acquisition of manufacturing intangible property. In the case of 
an acquisition of depreciable or amortizable manufacturing intangible 
property, the annual amount of product area research shall be be equal 
to the allowable depreciation or amortization on the intangible property 
for the taxable year. In the case of an acquisition of nondepreciable or 
nonamortizable manufacturing intangible property, the amount expended 
for the acquisition shall be deemed to be amortized over a five year 
period and included in product area research in the year of the deemed 
amortization. Any contingent payment made with respect to the 
acquisition of nonamortizable manufacturing intangible property shall be 
treated as amounts incurred in the acquisition of nonamortizable 
manufacturing intangible property when paid or accrued.
    Q. 4: Does royalty income from a person outside the affiliated group 
with respect to the manufacturing intangibles within a product area 
reduce the product area research pool within the same product area?

[[Page 101]]

    A. 4: Yes.
    Q. 5: Does income received from a person outside the affiliated 
group from the sale of a manufacturing intangible reduce the product 
area research pool within the same product area?
    A. 5: In determining product area research, the income from the sale 
attributable to noncontingent payments will reduce product area research 
ratably over the remaining useful life of the property in the case of an 
amortizable intangible and ratably over a 5-year period in the case of a 
nonamortizable intangible. Any income attributable to contingent amounts 
received with respect to the sale of manufacturing intangible property 
shall be treated as amounts received from the sale of the manufacturing 
intangible property in the year in which such contingent amounts are 
received or accrued.
    Q. 6: If a member of an affiliated group incurs research and 
development expenses pursuant to a contract with an unrelated person who 
is entitled to exclusive ownership of all the technology resulting from 
the expenditures, is the amount of product area research reduced by the 
amount of such expenditures?
    A. 6: To the extent that the product area research expenditures can 
be allocated solely to the technology produced for the unrelated person, 
such expenditures will not be included in product area research 
expenditures provided, however, that the unrelated person has exclusive 
ownership of all the technology resulting from these expenditures, and 
further that no member of the affiliated group has a right to use any of 
the technology.
    Q. 7: What is the treatment of product area research expenditures 
attributable to a component where the component and the integrated 
product fall within different product areas?
    A. 7: For purposes of the computation of product area research 
expenditures in the product area by the affiliated group, the product 
area in which the component falls is aggregated with the product area in 
which the integrated product falls. However, if the component product 
and integrated product are in separate SIC codes and if the component 
product is not included in the definition of the possession product, 
then the product area research expenditures are not aggregated. The same 
rule applies where the taxpayer elects a component product which 
encompasses another component product and the two component products 
fall into separate SIC codes. In such case, the product area in which 
the first component falls is aggregated with the product area in which 
the second component falls.
    (2) Possession sales and total sales.
    Q. 1: The cost sharing payment is the same proportion of the total 
cost of product area research which the amount of ``possession sales'' 
of the affiliated group bears to the ``total sales'' of the affiliated 
group within the product area. How are ``possession sales'' defined for 
purposes of the cost sharing fraction?
    A. 1: The term ``possession sales'' means the aggregate sales or 
other dispositions of the possession product, to persons who are not 
members of the affiliated group, less returns and allowances and less 
indirect taxes imposed on the production of the product, for the taxable 
year. Except as otherwise indicated in Sec. 1.936-6(a)(2), the sales 
price to be used is the sales price received by the affiliated group 
from persons who are not members of the affiliated group.
    Q. 2: For purposes of the numerator of the cost sharing fraction, 
how are possession sales computed where the possession product is a 
component product or an end-product form?
    A. 2: (i) The sales price of the component product or end-product 
form is determined as follows. With respect to a component product, an 
independent sales price from comparable uncontrolled transactions must 
be used if such price can be determined in accordance with Sec. 1.482-
2(e)(2). If an independent sales price of the component product from 
comparable uncontrolled transactions cannot be determined, then the 
sales price of the component product shall be deemed to be equal to the 
transfer price, determined under the appropriate section 482 method, 
which the possessions corporation uses under the cost sharing method in 
computing the income it derives from the

[[Page 102]]

active conduct of a trade or business in the possession with respect to 
the component product. The possessions corporation in lieu of using the 
transfer price determined under the preceding sentence may treat the 
sales price for the component product as equal to the same proportion of 
the third party sales price of the integrated product which the 
production costs attributable to the component product bear to the total 
production cost for the integrated product. Production cost will be the 
sum of direct and indirect production costs as defined in Sec. 1.936-
5(b)(4). If the possessions corporation determines the sales price of 
the component product using the production cost ratio, the transfer 
price used by the possessions corporation in computing its income from 
the component product under the cost sharing method may not be greater 
than such sales price.
    (ii) With respect to an end-product form, the sales price of the 
end-product form is equal to the difference between the third party 
sales price of the integrated product and the independent sales price of 
the excluded component(s) from comparable uncontrolled transactions, if 
such price can be determined under Sec. 1.482-2(e)(2). If an 
independent sales price of the excluded component(s) from uncontrolled 
transactions cannot be determined, then the sales price of the end-
product form shall be deemed to be equal to the transfer price, 
determined under the appropriate section 482 method, which the 
possessions corporation uses under the cost sharing method in computing 
the income it derives from the active conduct of a trade or business in 
the possession with respect to such end-product form. The possessions 
corporation in lieu of using the transfer price determined under the 
preceding sentence may use the production cost ratio method described 
above to determine the sales price of the end-product form (i.e., the 
same proportion of the third party sales price of the integrated product 
which the production costs attributable to the end-product form bear to 
the total production costs for the integrated product). If the 
possessions corporation determines the sales price of the end-product 
form using the production cost ratio, the transfer price used by the 
possessions corporation in computing its income from the end-product 
form under the cost sharing method may not be greater than such sales 
price. For similar rules applicable to the profit split option see Sec. 
1.936-6(b)(1), question and answer 12.
    Q. 3: For purposes of determining possessions sales in the numerator 
of the cost sharing fraction, will the replacement part price of the 
product be treated as a price from comparable uncontrolled transactions?
    A. 3: Prices for replacement parts are generally higher than prices 
for equipment sold as part of an original system. Thus, prices for 
replacement parts cannot generally be used directly as prices for 
comparable uncontrolled transactions. However, replacement part prices 
may be used for estimating comparable uncontrolled prices where the 
price differential can be reasonably determined and taken into account 
under Sec. 1.482-2(e)(2).
    Q. 4: For purposes of determining possession sales in the cost 
sharing fraction, what is the treatment of components that are purchased 
by one possessions corporation from an affiliated possessions 
corporation and which are incorporated into a possession product where 
the transferor possessions corporation treats the transferred component 
as a possession product?
    A. 4: When one possessions corporation purchases components from a 
second possessions corporation which is an affiliated corporation, the 
purchase price of the components paid to the second possessions 
corporation shall be subtracted from the sales proceeds of the product 
produced in the possession by the first possessions corporation, and 
only the remainder is included in the numerator of the cost sharing 
formula for the first corporation. For example, assume that N 
corporation manufactures a component for sale to O corporation for $100 
(a price which reflects prices in comparable uncontrolled transactions). 
Both N and O are affiliated possessions corporations. N has designated 
that component product as its possession product. O then incorporates 
that product into a second product which is sold to customers for

[[Page 103]]

$300 N and O must make separate cost sharing payments. The cost sharing 
payment of N corporation is determined by including $100 as possession 
sales, and the payment of O is determined by subtracting that $100 
purchase price from the $300 received from customers. Thus, the 
possessions sales amount of O is $200. This rule is intended to prevent 
the double counting of the sales of a component produced by one 
possessions corporation and incorporated into another product by an 
affiliated possessions corporation.
    Q. 5: Are pre-TEFRA sales included in the cost sharing fraction?
    A. 5: No. Pre-TEFRA sales are sales of products produced by the 
possessions corporation and transferred to an affiliate prior to a 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA sales are not included in either the numerator or 
denominator of the cost sharing fraction. If the U.S. affiliate uses the 
FIFO method of costing inventory, the pre-TEFRA inventory will be 
treated as the first inventory sold by the U.S. affiliate during the 
first year in which section 936(h) applies. If the U.S. affiliate uses 
the LIFO method of costing inventory (either dollar-value or specific 
goods LIFO), pre-TEFRA inventor will be treated as inventory sold by the 
U.S. affiliate in the year in which the U.S. afiliate's LIFO layer 
containing pre-TEFRA LIFO inventory is liquidated.
    Q. 6: How are ``possession sales'' determined under the cost sharing 
formula if members of the affiliated group (other than the possessions 
corporation) include purchases of the possession product, X, in a 
dollar-value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 6: Possession sales may be determined by applying the revenue 
identification method provided under paragraph (b)(1) Question and 
Answer 18 of this section.
    Q. 7: Do possession sales include excise taxes paid by the 
possessions corporation when the product is sold for ultimate use or 
consumption in the possession?
    A. 7: No. The amount of excise taxes is excluded from both the 
numerator and denominator of the cost sharing fraction.
    Q. 8: How are ``total sales'' defined for purposes of the cost 
sharing fraction?
    A. 8: The term ``total sales'' means aggregate sales or other 
dispositions of products in the same product area as the possession 
product, less returns and allowances and less indirect taxes imposed on 
the production of the product, for the taxable year to persons who are 
not members of the affiliated group. The sales price to be used is the 
sales price received by the affiliated group from persons who are not 
members of the affiliated group.
    Q. 9: In computing that cost sharing payment, how are ``total 
sales'' computed if the dollar-value LIFO inventory pool includes some 
products which are not included in the product area (determined under 
the 3-digit SIC code) on which the denominator of the cost sharing 
fraction is based?
    A. 9: In such case, the amount of the total sales within the product 
area to persons who are not members of the affiliated group by persons 
who are members of the affiliated group is determined by multiplying the 
total sales of the products within the dollar-value LIFO inventory pool 
by a fraction. The numerator of the fraction includes the dollar-value 
of purchases by members of the affiliated group (including the 
possessions corporation) of products within the product area made during 
the year, plus any added production costs (as defined in Sec. 1.471-
11(b), (c), and (d) but not including the costs of materials) incurred 
by the affiliates during the same period. The denominator of the 
fraction includes the dollar-value of purchases by members of the 
affiliated group (including the possessions corporation) of products 
within the dollar-value LIFO inventory pool made during the same period 
(including any production costs, as described above, incurred by the 
affiliate during the same period). For these purposes, purchases of a 
possession product are determined on the basis of the possessions 
corporation's cost for its inventory purposes.
    Q. 10: May a possessions corporation compute its income under the 
cost

[[Page 104]]

sharing method with respect to a possession product which the 
possessions corporation sells to a member of its affiliated group and 
which that member then leases to an unrelated person or uses in its own 
trade or business?
    A. 10: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2(e)(2), and, provided 
further, that such member complies with the requirements of Sec. 1.936-
6(a)(2), question and answer 14. If, however, there is a comparable 
uncontrolled price for an integrated product and the possession product 
is a component product or end-product form thereof, the possessions 
corporation may, if such member complies with the requirements of Sec. 
1.936-6(a)(2), question and answer 14, compute its income under the cost 
sharing method with respect to such possession product. In that case, 
the cost sharing payment shall be computed under the following question 
and answer.
    Q. 11: How are possession sales and total sales to be determined for 
purposes of computing the cost sharing payment with respect to a 
possession product which the possessions corporation sells to a member 
of its affiliated group where that member then leases the possession 
product to unrelated persons or uses it in its own trade or business?
    A. 11: If the possessions corporation is entitled to compute its 
income from such sales of the possession product under the cost sharing 
method, both possession sales and total sales shall be determined as if 
the possession product had been sold by the affiliate to an unrelated 
person at the time the possession product was first leased or otherwise 
placed in service by the affiliate. The sales price on such deemed sale 
shall be equal to the independent sales price from comparable 
uncontrolled transactions determined in accordance with Sec. 1.482-
2(e)(2), if any. If the possession product is a component product or an 
end-product form for which there is no such independent sales price but 
there is a comparable uncontrolled price for the integrated product 
which includes the possession product, the deemed sales price of the 
possession product shall be computed under the rules of Sec. 1.936-
6(a)(2) question and answer 2. The full amount of income received under 
the lease shall be treated as income of (and taxed to) the affiliate and 
not the possessions corporation.
    Q. 12: When may a possessions corporation take into account in 
computing total sales under the cost sharing method products in the same 
product area as the possession product (other than the possession 
product itself) where such products are leased by members of the 
affiliated group to unrelated persons or used by any such member in its 
own trade or business?
    A. 12: For purposes of computing total sales under the cost sharing 
method, the possessions corporation may take into account products in 
the same product area as the possession product itself where such 
products are leased by members of the affiliated group to unrelated 
persons or used in the trade or business of any such member, but only if 
an independent sales price of such products from comparable uncontrolled 
transactions may be determined under Sec. 1.482-2(e)(2). In such cases, 
the units of such products which are leased or otherwise used internally 
by members of the affiliated group may be treated as sold to unrelated 
persons for such independent sales price for purposes of computing total 
sales.
    Q. 13: Assuming that a possessions corporation is entitled to 
compute its income under the cost sharing method with respect to sales 
of a possession product to affiliates in cases where those affiliates 
lease units of the possession product to unrelated persons or use them 
internally, is the possessions corporation's income from the possession 
product any different than if the affiliates had sold the product to 
unrelated parties?
    A. 13: No.
    Q. 14: If a possessions corporation sells units of a possession 
product to a member of its affiliated group and that affiliate then 
leases those units to an unrelated person or uses the units in its own 
trade or business, what requirements must the affilate meet in order for 
the possessions corporation to be entitled to the benefits of the cost 
sharing method with respect to such units?

[[Page 105]]

    A. 14: (i) For taxable years of the possessions corporation 
beginning on or before June 13, 1986, the affiliate need not meet any 
special requirements in order for the possessions corporation to be 
entitled to the beneifts of the cost sharing method with respect to such 
units. Thus, the affiliate's basis in such units shall be equal to the 
transfer price used for computing the possessions corporation's gross 
income with respect to such units under section 936(h)(5)(C)(i)(II), and 
the income derived by the affiliate from such lease or internal use 
shall be reported by the affiliate when and to the extent actually 
derived. The affiliate shall not be deemed to have sold such units to an 
unrelated party at the time they were first leased or otherwise placed 
in service for any purpose other than the computation of possession 
sales and total sales. A similar rule applies to other products in the 
same product area as the possession product which are sold by any member 
in its own trade or business and which the possessions corporation takes 
into account in computing total sales under the cost sharing method.
    (ii) For taxable years of the possessions corporations beginning 
after June 13, 1986, a possessions corporations will not be entitled to 
the benefits of the cost sharing method with respect to units of the 
possession product which the possessions corporation sells to an 
affiliate where the affiliate then leases such units to an unrelated 
person or uses them in its own trade or business, unless the affiliate 
agrees to be treated for all tax purposes as having sold such units to 
an unrelated party at the time they were first leased or otherwise 
placed in service by such affiliate. The affiliate must demonstrate such 
agreement by reporting its income from such units as if:
    (A) It had sold such units to an unrelated person at such time at a 
price equal to the price used to compute possessions sales under Sec. 
1.936-6(a)(2), question and answer 11;
    (B) It had immediately repurchased such units for the same price; 
and
    (C) Its basis in such units for all subsequent purposes was equal to 
its cost basis from such deemed repurchase.


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

    Example. Possessions corporation S and its affiliate A are calendar 
year taxpayers. In 1985, S manufactures 100 units of possession product 
X. S sells 50 units of X to unrelated persons in arm's length 
transactions for $10 per unit. In applying the cost sharing method to 
determine the portion of its gross income from such sales which 
qualifies for the possessions tax credit, S determines that $8 of the 
$10 sales price may be taken into account. S sells the remaining 50 
units of X to A, and A then leases such units to unrelated persons. In 
1985, A also manufacturers 100 units of product Y, the only other 
product in the same product area as X manufactured or sold by any member 
of the affiliated group. A manufactured the 100 units of Y at a cost of 
$15 per unit, sold 50 units of Y to unrelated persons in arm's length 
transactions for $20 per unit, and leased the remaining 50 units of Y to 
unrelated persons.
    S may compute its income under the cost sharing method with respect 
to the 50 units of X it sold to A because S can determine an independent 
sales price of X from comparable uncontrolled transactions under Sec. 
1.482-2(e)(2). For purposes of computing both possessions sales and 
total sales, the 50 units of X sold to A will be deemed to have been 
sold by A to an unrelated person for $10 per unit. The income of S 
qualifying for the possessions tax credit from the sale of those 50 
units of X to A, and A's basis in those units, will both be determined 
using the $8 transfer price determined under section 936 
(h)(5)(C)(i)(II). For purposes of computing total sales in the 
denominator of the cost sharing fraction, S may also take into account 
the 50 units of Y leased by A to unrelated persons, as if A had sold 
those units for $20 per unit. A's basis in those units of Y will 
continue to be its actual cost basis of $15 per unit.
    If all of the above transactions had occurred in 1987, S would be 
entitled to compute its income under the cost sharing method with 
respect to the 50 units of X it sold to A only if A agreed to be treated 
for all tax purposes as if it had sold such units for $10 per unit, 
realized income on such deemed sale of $2 per unit, repurchased such 
units immediately for $10 per unit, and then leased such units, which 
would then have a $10 per unit basis in A's hands. For purposes of 
computing total sales, S would be entitled to take into account the 50 
units of X leased by A to unrelated persons as if A had sold such units 
for $20 per unit.

[[Page 106]]

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

[GRAPHIC] [TIFF OMITTED] TC09OC91.007

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

[[Page 107]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.008

[GRAPHIC] [TIFF OMITTED] TC09OC91.009

    Q. 3: The facts are the same as in question 1 except that S also 
manufactures and exports product E to a foreign affiliate, which resells 
it to unrelated persons for $1 million. S makes a separate election for 
its export sales. How should S compute the cost sharing amount for 
product E?
    A. 3: The numerator of the cost sharing fraction is the aggregate 
sales or other dispositions by members of the affiliated group of the 
units of product E produced in whole or in part in the possession to 
persons who are not members of the affiliated group. The cost sharing 
amount for product E would be computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.010

 or
[GRAPHIC] [TIFF OMITTED] TC09OC91.011

    Q. 4: The facts are the same as in question 1, except that S also 
receives $10,000 in royalty income from unrelated persons for the 
licensing of certain manufacturing intangible property rights. What is 
the amount of the product area research that must be allocated in 
determining the cost sharing amount?
    A. 4: If the affiliated group receives royalty income from unrelated 
persons with respect to manufacturing intangibles in the same product 
area, then the product area research to be considered shall be first 
reduced by such royalty income. In this case, the amount of product area 
research to be used in determining S's cost sharing payment should be 
reduced by the $10,000 royalty payment received to $340,000.
    Q. 5: May a possessions corporation redetermine the amount of its 
required cost sharing payment after filing its tax return?
    A. 5: If after filing its tax return, a possessions corporation 
files an amended return, or if an adjustment is made on audit, either of 
which affects the amount of the cost sharing payment required, then a 
redetermination of the cost sharing payment must be made. See, however, 
section 936(h)(5)(C)(i)(III)(a) with respect to the increase in the cost 
sharing payment due to interest imposed under section 6601(a).
    (5) Effect of election under the cost sharing method.
    Q. 1: What is the effect of the cost sharing method?

[[Page 108]]

    A. 1: The cost sharing payment reduces the amount of deductions (and 
the amount of reductions in earnings and profits) otherwise allowable to 
the U.S. affiliates (other than tax-exempt affiliates) within the 
affiliated group as determined under section 936(h)(5)(C)(i)(I)(b) which 
have incurred research expenditures (as defined in Sec. 1.936-6(a)(1), 
question and answer (3) in the same product area for which the cost 
sharing option is elected, during the taxable year in which the cost 
sharing payment accrues. If there are no such U.S. affiliates, the 
reductions with respect to deductions and earnings and profits, as the 
case may be, are made with respect to foreign affiliates within the same 
affiliated group which have incurred product area research expenditures 
in such product area attributable to a U.S. trade or business. If there 
are no affiliates which have incurred research expenditures in such 
product area, the reductions are then made with respect to any other 
U.S. affiliate and, if there is no such U.S. affiliate, then to any 
other foreign affiliate. The allocations of these reductions in each 
case shall be made in proportion to the gross income of the affiliates. 
In the case of foreign affiliates, the allocation shall be made in 
proportion to gross income attributable to the U.S. trade or business or 
worldwide gross income, as the case may be. With respect to each group 
above, the reduction of deductions shall be applied first to deductions 
under section 174, then to deductions under section 162, and finally to 
any other deductions on a pro rata basis.
    Q. 2: For purposes of estimated tax payments, when is the cost 
sharing amount deemed to accrue?
    A. 2: The cost sharing amount is deemed to accrue to the appropriate 
affiliate on the last day of the taxable year of each such affiliate in 
which or with which the taxable year of the possessions corporation 
ends.
    Q. 3: If the cost sharing method is elected and the year of accrual 
of the cost sharing payment to the appropriate affiliate (described in 
question and answer 1 of this paragraph (a)(5)) differs from the year of 
actual payment by the possessions corporation, in what year are the 
deductions of the recipients reduced?
    A. 3: In the year the cost sharing payment has accrued.
    Q. 4: What is the treatment of income from intangibles under the 
cost sharing method?
    A. 4: Under the cost sharing method, a possessions corporation is 
treated as the owner, for purposes of obtaining a return thereon, of 
manufacturing intangibles related to a possession product. The term 
``manufacturing intangible'' means any patent, invention, formula, 
process, design, pattern, or know-how. The possessions corporation will 
not be treated as the owner, for purposes of obtaining a return thereon, 
of any manufacturing intangibles related to a component product produced 
by an affiliated corporation and transferred to the possessions 
corporation for incorporation into the possession product, except in the 
case that the possession product is treated as including such component 
product for all purposes of section 936(h)(5). Further, the possessions 
corporation will not be treated as the owner, for purposes of obtaining 
a return thereon, of any marketing intangibles except ``covered 
intangibles.'' (See Sec. 1.936-6(c).)
    Q. 5: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of the manufacturing 
intangibles related to the possession product in order for the 
possessions corporation to receive a full return with respect to such 
intangibles?
    A. 5: No. There is no requirement that manufacturing intangibles be 
owned by the possessions corporation.
    Q. 6: How is income attributable to marketing intangibles treated 
under the cost sharing method?
    A. 6: Except in the case of ``covered intangibles'' (see Sec. 
1.936-6(c)), the possessions corporation is not treated as the owner of 
any marketing intangibles, and income attributable to marketing 
intangible of the possessions corporation will be allocated to the 
possessions corporation's U.S. shareholders with the proration of income 
based on shareholdings. If a shareholder of the possessions corporation 
is a foreign, person or is otherwise tax exempt, the possessions 
corporation is

[[Page 109]]

taxable on that shareholder's pro rata amount of the intangible property 
income. If the possessions corporation is a corporation any class of the 
stock of which is regularly traded on an established securities market, 
then the income attributable to marketing intangibles will be taxable to 
the possessions corporation rather than the corporation's U.S. 
shareholders.
    Q. 7: What is the source of the intangible property income described 
in question and answer 6?
    A. 7: The intangible property income is U.S. source whether taxed to 
the U.S. shareholder or taxed to the possessions corporation and section 
863 (b) does not apply for this purpose. However, such intangible 
property income, if treated as income of the possessions corporation, 
does not enter into the calculation of the 80-percent possession source 
test or the 65-percent active trade or business test.
    Q.7a: What is the source of the taxpayer's gross income derived from 
a sale in the United States of a possession product purchased by the 
taxpayer (or an affiliate) from a corporation that has an election in 
effect under section 936, if the income from such sale is taken into 
account to determine benefits under cost sharing for the section 936 
corporation? Is the result different if the taxpayer (or an affiliate) 
derives gross income from a sale in the United States of an integrated 
product incorporating a possession product purchased by the taxpayer (or 
an affiliate) from the section 936 corporation, if the taxpayer (or an 
affiliate) processes the possession product or an excluded component in 
the United States?
    A.7a: Under either scenario, the income is U.S. source, without 
regard to whether the possession product is a component, end-product, or 
integrated product. Section 863 does not apply in determining the source 
of the taxpayer's income. This Q&A 7a is applicable for taxable years 
beginning on or after November 13, 1998.
    Q. 8: May marketing intangible income, if any, be allocated to the 
possessions corporation with respect to custom-made products?
    A. 8: No. If the cost sharing option is elected, then income 
attributable to marketing intangibles (other than ``covered 
intangibles'' described in Sec. 1.936-6(c)) will be taxed as discussed 
in questions and answers 6 and 7 of paragraph (a)(5) of this section. It 
is immaterial whether the product is custom-made.
    Q. 9: In order to sell a pharmaceutical product in the United 
States, a New Drug Application (``NDA'') for the product must be 
approved by the U.S. Food and Drug Administration. Is an NDA considered 
a manufacturing or marketing intangible for purposes of the allocation 
of income under the cost sharing method?
    A. 9: A manufacturing intangible.
    Q. 10: Can a copyright be, in whole or in part, a manufacturing 
intangible for purposes of the allocation of income under the cost 
sharing method?
    A. 10: In general, a copyright is a marketing intangible. See 
section 936(h)(3)(B)(ii). However, copyrights may be treated either as 
manufacturing intangibles or nonmanufacturing intangibles (or as partly 
each) depending upon the function or the use of the copyright. If the 
copyright is used in manufacturing, it will be treated as a 
manufacturing intangible; but if it is used in marketing, even if it is 
also classified as know-how, it will be treated as a marketing 
intangible.
    Q. 11: If the cost sharing option is elected and a patent is related 
to the product produced by the possessions corporation, does the return 
to the possessions corporation with respect to the manufacturing 
intangible include the make, use, and sell elements of the patent?
    A. 11: Yes. A patent confers an exclusive right for 17 years to sell 
a product covered by the patent. During this period, the return to the 
possessions corporation includes the make, use and sell elements of the 
patent.
    Q. 12: For purposes of the cost sharing option, may a safe haven 
rule be applied to determine the amount of marketing intangible income?
    A. 12: No. The amount of marketing intangible income is determined 
on the basis of all relevant facts and circumstances. The section 482 
regulations will continue to apply except to the extent modified by the 
election. Rev. Proc. 63-10 and Rev. Proc. 68-22 do not apply for this 
purpose.

[[Page 110]]

    Q. 13: If a product covered by the cost sharing election is sold by 
a possessions corporation to an affiliated corporation for resale to an 
unrelated party, may the resale price method under section 482 be used 
to determine the intercompany price of the possessions corporation?
    A. 13: In general, the resale price method may be used if (a) no 
comparable uncontrolled price for the product exists, and (b) the 
affiliated corporation does not add a substantial amount of value to the 
product by manufacturing or by the provision of services which are 
reflected in the sales price of the product to the customer. The 
possessions corporation will not be denied use of the resale price 
method for purposes of such inter-company pricing merely because the 
reseller adds more than an insubstantial amount to the value of the 
product by the use of intangible property.
    Q. 14: If a possessions corporation makes the cost sharing election 
and uses the cost-plus method under section 482 to determine the arm's-
length price of a possession product, will the cost base include the 
cost of materials which are subject to processing or which are 
components in the possession product?
    A. 14: A taxpayer may include the cost of materials in the cost base 
if it is appropriate under the regulations under Sec. 1.482-2(e)(4).
    Q. 15: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, and the price of the 
product is determined under the cost-plus method under section 482, does 
the cost base used in computing cost-plus under section 482 include the 
amount of the cost sharing payment?
    A. 15: The amount of the cost sharing payment is included in the 
cost base. However, no profit with respect to the cost sharing payment 
will be allowed.
    Q. 16: If a member of the affiliated group transfers to a 
possessions corporation a component which is incorporated into a 
possession product, how will the transfer price for the component be 
determined?
    A. 16: The transfer price for the component will be determined under 
section 482, and as follows. If the possession product is treated as not 
including such component for purposes of section 936(h)(5), the transfer 
price paid for the component will include a return on all intangibles 
related to the component product. If the possession product is treated 
as including such component for purposes of section 936(h)(5), then the 
transfer price paid for the component by the possessions corporation 
will not include a return on any manufacturing intangible related to the 
component product, and the possessions corporation will obtain the 
return on the manufacturing intangibles associated with the component.
    Q. 17: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, with respect to 
which units of the product shall the possessions corporation be treated 
as owning intangible property as a result of having made the cost 
sharing election?
    A. 17: The possessions corporation shall not be treated as owning 
intangible property, as a result of having made the cost sharing 
election, with respect to any units of a possession product which were 
not taken into account by the possessions corporation in applying the 
significant business presence test for the current taxable year or for 
any prior taxable year in which the possessions corporation also had a 
significant business presence in the possession with respect to such 
product.
    (b) Profit split option--(1) Computation of combined taxable income.
    Q. 1: In determining combined taxable income from sales of a 
possession product, how are the allocations and apportionments of 
expenses, losses, and other deductions to be determined?
    A. 1: (i) Expenses, losses, and other deductions are to be allocated 
and apportioned on a ``fully-loaded'' basis under Sec. 1.861-8 to the 
combined gross income of the possessions corporation and other members 
of the affiliated group (other than foreign affiliates). For purposes of 
the profit split option, the term ``affiliated group'' is defined the 
same as under Sec. 1.936-6 (a)(1) question and answer 2. The amount of 
research, development, and experimental expenses allocated and 
apportioned to

[[Page 111]]

combined gross income is to be determined under Sec. 1.861-8(e)(3). The 
amount of research, development and experimental expenses and related 
deductions (such as royalties paid or accrued with respect to 
manufacturing intangibles by the possessions corporation or other 
domestic members of the affiliated group to unrelated persons or to 
foreign affiliates) allocated and apportioned to combined gross income 
shall in no event be less than the amount of the cost sharing payment 
that would have been required under the rules set forth in section 
936(h)(5)(C)(i)(II) and paragraph (a) of this section if the cost 
sharing option had been elected. Other expenses which are subject to 
Sec. 1.861-8(e) are to be allocated and apportioned in accordance with 
that section. For example, interest expense (including payments made 
with respect to bonds issued by the Puerto Rican Industrial, Medical and 
Environmental Control Facilities Authority (AFICA)) is to be allocated 
and apportioned under Sec. 1.861-8(e)(2). With the exception of 
marketing and distribution expenses discussed below, the other remaining 
expenses which are definitely related to a class of gross income shall 
be allocated to that class of gross income and shall be apportioned on 
the basis of any reasonable method, as described in Sec. 1.861-8 (b)(3) 
and (c)(1). Examples of such methods may include, but are not limited 
to, those specified in Sec. 1.861-8(c)(1)(i) through (vi).
    (ii) The class of gross income to which marketing and distribution 
expenses relate and shall be allocated is generally to be defined by the 
same ``product area'' as is determined for the relevant research, 
development, and experimental expenses (i.e., the appropriate 3-digit 
SIC code), but shall include only gross income generated or reasonably 
expected to be generated from the geographic area or areas to which the 
expenses relate. It shall be presumed that marketing and distribution 
expenses relate to all product sales within the same product area. If, 
however, it can be established that any of these expenses are separately 
identifiable expenses, such as advertising, and relate, directly or 
indirectly, solely to a specific product or a specific group of 
products, such expenses shall be allocated to the class of gross income 
defined by the specific product or group of products. Thus, advertising 
and other separately identifiable marketing expenses which relate 
specifically and exclusively to a particular product must be allocated 
entirely to the gross income from that product, even though the taxpayer 
or other members of an affiliated group which includes the taxpayer 
produce and market other products in the same 3-digit SIC code 
classification. The mere display of a company logo or mention of a 
company name solely in the context of identifying the manufacturer shall 
not prevent an advertisement from relating specifically and exclusively 
to a particular product or group of products.
    (iii) If marketing and distribution expenses are allocated to a 
class of gross income which consists both of income from sales of 
possession products (the statutory grouping) and other income such as 
from sale by U.S. affiliates of products not produced in the possession 
(the residual grouping), then these marketing and distribution expenses 
shall be apportioned on a ``fully loaded'' basis which reflects, to a 
reasonably close extent, the factual relationship between these 
deductions and the statutory and residual groupings of gross income. 
Apportionment methods based upon comparisons of amounts incurred before 
ultimate sale of a product (including apportionment on a comparison of 
costs of goods sold, other expenses incurred, or other comparisons set 
forth in Sec. 1.861-8 (c)(1)(v), such as time spent) are not on a 
``fully-loaded'' basis and do not reflect this required factual 
relationship. These deductions shall be apportioned on a basis of 
comparison of the amount of gross sales or receipts or another method if 
it is established that such method similarly reflects the required 
factual relationship. Thus, for example, a comparison of units sold may 
be used only where the units are of the same or similar value and are, 
thus, in fact comparable.
    (iv) The rules for allocation and apportionment of marketing and 
distribution expenses may be illustrated by the following examples:


[[Page 112]]


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

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


These expenses of 240X are allocated to gross income generated by all 
three products and shall be apportioned on the basis of gross sales or 
receipts of product 1 as compared to products 2 and 3 or another 
method which similarly reflects the factual relationship between these 
expenses and gross income derived from product 1 and products 2 and 
3. Thus, if a sales method were used and sales of product 1 accounted 
for one-third of sales receipts from the three products, 80X (240 / 3) 
of marketing and distribution expenses would be apportioned to the 
combined gross income from product 1.
    Example 2. Corporation B produces and sells Brand W whiskey, in the 
United States. B's subsidiary, S, which is a possessions corporation, 
produces soft drink extract in Puerto Rico which it sells to independent 
bottlers to produce Brand S soft drinks for sale in the United States. 
Corporation B's advertisements and other promotional materials for Brand 
W whiskey make no reference to Brand S soft drinks (or any other 
Corporation B products), and Brand S soft drink advertisements and other 
promotional materials make no reference to Brand W whiskey (or any other 
corporation B products). For purposes of section 936(h), the advertising 
and other promotional expenses for Brand W whiskey must be allocated 
entirely to the gross income from sales of Brand W whiskey and the 
advertising and other promotional expenses for Brand S soft drink must 
be allocated entirely to the gross income from the sales of soft drink 
extract, notwithstanding the fact that whiskey and soft drink extract 
are both included in SIC code 208. A similar result would apply, for 
example, to separately identifiable advertising and other marketing 
expenses which relate specifically and exclusively to one or the other 
of the following pairs of products: chewing gum and granulated sugar 
(SIC code 206); canned tuna fish and freeze-dried coffee (SIC code 209); 
children's underwear and ladies' brassieres (SIC code 234); aspirin 
tablets and prescription antibiotic tablets (SIC code 283); floor wax 
and perfume (SIC code 284); adhesives and inks (SIC code 289); semi-
conductors and cathode-ray tubes (SIC code 367); batteries and extension 
cords (SIC code 369); bandages and dental supplies (SIC code 384); 
stainless steel flatware and jewelry parts (SIC code 391); children's 
toys and sporting goods (SIC code 394); hair curlers and zippers (SIC 
code 396); and paint brushes and linoleum tiles (SIC code 399).
    Example 3. Assume the same facts as in Example 1 and that 
possessions corporation A also manufactures aspirin, a non-prescription 
product, for resale by its U.S. parent corporation, P. Further, assume 
that the advertising and separately identifiable marketing expenses 
which relate specifically and exclusively to aspirin sales total $100 
and that these expenses are allocable solely to gross income derived 
from aspirin sales. The sales method continues to be used to apportion 
the marketing and distribution expenses related, directly or indirectly, 
to products 1, 2, and 3, and the apportionment of such expenses to 
product 1 for purposes of determining combined taxable income from 
product 1 will remain as stated in Example 1. None of the advertising 
and other separately identifiable marketing expenses which relate 
specifically and exclusively to aspirin will be taken into account in 
allocating and apportioning the marketing and distribution expenses 
relating to the gross income attributable to products 1, 2, and 3. 
Gross income attributable to aspirin will be considered as a separate 
class of gross income, and all the advertising and separately 
identifiable marketing expenses which relate specifically and 
exclusively to aspirin sales of $100 will be allocated to the class of 
gross income derived from aspirin sales. Similarly, none of the 
marketing and distribution expenses, directly or indirectly, related 
solely to the group of products 1, 2, and 3 will be taken into 
account in determining the combined taxable income from aspirin sales. 
the remaining marketing and distribution expenses which do not, directly 
or indirectly, relate solely to any specific product or group of 
products (e.g., the salaries of a Vice-President of Marketing who has 
responsibility for marketing all products and his staff) shall be 
allocated and apportioned on the basis of the gross receipts from the 
sales of all of the products (or a similar method) in determining 
combined taxable income of any product.

    Q. 2: How may the allocation and apportionment of expenses to 
combined gross income be verified?
    A. 2: Substantiation of the allocation and apportionment of expenses 
will be required upon audit of the possessions corporation and 
affiliates. Detailed

[[Page 113]]

substantiation may be necessary, particularly where the entities are 
engaged in multiple lines of business involving distinct product areas. 
Sources of substantiation may include certified financial reports. Form 
10-K's, annual reports, internal production reports, product line 
assembly work papers, and other relevant materials. In this regard, see 
Sec. 1.861-8(f)(5).
    Q. 3: Does section 936(h) override the moratorium provided by 
section 223 of the Economic Recovery Tax Act of 1981 and any subsequent 
similar moratorium?
    A. 3: Yes. Thus, the allocation and apportionment of product area 
research described in question and answer 1 must be made without regard 
to the moratorium.
    Q. 4: Is the cost of samples treated as a marketing expense?
    A. 4: Yes. The cost of producing samples will be treated as a 
marketing expense and not as inventoriable costs for purposes of 
determining combined taxable income (and compliance with the significant 
business presence test). However, for taxable years beginning prior to 
January 1, 1986, the cost of producing samples may be treated as either 
a marketing expense or as inventoriable costs.
    Q. 5: If a possessions corporation uses the profit split method to 
determine its taxable income from sales of a product, how does it 
determine its gross income for purposes of the 80-percent possession 
source test and the 65-percent active trade or business test of section 
936(a)(2)?
    A. 5: One-half of the deductions of the affiliated group (other than 
foreign affiliates) which are used in determining the combined taxable 
income from sales of the product are added to the portion of the 
combined taxable income allocated to the possessions corporation in 
order to determine the possessions corporation's gross income from sales 
of such product.
    Q. 6: How will income from intangibles related to a possession 
product be treated under the profit split method?
    A. 6: Combined taxable income of the possessions corporation and 
affiliates from the sale of the possession product will include income 
attributable to all intangibles, including both manufacturing and 
marketing intangibles, associated with the product.
    Q. 7: Can a possessions corporation apply the profit split option to 
a possession product if no U.S. affiliates derive income from the sale 
of the possession product?
    A. 7: Yes.
    Q. 8: With respect to the factual situation discussed in question 
and answer 7 how is combined taxable income computed?
    A. 8: The profit split option is applied to the taxable income of 
the possessions corporation from sales of the possession product to 
foreign affiliates and unrelated persons. Fifty percent of that income 
is allocated to the possessions corporation, and the remainder is 
allocated to the appropriate affiliates as described in question and 
answer 13 of this paragraph (b)(1).
    Q. 9: May a possessions corporation compute its income under the 
profit split method with respect to units of a possession product which 
it sells to a U.S. affiliate if the U.S. affiliate leases such units to 
unrelated persons or to foreign affiliates or uses such units in its own 
trade or business?
    A. 9: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2 (e)(2). If, however, there 
is a comparable uncontrolled price for an integrated product and the 
possession product is a component product or end-product form thereof, 
the possessions corporation may compute its income under the profit 
split method with respect to such units. In either case, the possessions 
corporation shall compute combined taxable income with respect to such 
units under the following question and answer.
    Q. 10: If the possessions corporation is entitled to use the profit 
split method in the situation described in Q. 9 (leasing units of the 
possession product or use of such units in the taxpayer's own trade or 
business), how should it compute combined taxable income with respect to 
such units?
    A. 10: (i) Combined taxable income shall be computed as if the U.S. 
affiliate had sold the units to an unrelated person (or to a foreign 
affiliate) at the

[[Page 114]]

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


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

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

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


Subsequent leasing income is entirely taxed to A.

    Q. 12: If the possession product is a component product or an end-
product form, how is the combined taxable income for such product to be 
determined?

[[Page 115]]

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

Production costs (excluding costs of materials):
    1. O's costs for the component.........................          100
    2. S's costs for the microprocessors...................          500
    3. P's costs for the CPUs (the possession product).....          200
    4. Q's costs for the computers.........................          400
    5. Total production costs for the computer (Add lines 1        1,200
     through 4)............................................
    6. Combined production costs for the CPU (the                    800
     possession product) (Add lines 1 through 3)...........
    7. Ratio of production costs for the CPUs (the                 0.667
     possession product) to the production costs for the
     computer..............................................
Determination of combined taxable income for computers:
  Sales:
    8. Total possession sales of computers to unrelated            7,500
     customers and foreign affiliates......................
  Total costs of O, S, P, and Q incurred in production of a
   computer:
    9. Production costs (enter from line 5)................        1,200
    10. Material costs.....................................          100
    11. Total costs (line 9 plus line 10)..................        1,300
    12. Combined gross income from sale of computers (line         6,200
     8 minus line 11)......................................
  Expenses of the affiliated group (other than foreign
   affiliates) allocable and apportionable to the computers
   or any component thereof under the rules of Sec. Sec.
   1.861-8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:
    13. Expenses (other than research expenses)............          980
  Research expenses of the affiliated group allocable and
   apportionable to the computers:
    14. Total sales in the 3-digit SIC Code................       12,500
    15. Possession sales of the computers (enter from line         7,500
     8)....................................................

[[Page 116]]

 
    16. Cost sharing fraction (divide line 15 by line 14)..          0.6
    17. Research expenses incurred by the affiliated group           700
     in 3-digit SIC Code multiplied by 120 percent.........
    18. Cost sharing amount (multiply line 16 by line 17)..          420
    19. Research of the affiliated group (other than                 300
     foreign affiliates) allocable and apportionable under
     Sec. Sec. 1.861-17 and 1.861-14T(e)(2) to the
     computers.............................................
    20. Enter the greater of line 18 or line 19............          420
Computation of combined taxable income of the computer and
 the CPU:
    21. Combined taxable income attributable to the                4,800
     computer (line 12 minus line 13 and line 20)..........
    22. Combined taxable income attributable to CPUs               3,200
     (multiply line 21 by line 7) (production cost ratio)..
    23. Share of combined taxable income apportioned to S          1,600
     (50 percent of line 22)...............................
Share of combined taxable income apportioned to U.S.
 affiliate(s) of S:
    24. Adjustments for research expenses (line 18 minus              80
     line 19 multiplied by line 7).........................
    25. Adjusted combined taxable income (line 22 plus line        3,280
     24)...................................................
    26. Share of combined taxable income apportioned to            1,680
     affiliates of S (line 25 minus line 23)...............
 

    (v)(A) If a possession product is sold by a taxpayer or its 
affiliate to unrelated persons in covered sales both as an integrated 
product and as a component product and the conditions of paragraph 
(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine 
the combined taxable income derived from covered sales of the component 
product under this paragraph (v). In that case, the combined taxable 
income derived from covered sales of the component product shall be 
determined by using the same per unit combined taxable income as is 
derived from covered sales of the product as an integrated product, but 
subject to the limitation of paragraph (v)(D) of this A. 12.
    (B) In the case of a possession product that is an end-product form, 
if all of the excluded components are also separately sold by the 
taxpayer or its affiliate to unrelated persons in uncontrolled 
transactions and the conditions of paragraph (v)(C) of this A. 12 are 
satisfied, the taxpayer may elect to determine the combined taxable 
income of such end-product form under this paragraph (v). In that case, 
the combined taxable income derived from covered sales of the end-
product form shall be determined by reducing the per unit combined 
taxable income from the integrated product that includes the end-product 
form by the per unit combined taxable income for excluded components 
determined under the rules of this paragraph (v), but subject to the 
limitation of paragraph (v)(D) of this A. 12. For this purpose, combined 
taxable income of the excluded components must be determined under 
section 936 as if the excluded components were possession products.
    (C) In the case of component products, this paragraph (v) applies 
only if the sales price of the possession product sold in covered sales 
as an integrated product (i.e., in uncontrolled transactions) would be 
the most direct and reliable measure of an arm's length price within the 
meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the 
component product. For purposes of applying the fourth sentence of Sec. 
1.482-3(b)(2)(ii)(A), the sale of the integrated product that includes 
the component product is treated as being immediately preceded by a sale 
of the component (i.e. without further processing) in a controlled 
transaction. In the case of end-product forms, this paragraph (v) 
applies only if the sales price of excluded components separately sold 
in uncontrolled transactions would be the most direct and reliable 
measure of an arm's length price within the meaning of the fourth 
sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded components of an 
integrated product that includes an end-product form. For purposes of 
applying the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the sale of 
the integrated product that includes excluded components is treated as 
being immediately preceded by a sale of the excluded components (i.e. 
without further processing) in a controlled transaction. Under the 
fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the uncontrolled 
transactions referred to in this paragraph (v)(C) must have no 
differences with the controlled transactions that would affect price, or 
have only minor differences that have a definite and reasonably 
ascertainable effect on price and for which appropriate adjustments are 
made (resulting in appropriate adjustments to the computation of 
combined taxable income). If such adjustments cannot be made, or if 
there are more than minor differences

[[Page 117]]

between the controlled and uncontrolled transactions, the method 
provided by this paragraph (v)(C) cannot be used. Thus, for example, 
these uncontrolled transactions must involve substantially identical 
property in the same or a substantially identical geographic market, and 
must be substantially identical to the controlled transaction in terms 
of their volumes, contractual terms, and market level. See Sec. 1.482-
3(b)(2)(ii)(B).
    (D) In no case can the per unit combined taxable income as 
determined under paragraph (v)(A) or (B) of this A. 12 be greater than 
the per unit combined taxable income of the integrated product that 
includes the component product or end-product form.
    (E) The provisions of this paragraph (v) are illustrated by the 
following example. Taxpayer manufactures product A in a U.S. possession. 
Some portion of product A is sold to unrelated persons as an integrated 
product and the remainder is sold to related persons for transformation 
into product AB. The combined taxable income of integrated product A is 
$400 per unit and the combined taxable income of product AB is $300 per 
unit. The production cost ratio with respect to product A when sold as a 
component of product AB, is 2/3. Unless the taxpayer elects and 
satisfies the conditions of this paragraph (v), the combined taxable 
income with respect to A will be $200 per unit (combined taxable income 
for AB of $300 x the production cost ratio of 2/3). If, however, the 
comparability standards of paragraph (v)(C) of this A. 12 are met, the 
taxpayer may elect to determine combined taxable income of product A 
when sold as a component of product AB using the same per unit combined 
taxable income as product A when sold as an integrated product. However, 
the per unit combined taxable income from sales of product A as a 
component product may not exceed the per unit combined taxable income on 
the sale of product AB. Therefore, the combined taxable income of 
component product A may not exceed $300 per unit.
    (vi) Taxpayers that have not elected the percentage limitation under 
section 936(a)(1) for the first taxable year beginning after December 
31, 1993, may do so if the taxpayer has elected the profit split method 
and computation of combined taxable income is affected by Q&A.12 of this 
paragraph (b)(1).
    (vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for 
taxable years ending after June 9, 1996. If, however, the election under 
paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made, this election 
must be made for the taxpayer's first taxable year beginning after 
December 31, 1993, and if not made effective for that year, the election 
cannot be made for any later taxable year. A successor corporation that 
makes the same or substantially similar products as its predecessor 
corporation cannot make an election under paragraph (v) of A.12 of Sec. 
1.936-6(b)(1) unless the election was made by its predecessor 
corporation for its first taxable year beginning after December 31, 
1993.
    Q. 13: If the profit split option is elected, how is the portion of 
combined taxable income not allocated to the possessions corporation to 
be treated?
    A. 13: (i) The income shall be allocated to affiliates in the 
following order, but no allocations will be made to affiliates described 
in a later category if there are any affiliates in a prior category--
    (A) First, to U.S. affiliates (other than tax exempt affiliates) 
within the group (as determined under section 482) that derive income 
with respect to the product produced in whole or in part in the 
possession;
    (B) Second, to U.S. affiliates (other than tax exempt affiliates) 
that derive income from the active conduct of a trade or business in the 
same product area as the possession product;
    (C) Third, to other U.S. affiliates (other than tax-exempt 
affiliates);
    (D) Fourth, to foreign affiliates that derive income from the active 
conduct of a U.S. trade or business in the same product area as the 
possession product (or, if the foreign members are resident in a country 
with which the U.S. has an income tax convention, then to those foreign 
members that have a permanent establishment in the United States that 
derives income in the same product area as the possession product); and
    (E) Fifth, to all other affiliates.

[[Page 118]]

    (ii) The allocations made under paragraph (i)(A) of this A. 13 shall 
be made on the basis of the relative gross income derived by each such 
affiliate with respect to the product produced in whole or in part in 
the possession. For this purpose, gross income must be determined 
consistently for each affiliate and consistently from year to year.
    (iii) The allocations made under paragraphs (i)(B) and (i)(D) of 
this A. 13 shall be made on the basis of the relative gross income 
derived by each such affiliate from the active conduct of the trade or 
business in the same product area.
    (iv) The allocations made under paragraphs (i)(C) and (i)(E) of this 
A. 13 shall be made on the basis of the relative total gross income of 
each such affiliate before allocating income under this section.
    (v) Income allocated to affiliates shall be treated as U.S. source 
and section 863(b) does not apply for this purpose.
    (vi) For purposes of determining an affiliate's estimated tax 
liability for income thus allocated for taxable years beginning prior to 
January 1, 1995, the income shall be deemed to be received on the last 
day of the taxable year of each such affiliate in which or with which 
the taxable year of the possessions corporation ends. For taxable years 
beginning after December 31, 1994, quarterly estimated tax payments will 
be required as provided under section 711 of the Uruguay Round 
Agreements, Public Law 103-465 (1994), page 230, and any administrative 
guidance issued by the Internal Revenue Service thereunder.
    Q. 14: What is the source of the portion of combined taxable income 
allocated to the possessions corporation?
    A. 14: Income allocated to the possessions corporation shall be 
treated as possession source income and as derived from the active 
conduct of a trade or business within the possession.
    Q. 15: How is the profit split option to be applied to properly 
account for costs incurred in a year with respect to products which are 
sold by the possessions corporation to a U.S. affiliate during such 
year, but are not resold by the U.S. affiliate to persons who are not 
members of the affiliated group or to foreign affiliates until a later 
year?
    A. 15: The rules under Sec. 1.994-1(c)(5) are to be applied. 
Incomplete transactions will not be taken into consideration in 
computing combined taxable income. Thus, for example, if in 1983, A, a 
possessions corporation, sells units of a product with a cost to A of 
$5000 to B corporation, its U.S. affiliate, which use the dollar-value 
LIFO method of costing inventory, and B sells units with a cost of $4000 
(representing A's cost) to C corporation, a foreign affiliate, only 
$4000 of such costs shall be taken into consideration in computing the 
combined taxable income of the possessions corporation and U.S. 
affiliates for 1983. If a specific goods LIFO inventory method is used 
by B, the determination of whether A's goods remain in B's inventory 
shall be based on whether B's specific goods LIFO grouping has 
experienced an increment or decrement for the year on the specific LIFO 
cost of such units, rather than on an average unit cost of such units. 
If the FIFO method of costing inventory is used by B, transfers may be 
based on the cost of the specific units transferred or on the average 
unit production cost of the units transferred, but in each case a FIFO 
flow assumption shall be used to identify the units transferred. For a 
determination of which goods are sold by taxpayers using the LIFO 
method, see question and answer 19.
    Q. 16: If a possessions corporation purchases materials from an 
affiliate and computes combined taxable income for a possession product 
which includes such materials, how are those materials to be treated in 
the possessions corporation's inventory?
    A. 16: The cost of those materials is considered to be equal to the 
affiliate's cost using the affiliate's method of costing inventory.
    Q. 17: If the possessions corporation uses the FIFO method of 
costing inventory and the U.S. affiliate uses the LIFO method of costing 
inventory, or vice versa, what method of costing inventory should be 
used in computing combined taxable income?

[[Page 119]]

    A. 17: The transferor corporation's method of costing inventory 
determines the cost of inventory for purposes of combined taxable income 
while the transferee corporation's method of costing inventory 
determines the flow. Assume, for example, that X corporation, a 
possessions corporation, using the FIFO method of costing inventory 
purchases materials from Y corporation, U.S. affiliate, also using the 
FIFO method. X corporation produces a product which it transfers to Z 
corporation, another U.S. affiliate using the LIFO method. Assume also 
that the final product satisfies the significant business presence test. 
Under the facts, the cost of the materials purchased by X from Y is Y's 
FIFO cost. The costs of the inventory transferred by X to Z are 
determined under X's FIFO method of accounting as is the flow of the 
inventory from X to Z. The costs added by Z are determined under Z's 
LIFO method of inventory, as is the flow of the inventory from Z to 
unrelated persons or foreign affiliates.
    Q. 18: How are the costs of a possession product and the revenues 
derived from the sale of a possession product determined if the U.S. 
affiliate includes purchases of the possessions product in a dollar-
value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 18: The following method will be accepted in determining the 
revenues derived from the sale of a possession product and the costs of 
a possession product if the U.S. affiliate includes purchases of the 
possession product in a dollar-value LIFO inventory pool. The rules 
apply solely for the cost sharing and profit split options under section 
936(h).
    (i) Revenue identification. The identification of revenues derived 
from sales of a possession product must generally be made on a specific 
identification basis. The particular method employed by a taxpayer for 
valuing its inventory will have no impact on the determination of what 
units are sold or how much revenue is derived from such sales. Thus, if 
a U.S. affiliate sells both item A (a possession product) and item B (a 
non-possession product), the actual sales revenues received by the U.S. 
affiliate from item A sales would constitute possession product revenue 
for purposes of the profit split option and possession sales for 
purposes of the cost sharing option regardless of whether the U.S. 
affiliate values its inventories on the FIFO or the LIFO method. In 
instances where sales of item A (i.e., the possession product) cannot be 
determined by use of specific identification (for example, in cases 
where items A and B are identical except that one is produced in the 
possession (item A) and the other (item B) is produced outside of the 
possession and it is not possible to segregate these items in the hands 
of the U.S. affiliate), it will be necessary to identify the portion of 
the combined sales of items A and B (which together can be identified on 
a specific identification basis) which is attributed to item A sales and 
the portion which is attributed to item B sales. The determination of 
the portion of aggregated sales attributable to item A and item B is 
independent of the LIFO method used to determine the cost of such sales 
and may be made under the following approach. A taxpayer may, for 
purposes of this section of the regulations, use the relative purchases 
(in units) of items A and B by the U.S. affiliate during the taxable 
year (or other appropriate measuring period such as the period during 
the taxable year used to determine current-year costs, i.e., earliest 
acquisitions period, latest acquisitions period, etc.) in determining 
the ratio to apply against the combined items A and B sales revenue. If 
the sales exceed current purchases, the taxpayer can use a FIFO unit 
approach which identifies actual unit sales on a first-in, first-out 
basis. Revenue determination where specific identification is not 
possible is illustrated by the following example:

    Example. At the end of year 1, there are 600 units of combined items 
A and B which are to be allocated between A and B on the basis of annual 
purchases of A and B units during year 1. During year 1, 1,000 units of 
item A, a possession product, and 2,000 units of item B, a non-
possession product, were purchased. Thus, the 600 units in year 1 ending 
inventory are allocated 200 (i.e. \1/3\) to item A units and 400 (i.e. 
\2/3\) to item B units based on the relative purchases of A (1,000) and 
B (2,000) in year 1. These units appear as beginning inventory in year 
2.

[[Page 120]]

    In year 2, 1,500 units of item A are purchased and 1,500 units of 
item B are purchased. However, 3,300 units of items A and B in the 
aggregate are sold for $600,000. The relative proportion of the $600,000 
attributable to item A and to item B sales would be determined as 
follows:

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

                                                                  [GRAPHIC] [TIFF OMITTED] TC14NO91.144
                                                                  

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


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


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

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

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


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


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


[[Page 121]]


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


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


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


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

    Example. Assume the following:

[[Page 122]]



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

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

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

[[Page 123]]

of covered intangibles described in section 936(h)(5)(C)(i)(II)(c) 
related to the product in order for the possessions corporation to 
receive a full return with respect to such intangibles?
    A. 6: No. For purposes of section 936(h), it is immaterial whether 
such covered intangibles are owned by the possessions corporation or by 
another member of the affiliated group. Moreover, if the legal owner of 
such covered intangibles which are subject to section 936(h)(5) is an 
affiliate of the possessions corporation, such person will not be 
required to charge an arm's-length royalty under section 482 to the 
possessions corporation.

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



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

    (a) The rules in this section apply for purposes of section 936(h) 
and also for purposes of section 934(e), where applicable.
    (b) Manner of making election.
    Q. 1: How does a possessions corporation make an election to use the 
cost sharing method or profit split method?
    A. 1: A possessions corporation makes an election to use the cost 
sharing or profit split method by filing Form 5712-A (``Election and 
Verification of the Cost Sharing or Profit Split Method Under Section 
936(h)(5)'') and attaching it to its tax return. Form 5712-A must be 
filed on or before the due date (including extensions) of the tax return 
of the possessions corporation for its first taxable year beginning 
after December 31, 1982. The electing corporation must set forth on the 
form the name and the taxpayer identification number or address of all 
members of the affiliated group (including foreign affiliates not 
required to file a U.S. tax return). All members of the affiliated group 
must consent to the election. For elections filed with respect to 
taxable years beginning before January 1, 2003, an authorized officer of 
the electing corporation must sign the statement of election and must 
declare that he has received a signed statement of consent from an 
authorized officer, director, or other appropriate official of each 
member of the affiliated group. Elections filed for taxable years 
beginning after December 31, 2002, must incorporate a declaration by the 
electing corporation that it has received a signed consent from an 
authorized officer, director, or other appropriate official of each 
member of the affiliated group and will be verified by signing the 
return. The election is not valid for a taxable year unless all 
affiliates consent. A failure to obtain an affiliate's written consent 
will not invalidate the election out if the possessions corporation made 
a good faith effort to obtain all the necessary consents or the failure 
to obtain the missing consent was inadvertent. Subsequently created or 
acquired affiliates are bound by the election. If an election out is 
revoked under section 936(h)(5)(F)(iii), a new election out with respect 
to that product area cannot be made without the consent of the 
Commissioner. The possessions corporation shall file an amended Form 
5712-A with its timely filed (including extensions) income tax return to 
reflect any changes in the names or number of the members of the 
affiliated group for any taxable year after the first taxable year to 
which the election out applies. By consenting to the election out, all 
affiliates agree to provide information necessary to compute the cost 
sharing payment under the cost sharing method or combined taxable income 
under the profit split method, and failure to provide such information 
shall be treated as a request to revoke the election out under section 
936(h)(5)(F)(iii).
    Q. 2: May the ``election out'' under section 936(h)(5) be made on a 
product-by-product basis, or must it be made on a wide basis?
    A. 2: An electing corporation is required to treat products in the 
same product area in the same manner. Similarly, all possessions 
corporations in the same affiliated group that produce any products or 
render any services in the same product area must make the same election 
for all products that fall within the same product area. However, Sec. 
1.936-7(b) provides that the electing corporation may make a different 
election for export sales than

[[Page 124]]

for domestic sales. The electing corporation or corporations may also 
make different elections for products that fall within different product 
areas.
    Q. 3: May the possessions corporation elect to define product area 
more narrowly than the 3-digit SIC code?
    A. 3: No. Certain alternatives, such as the 4-digit SIC code, would 
not be permitted under the statute. However, other methods for defining 
product area may be considered by the Commissioner in the future.
    Q. 4: May a possessions corporation make an election out under the 
cost sharing method with respect to a product area if the affiliated 
group incurs no research, development or experimental costs in the 
product area?
    A. 4: Yes. In that case the cost sharing payment will be zero.
    Q. 5: If the significant business presence test is not satisfied for 
a product or type of service within the product area covered by the 
election out under section 936(h)(5) what rules will apply with respect 
to that product?
    A. 5: With respect to the product which does not satisfy the 
significant business presence test, the provisions of section 936 (h)(1) 
through (h)(4) will apply to the allocation of income. However, if a 
cost sharing or a profit split election has been made with respect to 
the product area, the cost sharing payment or the research and 
development floor under section 936(h)(5)(C)(ii)(II) will not be 
reduced.
    Q. 6: Is a taxpayer permitted to make a change of election with 
respect to the cost sharing and profit split methods?
    A. 6: In general, once the election is properly made, it is binding 
for the first year in which it applies and all subsequent years 
(including upon any later created or acquired affiliates), and 
revocation is only permitted with the consent of the Commissioner of 
Internal Revenue. However, a taxpayer will be permitted to change its 
election once from the cost sharing method to the profit split method or 
vice versa, or from the method permitted under section 936 (h)(1) 
through (h)(4) to cost sharing or profit split or vice versa, without 
the consent of the Commissioner if the change is made on the taxpayer's 
return for its first taxable year ending after June 13, 1986. Such 
change will apply to such taxable year and all subsequent taxable years, 
and, at the taxpayer's option, may also apply to all prior taxable years 
for which section 936(h) was in effect. A change of election will be 
treated as an election subject to the procedures set forth above and to 
section 481 of the Internal Revenue Code.
    Q. 7: If the Commissioner determines that a possessions corporation 
does not meet the 80-percent possession source test or the 65-percent 
active trade or business test (the ``qualification tests'') for any 
taxable year beginning after 1982, under what circumstances is the 
possessions corporation permitted to make a distribution of property 
after the close of its taxable year to meet the qualification tests?
    A. 7: A possessions corporation may make a pro rata distribution of 
property to its shareholders after the close of the taxable year if the 
Commissioner determines that the possessions corporation does not 
satisfy the qualification tests (a) by reason of the exclusion from 
gross income of intangible income under section 936(h)(1)(B) or section 
936(h)(5)(C)(i)(II) or (b) by reason of the allocation to the 
shareholders of the possessions corporation of income under section 
936(h)(5)(C)(ii)(III); provided, however, that the determination of the 
Commissioner does not contain a finding that the failure of such 
corporation to satisfy the qualification tests was due, in whole or in 
part, to fraud with intent to evade tax or willful neglect on the part 
of the possessions corporation. The possessions corporation must 
designate the distribution at the time the distribution is made as a 
distribution to meet qualification requirements, and it will be subject 
to the provisions of section 936(h)(4). Such distributions will not 
qualify for the dividends received deduction.
    Q. 8: If a possessions corporation owns stock in a subsidiary 
possessions corporation, any intangible property income allocated to the 
parent possessions corporation under section 936(h) will be treated as 
U.S. source income and taxable to the parent possessions corporation. Is 
the intangible property

[[Page 125]]

income taken into consideration in determining whether the parent 
possessions corporation meets the income tests of section 936(a)(2)?
    A. 8: While taxable to the parent possessions corporation, the 
intangible property income does not enter into the calculation of the 
80-percent possession source test or the 65-percent active trade or 
business test of section 936(a)(2)(A) and (B). This would also be the 
case if the subsidiary possessions corporation made a qualifying 
distribution under section 936(h)(4).
    (c) Separate election for export sales.
    Q. 1: What methods of computing income can a possessions corporation 
use under the separate election for export sales?
    A. 1: The only two methods which are available under the separate 
election for export sales are the cost sharing method and the profit 
split method.
    Q. 2: What is the definition of export sales for purposes of the 
separate election for export sales?
    A. 2: The determination of export sales is based upon the 
destination of the product, i.e., where it is to be used or consumed. If 
the product is sold to a U.S. affiliate, it will be treated as an export 
sale only if resold or otherwise transferred abroad to a foreign person 
(including a foreign affiliate or foreign branch of a U.S. affiliate) 
within one year from the date of sale to the U.S. affiliate for ultimate 
use or consumption outside the United States as provided under Sec. 
1.954-3(a)(3)(ii).
    Q. 3: Assume that a possessions corporation sells a product to both 
foreign affiliates and foreign branches of U.S. affiliates. In addition, 
it sells the product to its U.S. parent for resale in the U.S. The 
possessions corporation makes a profit split election for domestic sales 
and a cost sharing election of export sales. Will the sales to foreign 
branches of U.S. affiliates be treated as exports subject to the cost 
sharing method or as domestic sales subject to the profit split method?
    A. 3: The sales to a foreign branch of a U.S. corporation are 
exports if for ultimate use or consumption outside of the United States 
as provided under Sec. 1.954-3(a)(3)(ii).
    Q. 4: Under what circumstances may a possessions corporation make 
the separate election under section 936(h)(5)(F)(iv)(II) for computing 
its income from products exported to a foreign person when the income 
derived by such foreign person on the resale of such products is 
included in foreign base company income under section 954(a)?
    A. 4: If the income derived by a foreign person on the resale of 
products manufactured, in whole or in part, by a possessions corporation 
is included in foreign base company income under section 954(a), then 
the possessions corporation may make the separate export election under 
section 936(h)(5)(F)(iv)(II) for computing its income from such products 
only if such foreign person has been formed or is availed of for 
substantial business reasons that are unrelated to an affiliated 
corporation's U.S. tax liability. For purposes of the proceding 
sentence, a foreign person will be considered to be formed or availed of 
for such substantial business reasons if the foreign person in the 
normal course of business purchases substantial quantities of products 
from both the possessions corporation and its affiliates for resale, 
and, in addition provides support services for affiliated companies such 
as centralized testing, marketing of products, management of local 
currency exposures, or other similar services. However, a foreign person 
that purchases and resells products only from a possessions corporation 
is presumed to be formed or availed of for other than such substantial 
business reasons, even if the foreign person provides additional 
services.
    Q. 5: When will the ``manufacturing'' test set forth in subsection 
(d)(1)(A) of section 954 be applicable to the export sales of a product 
of a possessions corporation which makes a separate election for export 
sales?
    A. 5: An electing corporation will be required to meet the 
``manufacturing'' test set forth in subsection (d)(1)(A) of section 954 
with respect to export sales of its product in each taxable year in 
which the separate election for export sales is in effect.
    (d) Revocation of election under section 936(a).
    Q. 1: When may an election under section 936(a) be revoked?

[[Page 126]]

    A. 1: An election under section 936(a) may be revoked during the 
first ten years of section 936 status only with the consent of the 
Commissioner, and without the Commissioner's consent after that time. 
The Commissioner hereby consents to all requests for revocation that are 
made with respect to the taxapayer's first taxable year beginning after 
December 31, 1982 provided that the section 936(a) election was in 
effect for the corporation's last taxable year beginning before January 
1, 1983, if the taxpayer agrees not to re-elect section 936(a) prior to 
its first taxable year beginning after December 31, 1988. A taxpayer 
that wishes to revoke a section 936(a) election under the terms of the 
blanket revocation must attach a ``Statement of Revocation--Section 
936'' to the taxpayer's timely filed return (including extensions) and 
must state that in revoking the election the taxpayer agrees not to re-
elect section 936(a) prior to its first taxable year beginning after 
December 31, 1988. Other requests to revoke not covered by the 
Commissioner's blanket consent should be addressed to the District 
Director having jurisdiction over the taxpayer's tax return.

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



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



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



Sec. 1.936-10  Qualified investments.

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


A loan by a qualified financial institution shall not be disqualified 
merely because the loan transaction is processed by the central bank of 
issue of the country into which the loan is made pursuant to, and solely 
for purposes of complying with, the exchange control laws or regulations 
of such country. Further, a loan by a qualified financial institution 
shall not be disqualified merely because the loan is acquired by another 
person, provided such other person is also a qualified financial 
institution.
    (2) Termination of qualification--(i) In general. An investment 
that, at any time after having met the requirements for a qualified 
investment in a qualified Caribbean Basin country under the terms of 
this paragraph (c), fails to meet any of the conditions enumerated in 
this paragraph (c) shall no longer be considered a qualified investment 
in a qualified Caribbean Basin country from the time of such failure, 
unless the investment satisfies the requirements for a timely cure 
described in paragraph (c)(2)(ii) of this section. Such a failure 
includes, but is not limited to, the occurrence of any of the following 
events:
    (A) Active business assets cease to qualify as such;
    (B) Proceeds from the investment are diverted for the financing of 
assets, projects, or operations that are not active business assets or 
development

[[Page 127]]

projects or are not the assets or the project of the qualified 
recipient;
    (C) The holder of the qualified recipient's obligation is not a 
qualified financial institution;
    (D) The qualified recipient's qualified business activity ceases to 
qualify as such; or
    (E) The qualified Caribbean Basin country ceases to be a country 
described in paragraph (c)(10)(ii) of this section.
    (ii) Timely cure--(A) In general. A timely cure shall be considered 
to have been made if the event or events that cause disqualification of 
the investment are corrected within a reasonable period of time. For 
purposes of this section, a reasonable period of time shall not exceed 
60 days after such event or events come to the attention of the 
qualified recipient or the qualified financial institution or should 
have some to their attention by the exercise of reasonable diligence.
    (B) Due diligence requirements. A time cure of a failure to comply 
with the due diligence requirements of paragraphs (c)(11), (12), and 
(13) of this section shall be considered to be made if the failure to 
comply is due to reasonable cause and, upon request of the Commissioner 
of Financial Institutions of Puerto Rico (or his delegate) or of the 
Assistant Commissioner (International) (or his authorized 
representative), the qualified financial institution (and its trustee or 
agent), if any), the financial intermediary, or the qualified recipient 
establishes to the satisfaction of the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) or of the Assistant 
Commissioner (International) (or his authorized representative) that it 
has exercised due diligence in ensuring that the funds were property 
disbursed to a qualified recipient and applied by or on behalf of such 
qualified recipient to uses that qualify the investment as an investment 
in qualified business assets or a development project under the 
provisions of this paragraph (c).
    (iii) Assumption of qualified recipient's obligation. An investment 
shall not cease to qualify merely because the qualified recipient's 
obligation to the qualified financial institution (or to a financial 
intermediary, if any) is assumed by another person, provided such other 
person assumes the qualified recipient's agreement and certification 
requirements under paragraph (c)(11)(i) of this section and is either--
    (A) A qualified recipient on the date of assumption, in which case 
such person shall be treated for purposes of this section as the 
original qualified recipient and shall be subject to all the 
requirements of this section for continued qualification of the loan as 
a qualified investment in a qualified Caribbean Basin country; or
    (B) An international organization, the principal purpose of which is 
to foster economic development in developing countries and which is 
described in section 1 of the International Organizations Immunities Act 
(22 U.S.C. 288), if the assumption of the obligation is pursuant to a 
bona fide guarantee agreement.
    (3) Qualified financial institution--(i) General rule. For purposes 
of section 936(d)(4)(A) and this section, a qualified financial 
institution includes only--
    (A) A banking, financing, or similar business defined in Sec. 
1.864-4(c)(5)(i) that is an eligible institution described in paragraph 
(c)(3)(ii) of this section, but not including branches of such 
institution outside of Puerto Rico;
    (B) A single-purpose entity described in paragraph (c)(3)(iii) of 
this section;
    (C) The Government Development Bank for Puerto Rico;
    (D) The Puerto Rico Economic Development Bank; and
    (E) Such other entity as may be determined by the Commissioner by 
Revenue Procedure or other guidance published in the Internal Revenue 
Bulletin.
    (ii) Eligible institution. An eligible institution means an 
institution--
    (A) That is an entity organized under the laws of the Commonwealth 
of Puerto Rico or is the Puerto Rican branch of an entity organized 
under the laws of another jurisdiction, if such entity is engaged in a 
banking, financing, or similar business defined in Sec. 1.864-
4(c)(5)(i), and
    (B) That is licensed as an eligible institution under Regulation No. 
3582 (or any successor regulation) issued by the Commissioner of 
Financial Institutions

[[Page 128]]

of Puerto Rico (hereinafter ``Puerto Rican Regulation No. 3582'').
    (iii) Single-purpose entity. A single-purpose entity is an entity 
that meets all of the following conditions:
    (A) The entity is organized under the laws of the Commonwealth of 
Puerto Rico and is a corporation, a partnership or a trust, which 
conducts substantially all of its activities in Puerto Rico.
    (B) The sole purpose of the entity is to use qualified funds from 
possessions corporations to make one or more qualified investments in a 
qualified Caribbean Basin country and the entity actually uses such 
funds only for such purpose.
    (C) In the case of an entity that is a trust, one of the trustees is 
a qualified financial institution described in paragraph (c)(3)(i) of 
this section.
    (D) The entity is licensed as an eligible institution under Puerto 
Rican Regulation No. 3582 (or any successor regulation).
    (E) Any temporary investment by the entity for its own account of 
funds received from a possessions corporation, and the income from the 
investment thereof, and any temporary investment by the entity for its 
own account of principal and interest paid by a borrower to the entity, 
and the income from the investment thereof, are limited to investments 
in eligible activities, as described in section 6.2.4 of Puerto Rican 
Regulation No. 3582, as in effect on September 22, 1989.
    (4) Investments in active business assets--(i) In general. For 
purposes of section 936(d)(4)(A)(i)(I) and this section and subject to 
the provisions of paragraph (c)(8) of this section, a loan qualifies as 
an investment in active business assets if--
    (A) The amounts disbursed to a qualified recipient under the loan or 
bond issue are promptly applied (as defined in paragraphs (c)(6) and (7) 
of this section) by (or on behalf of) the qualified recipient solely for 
capital expenditures for the construction, rehabilitation (including 
demolition associated therewith), improvement, or upgrading of qualified 
assets described in paragraphs (c)(4)(ii)(A), (B), (E), and (F) of this 
section, for the acquisition of qualified assets described in paragraphs 
(c)(4)(ii)(B), (C), (E), and (F) of this section, for the expenditures 
described in paragraphs (c)(4)(ii)(D), (E), and (F) of this section, 
and, if applicable, for the financing of incidental expenditures 
described in paragraph (c)(4)(iii) of this section;
    (B) The qualified recipient owns the assets for United States income 
tax purposes and uses them in a qualified business activity (as defined 
in paragraph (c)(4)(iv)); and
    (C) The requirements of paragraph (c)(6) of this section (regarding 
temporary investments and time periods within which the funds must be 
invested) and of paragraph (c)(7) of this section (regarding the 
refinancing of existing funding and the time periods within which 
funding for investments must be secured) are satisfied.
    (ii) Definition of qualified assets. For purposes of this paragraph 
(c), qualified assets mean--
    (A) Real property;
    (B) Tangible personal property (such as furniture, machinery, or 
equipment) that is not property described in section 1221(1) and that is 
either new property or property which at no time during the period 
specified in paragraph (c)(4)(v) of this section was used in a business 
activity in the qualified Caribbean Basin country in which the property 
is to be used;
    (C) Rights to intangible property that is a patent, invention, 
formula, process, design, pattern, know-how, or similar item, or rights 
under a franchise agreement, provided that such rights--
    (1) Were not at any time during the period specified in paragraph 
(c)(4)(v) of this section used in a business activity in the qualified 
Caribbean Basin country in which the rights are to be used,
    (2) Are not rights the use of which gives rise, or would give rise 
if used, to United States source income, and
    (3) Are not rights acquired by the qualified recipient from a person 
related (within the meaning of section 267(b), using ``10 percent'' 
instead of ``50 percent'' in the places where it appears) to the 
qualified recipient;
    (D) Exploration and development expenditures incurred by a qualified 
recipient for the purpose of ascertaining

[[Page 129]]

the existence, location, extent or quality of any deposit of ore, oil, 
gas, or other mineral in a qualified Caribbean Basin country, as well as 
for purposes of developing such deposit (within the meaning of section 
616 of the Code and the regulations thereunder);
    (E) Living plants and animals (other than crops, plants, and animals 
that are acquired primarily to hold as inventory by the qualified 
recipient for resale in the ordinary course of trade or business) 
acquired in connection with a farming business (as defined in Sec. 
1.263-1T(c)(4)(i)), expenditures of a preparatory nature to prepare the 
land or area for farming (such as planting trees, drilling wells, 
clearing brush, leveling land, laying pipes, building roads, 
constructing tanks and reservoirs), expenditures for soil and water 
conservation of a type described in section 175(c)(1), and expenditures 
of a development nature incurred in connection with, and during, the 
preproductive period of property produced in a farming business (as 
defined in Sec. 1.263-1T(c)(4)(ii));
    (F) Other assets or expenditures that are not described in 
paragraphs (c)(4)(ii)(A) through (E) of this section and that the 
Commissioner may, by Revenue Procedure or other guidance published in 
the Internal Revenue Bulletin or by ruling issued to a qualified 
financial institution or qualified recipient upon its request, determine 
to be qualified assets.
    (iii) Incidental expenditures. An amount in addition to the loan 
proceeds borrowed to make an investment in active business assets shall 
be considered an investment in active business assets if such amount is 
applied to finance expenditures that are incidental to making the 
investment in active business assets, provided such amount is disbursed 
at or about the same time the proceeds for making the investment in 
active business assets are disbursed. For purposes of this section, 
expenditures incidental to an investment in active business assets 
include only the following items:
    (A) A reasonable amount of costs (other than the cost of credit 
enhancement or bond insurance premiums) associated with arranging the 
financing of an investment in active business assets, not to exceed 3.5 
percent of the proceeds of the loan or bond issue.
    (B) A reasonable amount of installation costs and other reasonable 
costs associated with placing an active business asset in service in the 
qualified business activity.
    (C) An amount not in excess of 10 percent of the total amount of 
investment in qualified assets to finance the acquisition of inventory, 
and other working capital requirements, but if an investment is in 
connection with a manufacturing or farming business, the percentage 
limitation shall be 50 percent rather than 10 percent provided the 
excess over the 10 percent limitation is used to finance inventory 
property. For purposes of this paragraph (c), whether a business is a 
manufacturing business shall be determined under principles similar to 
those described in section 954(d)(1)(A) and the regulations thereunder; 
whether a business is a farming business shall be determined under Sec. 
1.263-1T(c)(4)(i).
    (D) An amount not in excess of 5 percent of the sum of the 
investment in active business assets and the costs described in 
paragraphs (c)(4)(iii)(A), (B), and (C) of this section for the 
refinancing of an existing debt of the qualified recipient if such 
refinancing is incidental to an investment in active business assets. 
For this purpose, the replacement of an existing loan arrangement shall 
not be considered the refinancing of an existing indebtedness to the 
extent that the funds under such loan arrangement have not yet been 
disbursed to the qualified recipient.
    (iv) Qualified business activity. A qualified business activity is a 
lawful industrial or commercial activity that is conducted as an active 
trade or business (under principles similar to those described in Sec. 
1.367(a)-2T(b) (2) and (3)) in a qualified Caribbean Basin country. A 
trade or business for purposes of this paragraph (c)(4)(iv) is any 
business activity meeting the principles of section 367 of the Code and 
described in Divisions A through I (excluding group 43 in Division E 
(relating to the United States Postal Service) and groups 84 (relating 
to museums, art galleries, and botanical and zoological gardens), 86 
(relating to membership organizations), and 88 (relating to private

[[Page 130]]

households in Division I) of the 1987 Standard Industrial Classification 
Manual issued by the Executive Office of the President, Office of 
Management and Budget, or in the comparable provisions of any successor 
Standard Industrial Classification Manual that is adopted by the 
Commissioner of Internal Revenue in a notice, regulation, or other 
document published in the Internal Revenue Cumulative Bulletin.
    (v) Period of use. The period referred to in paragraphs 
(c)(4)(ii)(B) and (C) of this section shall be a five year period 
preceding the date of acquisition with the loan proceeds, if the date of 
acquisition is on or before May 13, 1991. If the date of acquisition is 
after May 13, 1991, then the period specified in this paragraph 
(c)(4)(v) shall be three years preceding the date of acquisition with 
the loan proceeds.
    (5) Investments in development projects--(i) In general. Subject to 
the provisions of paragraph (c)(8) of this section, this paragraph 
(c)(5)(i) describes the requirements in order for a loan by a qualified 
financial institution to qualify as an investment in a development 
project for purposes of section 936(d)(4)(A)(i)(II) and for this 
section.
    (A) The amounts disbursed under the loan or bond issue must be 
promptly applied (as defined in paragraphs (c)(6) and (7) of this 
section) by (or on behalf of) the qualified recipient solely for one or 
more investments described in paragraph (c)(4)(i)(A) of this section and 
in any land, buildings, or other property functionally related and 
subordinate to a facility described in paragraph (c)(5)(ii) of this 
section (determined under principles similar to those described in Sec. 
1.103-8(a)(3)), for use (under principles similar to those described in 
Sec. 1.367(a)-2T(b)(5)) in connection with one or more activities 
described in paragraph (c)(5)(i)(B) of this section.
    (B) The activities referred to in paragraph (c)(5)(i)(A) of this 
section are--
    (1) A development project described in paragraph (c)(5)(ii) of this 
section in a qualified Caribbean Basin country; or
    (2) The performance in a qualified Caribbean Basin country of a non-
commercial governmental function described in paragraph (c)(5)(iv) of 
this section;
    (C) The qualified recipient must own the assets for United States 
income tax purposes;
    (D) The requirements of paragraph (c)(6) of this section (regarding 
temporary investments and time periods within which the funds must be 
invested) and of paragraph (c)(7) of this section (regarding the 
refinancing of existing funding and time periods within which funding 
for investments must be secured) must be satisfied.
    (ii) Development project. For purposes of this paragraph (c), a 
development project is one or more facilities in a qualified Caribbean 
Basin country that support economic development in that country and that 
satisfy the public use requirement of paragraph (c)(5)(iii) of this 
section. Examples of facilities that may meet the public use requirement 
include, but are not limited to--
    (A) Transportation systems and equipment, including sea, surface, 
and air, such as roads, railways, air terminals, runways, harbor 
facilities, and ships and aircraft;
    (B) Communications facilities;
    (C) Training and education facilities related to qualified business 
activities;
    (D) Industrial parks, including necessary support facilities such as 
roads; transmission lines for water, gas, electricity, and sewage; 
docks; plant sites preparations; power generation; sewage disposal; and 
water treatment;
    (E) Sports facilities;
    (F) Convention or trade show facilities;
    (G) Sewage, solid waste, water, and electric facilities;
    (H) Housing projects pursuant to a government program designed to 
provide affordable housing to low or moderate income families, based 
upon local standards; and
    (I) Hydroelectric generating facilities.
    (iii) Public use requirement. To satisfy the public use requirement 
in paragraph (c)(5)(ii) of this section, a facility must serve or be 
available on a regular basis for general public use, as contrasted with 
similar types of facilities which are constructed for the exclusive use 
of a limited number of persons as

[[Page 131]]

determined under principles similar to those described in Sec. 1.103-
8(a)(2).
    (iv) Non-commercial governmental functions. For purposes of 
paragraph (c)(5)(i)(B) of this section, the term ``non-commercial 
governmental functions'' refers to activities that, under U.S. 
standards, are not customarily attributable to or carried on by private 
enterprises for profit and are performed for the general public with 
respect to the common welfare or which relate to the administration of 
some phase of government. For example, the operation of libraries, toll 
bridges, or local transportation services, and activities substantially 
equivalent to those carried out by the Federal Aviation Authority, 
Interstate Commerce Commission, or United States Postal Service, are 
considered non-commercial governmental functions. For purposes of this 
section, non-commercial government functions shall not include military 
activities.
    (v) [Reserved]
    (6) Prompt application of borrowed proceeds. This paragraph (c)(6) 
provides rules for determining whether amounts disbursed to a qualified 
recipient by a qualified financial institution (or a financial 
intermediary) shall be considered to have been promptly applied for the 
purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section.
    (i) In general. Except as otherwise provided in paragraphs 
(c)(6)(ii) and (c)(7)(iii)(B) of this section, amounts disbursed to a 
qualified recipient by a qualified financial institution (or a financial 
intermediary) shall be considered to have been promptly applied for the 
purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section if 
the amounts are fully expended for any of the purposes described in 
paragraphs (c)(4)(i)(A) or (c)(5)(i)(A) of this section no later than 
six months from the date of such disbursement and any temporary 
investment of such funds by the qualified recipient during such period 
complies with the rules of paragraph (c)(6)(iii)(A) of this section. 
Where the amounts disbursed are bond proceeds described in paragraph 
(c)(6)(iv)(A) of this section, the six-month period shall begin on the 
date of issuance of the bonds. In the event the qualified financial 
institution (or financial intermediary) invests any part of the bond 
proceeds before disbursement of those proceeds to the qualified 
recipient, all earnings from any such investment shall be paid to the 
qualified recipient or applied for its benefit.
    (ii) Special rules for long term projects financed out of bond 
proceeds. In the case of a long term project described in paragraph 
(c)(6)(iv)(B) of this section that is financed out of bond proceeds, the 
six-month period described in paragraph (c)(6)(i) of this section shall 
be extended with respect to the amount of bond proceeds used to fund the 
project for such reasonable period of time as shall be necessary until 
completion of the project or until beginning of production (in the case 
of a farming business), but, in any event, not to exceed three years 
from the date of issuance of the bonds, and only if--
    (A) The project that is financed out of bond proceeds was identified 
as of the date of issue;
    (B) A construction and expenditure plan certified by an independent 
expert (such as an engineer, an architect, or a farming expert) is filed 
with, and approved by, the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) prior to the date of issue, which makes a 
reasonable estimate, as of the date of filing of the plan, of the 
amounts and uses of the bond proceeds and the time of completion or 
production, and includes a schedule of progress payments until such 
time;
    (C) The terms of the construction and expenditure plan are disclosed 
in the public offering memorandum, private placement memorandum, or 
similar document prepared for information or disclosure purposes in 
relation to the issuance of bonds; and
    (D) Any temporary investment of the bond proceeds complies with the 
rules of paragraph (c)(6)(iii)(A) and (B) of this section.
    (iii) Temporary investments--(A) During six-month period. During the 
six-month period described in paragraph (c)(6)(i) of this section, 
during the first six months of the period described in paragraph 
(c)(6)(ii) of this section, and during the 30-day period described in 
paragraph (c)(7)(iii)(A) of this section, loan proceeds disbursed to a 
qualified recipient, bond proceeds, and income

[[Page 132]]

from the investment thereof, may be held in unrestricted yield 
investments, provided such yield reflects normal market yield for such 
type of investments and provided the income from such investments, if 
any, is or would be sourced either in Puerto Rico or in a country in 
which the investment in active business assets or development project is 
to be made.
    (B) During other periods. During any other period, any temporary 
investment of bond proceeds, and of income from such investments, shall 
be limited to investments in eligible activities. For purposes of this 
paragraph (c)(6)(iii)(B), the term ``eligible activities'' shall mean 
those investments described in section 6.2.4 of Puerto Rican Regulation 
No. 3582, as in effect on September 22, 1989.
    (iv) Definitions--(A) Bond proceeds. For purposes of this paragraph 
(c), bond proceeds shall mean the proceeds from the issuance of 
obligations by way of a public offering or a private placement by a 
qualified financial institution for investment in active business assets 
or a development project that has been identified at the time of issue 
and is described in a public offering memorandum, private placement 
memorandum, or similar document prepared for information or disclosure 
purposes in relation to the issuance of the bonds.
    (B) Long term project. For purposes of this section, the term long 
term project means--
    (1) A project, whether or not under a contract, for the 
construction, rehabilitation, improvement, upgrading, or production of 
qualified assets, or for expenditures, described in paragraph (c)(4)(ii) 
of this section (other than paragraph (c)(4)(ii)(C) of this section), 
which is reasonably expected to require more than 12 months to complete; 
or
    (2) The production of property in a farming business referred to in 
paragraph (c)(4)(ii)(E) of this section, which is reasonably expected to 
require a preproductive period in excess of 12 months.
    (7) Financing of previously incurred costs. Loan or bond proceeds 
which are disbursed after a qualified recipient has paid or incurred 
part or all of the costs of acquiring active business assets or 
investing in a development project shall be considered to have been 
applied for such purposes only as provided in this paragraph (c)(7).
    (i) Replacement of temporary non-section 936 financing of a 
qualified investment. This paragraph (c)(7)(i) prescribes the maximum 
time limits within which temporary non-section 936 financing of 
qualified investments may be replaced with section 936 funds without 
being considered a prohibited refinancing transaction. This paragraph 
(c)(7)(i) applies to the refinancing of costs incurred with respect to 
investments that, at the time the costs were first incurred, were either 
qualified investments in a qualified Caribbean Basin country or were 
investments by a qualified recipient in active business assets or a 
development project in a qualified Caribbean Basin country. This 
paragraph (c)(7)(i) applies also to the refinancing of costs incurred 
with respect to any other investment. However, in the latter case, the 
amount of costs that may be refinanced with section 936 funds is limited 
to the amount of costs that are incurred with respect to the investment 
after the investment becomes a qualified investment in a qualified 
Caribbean Basin country. For purposes of this paragraph (c)(7)(i), the 
time when costs are incurred shall be determined under principles 
similar to those applicable under section 461(h) dealing with the 
economic performance test for the accrual of deductible liabilities. 
This paragraph (c)(7)(i) applies only to the situations described in 
this paragraph (c)(7)(i).
    (A) In the case of an investment in active business assets or a 
development project, a loan shall be a qualified investment for purposes 
of this paragraph (c) if the loan proceeds are disbursed, or the 
obligations are issued, no later than six months after the date on which 
the qualified recipient takes possession of the asset or the facility 
or, if earlier, places the asset or the facility in service. However, in 
the case of a small project described in paragraph (c)(8)(v) of this 
section, the six-month period shall be one year.
    (B) In the case of an investment in active business assets or a 
development project that is part of a long term project described in 
paragraph

[[Page 133]]

(c)(6)(iv)(B) of this section, a loan shall also be a qualified 
investment for purposes of this paragraph (c) if the loan proceeds are 
disbursed, or the obligations are issued, no later than six months after 
completion of the project or, in the case of a farming business, after 
the beginning of production, and in any event, no later than three years 
after the date on which the first payment is made toward the eligible 
costs of the project. The amount of the qualified investment may not 
exceed the sum of--
    (1) The eligible costs relating to investments described in 
paragraph (c)(4)(i)(A) in the case of an investment in active business 
assets, or the eligible costs relating to investments described in 
paragraph (c)(5)(i) of this section in the case of a development 
project, but only to the extent of the costs that are incurred after the 
date described in paragraph (c)(7)(i)(D) of this section, and
    (2) The portion of unpaid interest that would be required to be 
capitalized under U.S. tax rules and that accrued on prior temporary 
non-section 936 financing from the date described in paragraph 
(c)(7)(i)(D) of this section through the date the section 936 loan 
proceeds are disbursed or the section 936 obligations are issued.
    (C) In order to qualify for the special rules of this paragraph 
(c)(7)(i), a plan must be filed with the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) stating the qualified 
recipient's intention to refinance the costs of the long term project 
with section funds.
    (D) The date referred to in paragraph (c)(7)(i)(B) (1) and (2) of 
this section is a date that is the later of--
    (1) The date the plan described in paragraph (c)(7)(i)(C) is filed, 
or
    (2) The date the investment becomes a qualified investment by a 
qualified recipient in active business assets or a development project 
in a qualified Caribbean Basin country.
    (ii) Refinancing of section 936 financing. A section 936 loan or 
bond issue used to finance a qualified investment described in paragraph 
(c)(1) of this section may be refinanced with section 936 funds through 
a new loan or bond issue to the extent of the remaining principal 
balance on such existing qualified financing, increased by the amount of 
unpaid interest accrued through the date the new loan proceeds are 
disbursed or the new obligations are issued and that would be required 
to be capitalized under U.S. tax rules.
    (iii) Prompt application of borrowed proceeds--(A) In general. In 
the case of a loan or bond issue described in paragraph (c)(7)(i) or 
(ii) of this section, the rules of paragraph (c)(6) of this section 
shall apply but the six-month period described in paragraph (c)(6)(i) of 
this section shall be limited to 30 days from the date of disbursement 
of loan proceeds to the qualified recipient or from the date of issuance 
in the case of a bond issue.
    (B) Special rules for long term projects financed out of bond 
proceeds. In the case of a long term project described in paragraph 
(c)(6)(iv)(B) of this section that is financed out of bond proceeds, the 
30-day period described in paragraph (c)(7)(iii)(A) of this section 
shall be extended with respect to the amount of bond proceeds used for 
the permanent financing of the long term project for such reasonable 
period of time as shall be necessary until completion of the project or 
beginning of production (in the case of a farming business), but, in any 
event, not to exceed three years from the date of issuance of the bonds. 
For purposes of this paragraph (c)(7)(iii)(B), the period of time shall 
be considered reasonable only if--
    (1) A construction and expenditure plan certified by an independent 
expert (such as an engineer, an architect, or a farming expert) is filed 
with, and approved by, the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) prior to the date of issue, which makes a 
reasonable estimate, as of the date of issue, of the amounts and uses of 
the bond proceeds and the time of completion or production, and includes 
a schedule of progress payments until such time; and
    (2) The terms of the construction and expenditure plan are disclosed 
in the public offering memorandum, private placement memorandum, or 
similar document prepared for information or disclosure purposes in 
relation to the bond issue.

[[Page 134]]

    (8) Miscellaneous operating rules--(i) Sale and leaseback. An asset 
that is acquired and leased back to the person from whom acquired does 
not constitute an investment in an active business asset or an 
investment in a development project.
    (ii) Use of asset in qualified business activity. For purposes of 
paragraph (c)(4)(i)(B), an asset shall be considered used or held for 
use in a qualified business activity if it is used or held for use in 
such activity under principles similar to those described in Sec. 
1.367(a)-2T(b)(5), or a successor provision.
    (iii) Definition of capital expenditures. For purposes of this 
paragraph (c), capital expenditures mean those expenditures described in 
section 263(a) of the Code (without regard to paragraphs (A) through (G) 
of section 263(a)(1)), and those costs required to be capitalized under 
section 263A with respect to property described in section 263A(b)(1), 
relating to self-constructed assets.
    (iv) Loans through certain financial intermediaries. A loan by a 
qualified financial institution shall not be disqualified from being an 
investment in active business assets or in a development project merely 
because the proceeds are first lent to a financial intermediary (as 
defined in paragraph (c)(8)(iv)(H) of this section) which, in turn, on-
lends the proceeds directly to a qualified recipient, provided the 
requirements of this paragraph (c)(8)(iv) are satisfied.
    (A) The loan to the qualified recipient must satisfy the 
requirements of paragraph (c)(4)(i) of this section in the case of an 
investment in active business assets, or of paragraph (c)(5)(i) of this 
section in the case of an investment in a development project.
    (B) The qualified recipient and the active business assets or 
development project in which the proceeds are to be invested must be 
identified prior to disbursement of any part of the proceeds by the 
qualified financial institution to the financial intermediary.
    (C) The effective interest rate charged by the qualified financial 
institution to the financial intermediary must not exceed the average 
interest rate paid by the qualified financial institution with respect 
to its eligible funds, increased by such number of basis points as is 
required to provide reasonable compensation to the qualified financial 
institution for services performed and risks assumed with respect to the 
loan to the financial intermediary that are not ordinarily required to 
be performed or assumed with respect to a deposit, loan, repurchase 
agreement or other transfer of eligible funds with another qualified 
financial institution. The average interest rate shall be the average 
rate, determined on a daily basis, paid by the qualified financial 
institution on its eligible funds over the most recent quarter preceding 
the date on which the rate on the loan to the financial intermediary is 
committed.
    (D) The effective interest rate charged by the financial 
intermediary to the qualified recipient must not exceed the effective 
interest rate charged to the financial intermediary by the qualified 
financial institution, increased by such number of basis points as is 
required to provide reasonable compensation to the financial 
intermediary for services performed and risks assumed with respect to 
the loan to the qualified recipient.
    (E) The financial intermediary must borrow from the qualified 
financial institution under substantially the same terms as it lends to 
the qualified recipient. In particular, both loans must have 
disbursement terms, repayment schedules and maturity dates for interest 
and principal amounts such that the financial intermediary does not 
retain for more than 48 hours any of the funds disbursed by the 
qualified financial institution nor any of the funds paid by the 
qualified recipient in repayment of principal or interest on the loan.
    (F) The financial institution and the financial intermediary must 
agree to comply with the due diligence requirements described in 
paragraphs (c)(11), (12), and (13) of this section;
    (G) The time periods and temporary investments rules in paragraphs 
(c)(6) and (7) of this section must be complied with; and
    (H) For purposes of this paragraph (c), the financial intermediary 
must be--

[[Page 135]]

    (1) An active trade or business which a person maintains in a 
qualified Caribbean Basin country and which consists of a banking, 
financing or similar business as defined in Sec. 1.864-4(c)(5)(i) 
(other than a central bank of issue); or
    (2) A public international organization, the principal purpose of 
which is to foster economic development in developing countries and 
which is described in section 1 of the International Organizations 
Immunities Act (22 U.S.C. 288).


For purposes of paragraphs (c)(8)(iv)(C) and (D) of this section, the 
determination of whether compensation is reasonable shall be made in 
relation to normal commercial practices for comparable transactions 
carrying a similar degree of commercial, currency and political risk. 
Reasonable credit enhancement fees and other reasonable fees and amounts 
charged to the financial intermediary or the qualified recipient with 
respect to the loan transaction in addition to interest shall be added 
to the interest cost in determining the effective interest rate.
    (v) Small project. For purposes of this paragraph (c), a small 
project shall be a project (including the acquisition of an asset) for 
which the total amount of section 936 funds used for its financing does 
not exceed $1,000,000 in the aggregate, or such other amount as the 
Commissioner may publish, from time to time, in the Internal Revenue 
Bulletin.
    (9) Qualified recipient. For purposes of this section, a qualified 
recipient is any person described in paragraph (c)(9)(i) or (ii) of this 
section. The term ``person'' means a person described in section 
7701(a)(1) or a government (within the meaning of Sec. 1.892-2T(a)(1)) 
of a qualified Caribbean Basin country.
    (i) In the case of an investment described in paragraph (c)(4) of 
this section (relating to investments in active business assets), a 
qualified recipient is a person that carries on a qualified business 
activity in a qualified Caribbean Basin country, and complies with the 
agreement and certification requirements described in paragraph 
(c)(11)(i) of this section at all times during the period in which the 
investment remains outstanding.
    (ii) In the case of an investment described in pargraph (c)(5) of 
this section (relating to investments in development projects), a 
qualified recipient is the borrower (including a person empowered by the 
borrower to authorize expenditures for the investment in the development 
project) that has authority to comply, and complies, with the agreement 
and certification requirements described in paragraph (c)(11)(i) of this 
section at all times during the period in which the investment remains 
outstanding.
    (10) Investments in a qualified Caribbean Basin country--(i) Rules 
for determining the place of an investment. The rules of this paragraph 
(c)(10)(i) shall apply to determine the extent to which an investment in 
an active business asset or a development project will be considered 
made in qualified Caribbean Basin Country.
    (A) An investment in real property is considered made in the 
qualified Caribbean Basin country in which the real property is located.
    (B) Except as otherwise provided in this paragraph (c)(10)(i)(B), an 
investment in tangible personal property is considered made in a 
qualified Caribbean Basin Country so long as the tangible personal 
property is predominantly used in that country. Whether property is used 
predominantly in a qualified Caribbean Basin country shall be determined 
under principles similar to those described in Sec. 1.48-1(g)(1), 
(g)(2)(ii), (g)(2)(iv), (g)(2)(vi), (g)(2)(viii), and (g)(2)(x) 
(relating to investment tax credits for property used outside the United 
States) as in effect on December 31, 1985. A vessel, container, or 
aircraft shall be considered for use predominantly in a qualified 
Caribbean Basin country in any year if it is used for transport to and 
from such country with some degree of frequency during that year and at 
least 30 percent of the income from the use of such vessel, container or 
aircraft for that year is sourced in such country under principles 
similar to those described in section 863(c)(1) and (2) (relating to 
source rules for certain transportation income). Cables and pipelines 
which are premanently installed as part of a communication or 
transportation system between a qualified Caribbean Basin country and 
another country or among several countries which include a

[[Page 136]]

qualified Caribbean Basin country shall be considered used in a 
qualified Caribbean Basin country to the extent of 50 percent of the 
portion of the facility that directly links the qualified country to 
another country or to a hub, unless it is established by notice or other 
guidance published in the Internal Revenue Bulletin or by ruling issued 
to a qualified institution or qualified recipient upon request that it 
is appropriate to attribute a greater portion of the cost of the 
facility to the qualified Caribbean Basin country.
    (C) An investment in rights to intangible property is considered 
made in a qualified Caribbean Basin country to the extent such rights 
are used in that country. Where rights to intangible property are used 
shall be determined under principles similar to those described in Sec. 
1.954-2T(b)(3)(vii) or a successor provision.
    (ii) Qualified Caribbean Basin country. For purposes of this 
section, the term ``qualified Caribbean Basin country'' means any 
beneficiary country (within the meaning of section 212(a)(1)(A) of the 
Caribbean Basin Economic Recovery Act, Public Law 98-67 (Aug. 5, 1983), 
97 Stat. 384, 19 U.S.C. 2702(a)(1)(A)), which meets the requirements of 
section 274(h)(6)(A)(i) and (ii) and the U.S. Virgin Islands, and 
includes the territorial waters and continental shelf thereof.
    (11) Agreements and certifications by qualified recipients and 
financial intermediaries--(i) In general. In order for an investment to 
be considered a qualified investment under section 936(d)(4) and 
paragraph (c)(1) of this section, a qualified recipient must certify to 
the qualified financial institution (or to the financial intermediary, 
if the loan is made through a financial intermediary) on the date of 
closing of the loan agreement and on each anniversary date thereof, that 
it is a qualified recipient described in paragraph (c)(9) of this 
section. In addition, the qualified recipient must agree in the loan 
agreement with the qualified financial institution (or with the 
financial intermediary, if the loan is made through a financial 
intermediary)--
    (A) To use the funds at all times during the period the loan is 
outstanding solely for the purposes and in the manner described in 
paragraph (c)(4) of this section (regarding investment in active 
business assets) or in paragraph (c)(5) of this section (regarding 
investment in development projects);
    (B) To comply with the requirements of paragraph (c)(6) of this 
section (regarding temporary investments and time periods within which 
the funds must be invested) and paragraph (c)(7) of this section 
(regarding the refinancing of existing funding and the time periods 
within which funding for investments must be secured);
    (C) To notify the Assistant Commissioner (International), the 
qualified financial institution (or the financial intermediary, if the 
loan is made through a financial intermediary), and the Commissioner of 
Financial Institutions of Puerto Rico (or his delegate) pursuant to 
paragraph (c)(14) of this section if it no longer is a qualified 
recipient or if, for any other reason, the investment has ceased to 
qualify as a qualified investment described in paragraph (c)(1) of this 
section, promptly upon the occurrence of such disqualifying event; and
    (D) To permit examination by the office of the Assistant 
Commissioner (International) (or by the office of any District Director 
authorized by the Assistant Commissioner (International)) and the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
of all necessary books and records that are sufficient to verify that 
the funds were used for investments in active business assets or 
development projects in conformity with the terms of the loan agreement.
    (ii) Certification by a financial intermediary. In the case of a 
loan by a qualified financial institution to a financial intermediary, 
the financial intermediary must certify to the qualified financial 
institution (using the procedures described in paragraph (c)(11)(i) of 
this section) that it is a financial intermediary described in paragraph 
(c)(8)(iv)(H) of this section, and must furnish to the qualified 
financial institution a copy of the qualified recipient's certification 
described in paragraph (c)(11)(i) of this section and of its loan 
agreement with the qualified recipient. In addition, the financial 
intermediary must agree in the

[[Page 137]]

loan agreement with the qualified financial institution:
    (A) To comply with the requirements of paragraph (c)(8)(iv) of this 
section; and
    (B) To permit examination by the office of the Assistant 
Commissioner (International) (or by the office of any District Director 
authorized by the Assistant Commissioner (International)) and the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
of all its necessary books and records that are sufficient to verify 
that the funds were used in conformity with the terms of the loan 
agreements.
    (12) Certification requirements. In order for an investment to be 
considered a qualified investment under section 936(d)(4), section 
936(d)(4)(C)(i) requires that both the person in whose trade or business 
such investment is made and the financial institution certify to the 
Secretary of the Treasury and the Commissioner of Financial Institutions 
of Puerto Rico that the proceeds of the loan will be promptly used to 
acquire active business assets or to make other authorized expenditures. 
This certification requirement is satisfied as to the qualified 
financial institution, the financial intermediary (if any), and the 
qualified recipient if the qualified financial institution submits a 
certificate to both the Assistant Commissioner (International) and to 
the Commissioner of Financial Institutions of Puerto Rico (or his 
delegate) pursuant to paragraph (c)(14) of this section upon 
authorization of the investment by the Commissioner of Financial 
Institutions and, in any event, prior to the first disbursement of the 
loan proceeds to the qualified recipient or to the financial 
intermediary (if any), in which the qualified financial institution--
    (i) Represents that, as of the date of the certification, the 
qualified recipient and the financial intermediary (if any) have 
complied with the requirements described in paragraph (c)(11) of this 
section;
    (ii) Describes the important terms of the loan to the financial 
intermediary (if any) and to the qualified recipient, including the 
amount of the loan, the nature of the investment, the basis for its 
qualification as an investment in active business assets or a 
development project under this section, the identity of the financial 
intermediary (if any) and of the qualified recipient, the qualified 
Caribbean Basin country involved, and the nature of the collateral or 
other security used, including any guarantee;
    (iii) Agrees to permit examination by the Assistant Commissioner 
(International) (or by the office of any District Director authorized by 
the Assistant Commissioner (International)) and the Commissioner of 
Financial Institutions of Puerto Rico (or his delegate) of all its 
necessary books and records that are sufficient to verify that the funds 
were used for investments in active business assets or development 
projects in conformity with the terms of the loan agreement or 
agreements with the financial intermediary (if any) and with the 
qualified recipient; and
    (iv) In the case of a single-purpose entity that is a qualified 
financial institution, discloses the name and address of the entity's 
trustee or agent, if any, that assists the qualified financial 
institution in the performance of its due diligence requirement under 
paragraph (c) of this section, and represents that the trustee or agent 
has agreed with the qualified financial institution to permit 
examination by the Assistant Commissioner (International) (or by the 
office of any District Director authorized by the Assistant Commissioner 
(International)) and the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) of all necessary books and records of such 
trustee or agent that are sufficient to verify that the funds were used 
for investments in active business assets or development projects in 
conformity with the terms of the loan agreement or agreements with the 
financial intermediary (if any) and with the qualified recipient.
    (13) Continuing due diligence requirements. In order to maintain the 
qualification for an investment under paragraph (c)(1) of this section, 
the continuing due diligence requirements described in this paragraph 
(c)(13) must be satisfied.
    (i) Requirements of qualified recipient. A qualified recipient 
must--

[[Page 138]]

    (A) Submit annually to the qualified financial institution or to the 
financial intermediary from which its qualified funds were obtained a 
copy of its most recent annual financial statement accompanied by an 
opinion of an independent accountant familiar with the financials of the 
qualified recipient disclosing the amount of the loan, the current 
outstanding balance of the loan, describing the assets financed with 
such loan and the qualified business activity in which such assets are 
used or the development project for which the loan is used, and stating 
that there are no reasons to doubt that the loan proceeds have been 
properly used and continue to be properly used, and
    (B) Act in a manner consistent with its representations and 
agreements described in paragraph (c)(11) of this section.
    (ii) Requirements of qualified financial institutions. Except as 
otherwise provided in paragraph (c)(13)(iii) of this section, a 
qualified financial institution described in paragraph (c)(3) of this 
section must maintain in its records and have available for inspection 
the documentation described in paragraph (c)(13)(ii)(A) or (B) of this 
section. In addition, the qualified financial institution is required to 
notify the Assistant Commissioner (International) and the Commissioner 
of Financial Institutions of Puerto Rico (or his delegate) pursuant to 
paragraph (c)(14) of this section upon becoming aware that a loan has 
ceased to be an investment in active business assets or a development 
project under this section. For purposes of this paragraph (c)(13)(ii), 
multiple loans for investment in a single qualified business activity or 
development project will be aggregated in determining what due diligence 
requirements apply.
    (A) In the case of a small project described in paragraph (c)(8)(v) 
of this section, the following documents must be maintained and 
available for inspection:
    (1) The loan application or other similar document;
    (2) The financial statements of the qualified recipient filed as 
part of the loan application;
    (3) The statement required by section 6.4.3(a)(iii) of Puerto Rican 
Regulation No. 3582 or any successor thereof, signed by the qualified 
recipient (or its duly authorized representative), acknowledging the 
receipt of the loan proceeds, describing the assets financed with such 
loan and the business activity in which such assets are to be used or 
the development project for which the funds will be utilized, the 
collateral to be provided for the transaction including any guarantee, 
and the basis for its qualification as a qualified recipient;
    (4) The loan documents; and
    (5) In the case of a qualified financial institution that is a 
single-purpose entity, a copy of the agreement with the entity's trustee 
or agent, if any, described in paragraph (c)(12)(iv) of this section.
    (B) In the case of a disbursement concerning a project that is not a 
small project described in paragraph (c)(8)(v) of this section, the 
following documents must be maintained and available for inspection, in 
addition to the documents required by paragraph (c)(13)(ii)(A) of this 
section:
    (1) A memorandum of credit prepared by an officer of the qualified 
financial institution (or, in the case of a single purpose entity, an 
agent of the entity or a trustee for the entity, if any) and signed by 
the officer of the qualified financial institution, containing the 
details of the investigation and review that the qualified financial 
institution, or its trustee or agent, if any, conducted in order to 
evaluate whether the investment is qualified under paragraph (c)(1) of 
this section and the opinion of the officer of the qualified financial 
institution, or the opinion of an officer of the agent of, or of the 
trustee for, the qualified financial institution, if any, that there is 
no reasonable ground for belief that the qualified funds will be 
diverted to a use that is not permitted under the provisions of this 
section; in making this investigation and review, factors that must be 
utilized are ones similar to those listed in Puerto Rico Regulation No. 
3582, section 6.4.2;
    (2) The annual financial statement of the qualified recipient; and
    (3) The written report of an officer of the qualified financial 
institution, or of an officer of an agent of, or of the

[[Page 139]]

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

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



Sec. 1.936-11  New lines of business prohibited.

    (a) In general. A possessions corporation that is an existing credit 
claimant, as defined in section 936(j)(9)(A)

[[Page 140]]

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

[[Page 141]]

an existing credit claimant, the acquiring corporation may make a 
section 936(e) election for the taxable year in which the assets are 
acquired with the following effects--
    (1) The acquiring corporation will be treated as an existing
    (2) The activity will be considered a pre-existing business of the 
acquiring corporation;
    (3) The acquiring corporation will be deemed to satisfy the rules of 
section 936(a)(2) for the year of acquisition; and
    (4) After making an election under section 936(e), a non-affiliated 
acquiring corporation will not be bound by elections under sections 
936(a)(4) and (h) made by the predecessor existing credit claimant.
    (C) For purposes of this section the assets of a trade or business 
are determined at the time of acquisition provided that the transferee 
actively conducts the trade or business acquired.
    (D) A mere change in the stock ownership of a possessions 
corporation will not affect its status as an existing credit claimant 
for purposes of this section.
    (4) Leasing of Assets. (i) The leasing of assets (and employees to 
operate leased assets) will not, for purposes of this section, be 
considered a new line of business of the existing credit claimant if--
    (A) The existing credit claimant used the leased assets in an active 
trade or business for at least five years;
    (B) The existing credit claimant does not through its own officers 
or staff of employees perform management or operational functions (but 
not including operational functions performed through leased employees) 
with respect to the leased assets; and
    (C) The existing credit claimant does not perform marketing 
functions with respect to the leasing of the assets.
    (ii) Any income from the leasing of assets not considered a new line 
of business pursuant to paragraph (b)(4)(i) of this section will not be 
income from the active conduct of a trade or business (and, therefore, 
the existing credit claimant may not receive a possession tax credit 
with respect to such income).
    (5) Timing rule. The tests for a new line of business in this 
paragraph (whether the new activity is closely related to a pre-existing 
business) are applied only at the end of the taxable year during which 
the new activity is added.
    (c) Substantial--(1) In general. A new line of business is 
considered to be substantial as of the earlier of--
    (i) The taxable year in which the possessions corporation derives 
more than 15 percent of its gross income from that new line of business 
(gross income test); or
    (ii) The taxable year in which the possessions corporation directly 
uses in that new line of business more than 15 percent of its assets 
(assets test).
    (2) Gross income test. The denominator in the gross income test is 
the amount that is the gross income of the possessions corporation for 
the current taxable year, while the numerator is the amount that is the 
gross income of the new line of business for the current taxable year. 
The gross income test is applied at the end of each taxable year. For 
purposes of this test, if a new line of business is added late in the 
taxable year, the income is not to be annualized in that year. In the 
case of a new line of business acquired through the purchase of assets, 
the gross income of such new line of business for the taxable year of 
the acquiring corporation that includes the date of acquisition is 
determined from the date of acquisition through the end of the taxable 
year. In the case of a consolidated group election made pursuant to 
section 936(i)(5), the test applies on a company by company basis and 
not on a consolidated basis.
    (3) Assets test--(i) Computation. The denominator is the adjusted 
tax basis of the total assets of the possessions corporation for the 
current taxable year. The numerator is the adjusted tax basis of the 
total assets utilized in the new line of business for the current 
taxable year. The assets test is computed annually using all assets 
including cash and receivables.
    (ii) Exception. A new line of business of a possessions corporation 
will not be treated as substantial as a result of meeting the assets 
test if an event that is not reasonably anticipated causes assets used 
in the new line of business

[[Page 142]]

of the possessions corporation to exceed 15 percent of the adjusted tax 
basis of the possessions corporation's total assets. For example, an 
event that is not reasonably anticipated would include the destruction 
of plant and equipment of the pre-existing business due to a hurricane 
or other natural disaster, or other similar circumstances beyond the 
control of the possessions corporation. The expiration of a patent is 
not such an event and will not permit use of this exception.
    (d) Examples. The following examples illustrate the rules described 
in paragraphs (a), (b), and (c) of this section. In the following 
examples, X Corp. is an existing credit claimant unless otherwise 
indicated:

    Example 1. X Corp. is a pharmaceutical corporation which 
manufactured bulk chemicals (a component product). In March 1997, X 
Corp. began to also manufacture pills (e.g., finished dosages or an 
integrated product). The new activity provides products very similar to 
the products provided by the pre-existing business. The new activity is 
of a type that is normally conducted in the same business location as 
the pre-existing business. The activity's economic success depends on 
the success of the pre-existing business. The manufacture of bulk 
chemicals is in NAICS code 325411, Medicinal and Botanical 
Manufacturing, while the manufacture of the pills is in NAICS code 
325412, Pharmaceutical Preparation Manufacturing. Although the products 
have a different end-use, may be marketed to a different class of 
customers, and may not use similar operating assets, they are within the 
same five-digit NAICS code and the activity also satisfies paragraphs 
(b)(2)(i)(A), (C), and (E) of this section. The manufacture of the pills 
by X Corp. will be considered closely related to the manufacture of the 
bulk chemicals. Therefore, X Corp. will not be considered to have added 
a new line of business for purposes of paragraph (b) of this section 
because it falls within the safe harbor rule of (b)(2)(ii)(B).
    Example 2. X Corp. currently manufactures printed circuit boards in 
a possession. As a result of a technological breakthrough, X Corp. could 
produce the printed circuit boards more efficiently if it modified its 
existing production methods. Because demand for its products was high, X 
Corp. expanded when it modified its production methods. After these 
modifications to the facilities and production methods, the products 
produced through the new technology were in the same six-digit NAICS 
code as products produced previously by X Corp. See paragraph 
(b)(2)(ii)(A) of this section. Therefore, X Corp. will not be considered 
to have added a new line of business for purposes of paragraph (b) of 
this section because it falls within the safe harbor rule of 
(b)(2)(ii)(A).
    Example 3. X Corp. has manufactured Device A in Puerto Rico for a 
number of years and began to manufacture Device B in Puerto Rico in 
1997. Device A and Device B are both used to conduct electrical current 
to the heart and are both sold to cardiologists. There is no significant 
change in the type of activity conducted in Puerto Rico after the 
transfer of the manufacturing of Device B to Puerto Rico. Similar 
manufacturing equipment, manufacturing processes and skills are used in 
the manufacture of both devices. Both are regulated and licensed by the 
Food and Drug Administration. The economic success of Device B is 
dependent upon the success of Device A only to the extent that the 
liability and manufacturing prowess with respect to one reflects 
favorably on the other. Depending upon the heart abnormality, the 
cardiologist may choose to use Device A, Device B or both on a patient. 
The manufacture of Device B is treated as a unit with the manufacture of 
Device A in X Corp.'s accounting records. The manufacture of Device A is 
in the six-digit NAICS code 339112, Surgical and Medical Instrument 
Manufacturing. The manufacture of Device B is in the six-digit NAICS 
code 334510, Electromedical and Electrotherapeutic Apparatus 
Manufacturing. (The manufacture of Device A is in the four-digit SIC 
code 3845, Electromedical and Electrotherapeutic Apparatus. The 
manufacture of Device B is in the four-digit SIC code 3841, Surgical and 
Medical Instruments and Apparatus.) The safe harbor of paragraph 
(b)(2)(ii)(B) of this section applies because the two activities are 
within the same three-digit SIC code and Corp. X satisfies paragraphs 
(b)(2)(i)(A), (B), (C), (D), (F), and (G) of this section.
    Example 4. X Corp. has been manufacturing house slippers in Puerto 
Rico since 1990. Y Corp. is a U.S. corporation that is not affiliated 
with X Corp. and is not an existing credit claimant. Y Corp. has been 
manufacturing snack food in the United States. In 1997, X Corp. 
purchased the assets of Y Corp. and began to manufacture snack food in 
Puerto Rico. House slipper manufacturing is in the six-digit NAICS code 
316212 (Four-digit SIC code 3142, House Slippers). The manufacture of 
snack foods falls under the six-digit NAICS code 311919, Other Snack 
Food Manufacturing (four-digit SIC code 2052, Cookies and Crackers 
(pretzels)). Because these activities are not within the same five or 
six digit NAICS code (or the same three or four-digit SIC code), and 
because snack food is not an integrated product that contains house 
slippers, the safe harbor of paragraph (b)(2)(ii) of this section cannot 
apply. Considering all the facts and circumstances, including the seven 
factors of paragraph (b)(2)(i) of

[[Page 143]]

this section, the snack food manufacturing activity is not closely 
related to the manufacture of house slippers, and is a new line of 
business, within the meaning of paragraph (b) of this section.
    Example 5. X Corp., a calendar year taxpayer, is an existing credit 
claimant that has elected the profit-split method for computing taxable 
income. P Corp. was not an existing credit claimant and manufactured a 
product in a different five-digit NAICS code than the product 
manufactured by X Corp. In 1997, X Corp. acquired the stock of P Corp. 
and liquidated P Corp. in a tax-free liquidation under section 332, but 
continued the business activity of P Corp. as a new business segment. 
Assume that this new business segment is a new line of business within 
the meaning of paragraph (c) of this section. In 1997, X Corp. has gross 
income from the active conduct of a trade or business in a possession 
computed under section 936(a)(2) of $500 million and the adjusted tax 
basis of its assets is $200 million. The new business segment had gross 
income of $60 million, or 12 percent of the X Corp. gross income, and 
the adjusted basis of the new segment's assets was $20 million, or 10 
percent of the X Corp. total assets. In 1997, X Corp. does not derive 
more than 15 percent of its gross income, or directly use more that 15 
percent of its total assets, from the new business segment. Thus, the 
new line of business acquired from P Corp. is not a substantial new line 
of business within the meaning of paragraph (c) of this section, and the 
new activity will not cause X Corp. to lose its status as an existing 
credit claimant during 1997. In 1998, however, the gross income of X 
Corp. grew to $750 million while the gross income of the new line of 
business grew to $150 million, or 20% of the X Corp. 1998 gross income. 
Thus, in 1998, the new line of business is substantial within the 
meaning of paragraph (c) of this section, and X Corp. loses its status 
as an existing credit claimant for 1998 and all years subsequent.

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

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



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

    (a) Scope--(1) In general. Section 937(a) and this section set forth 
the rules for determining whether an individual qualifies as a bona fide 
resident of a particular possession (the relevant possession) for 
purposes of subpart D, part III, Subchapter N, Chapter 1 of the Internal 
Revenue Code as well as section 865(g)(3), section 876, section 881(b), 
paragraphs (2) and (3) of section 901(b), section 957(c), section 
3401(a)(8)(C), and section 7654(a).
    (2) Definitions. For purposes of this section and Sec. Sec. 1.937-2 
and 1.937-3--
    (i) Possession means one of the following United States possessions: 
American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the 
Virgin Islands. When used in a geographical sense, the term comprises 
only the territory of each such possession (without application of 
sections 932(c)(3) and 935(c)(2) (as in effect before the effective date 
of its repeal)).
    (ii) United States, when used in a geographical sense, is defined in 
section 7701(a)(9), and without application of sections 932(a)(3) and 
935(c)(1) (as in effect before the effective date of its repeal).
    (b) Bona fide resident--(1) General rule. An individual qualifies as 
a bona fide resident of the relevant possession if such individual 
satisfies the requirements of paragraphs (c) through (e) of this section 
with respect to such possession.
    (2) Special rule for members of the Armed Forces. A member of the 
Armed Forces of the United States who qualified as a bona fide resident 
of the relevant possession in a prior taxable year is deemed to have 
satisfied the requirements of paragraphs (c) through (e) of this section 
for a subsequent taxable year if such individual otherwise is unable to 
satisfy such requirements by reason of being absent from such possession 
or present in the United States during such year solely in compliance

[[Page 144]]

with military orders. Conversely, a member of the Armed Forces of the 
United States who did not qualify as a bona fide resident of the 
relevant possession in a prior taxable year is not considered to have 
satisfied the requirements of paragraphs (c) through (e) of this section 
for a subsequent taxable year by reason of being present in such 
possession solely in compliance with military orders. Armed Forces of 
the United States is defined (and members of the Armed Forces are 
described) in section 7701(a)(15).
    (3) Juridical persons. Except as provided in Sec. 1.881-5(f):
    (i) Only natural persons may qualify as bona fide residents of a 
possession; and
    (ii) The rules governing the tax treatment of bona fide residents of 
a possession do not apply to juridical persons (including corporations, 
partnerships, trusts, and estates).
    (4) Transition rule. For taxable years beginning before October 23, 
2004, and ending after October 22, 2004, an individual is considered to 
qualify as a bona fide resident of the relevant possession if that 
individual would be a bona fide resident of the relevant possession by 
applying the principles of Sec. Sec. 1.871-2 through 1.871-5.
    (5) Special rule for cessation of bona fide residence in Puerto 
Rico. See paragraph (f)(2)(ii) of this section for a special rule 
applicable to a citizen of the United States who ceases to be a bona 
fide resident of Puerto Rico during a taxable year.
    (c) Presence test--(1) In general. A United States citizen or 
resident alien individual (as defined in section 7701(b)(1)(A)) 
satisfies the requirements of this paragraph (c) for a taxable year if 
that individual--
    (i) Was present in the relevant possession for at least 183 days 
during the taxable year;
    (ii) Was present in the relevant possession for at least 549 days 
during the three-year period consisting of the taxable year and the two 
immediately preceding taxable years, provided that the individual was 
also present in the relevant possession for at least 60 days during each 
taxable year of the period;
    (iii) Was present in the United States for no more than 90 days 
during the taxable year;
    (iv) During the taxable year had earned income (as defined in Sec. 
1.911-3(b)) in the United States, if any, not exceeding in the aggregate 
the amount specified in section 861(a)(3)(B) and was present for more 
days in the relevant possession than in the United States; or
    (v) Had no significant connection to the United States during the 
taxable year. See paragraph (c)(5) of this section.
    (2) Special rule for alien individuals. A nonresident alien 
individual (as defined in section 7701(b)(1)(B)) satisfies the 
requirements of this paragraph (c) for a taxable year if during that 
taxable year that individual satisfies the substantial presence test of 
Sec. 301.7701(b)-1(c) of this chapter (except for the substitution of 
the name of the relevant possession for the term United States where 
appropriate).
    (3) Days of presence. For purposes of paragraph (c)(1) of this 
section--
    (i) An individual is considered to be present in the relevant 
possession on:
    (A) Any day that the individual is physically present in that 
possession at any time during the day;
    (B) Any day that an individual is outside of the relevant possession 
to receive, or to accompany on a full-time basis a parent, spouse, or 
child (as defined in section 152(f)(1)) who is receiving, qualifying 
medical treatment as defined in paragraph (c)(4) of this section; and
    (C) Any day that an individual is outside the relevant possession 
because the individual leaves or is unable to return to the relevant 
possession during any--
    (1) 14-day period within which a major disaster occurs in the 
relevant possession for which a Federal Emergency Management Agency 
Notice of a Presidential declaration of a major disaster is issued in 
the Federal Register; or
    (2) Period for which a mandatory evacuation order is in effect for 
the geographic area in the relevant possession in which the individual's 
place of abode is located.

[[Page 145]]

    (ii) An individual is considered to be present in the United States 
on any day that the individual is physically present in the United 
States at any time during the day. Notwithstanding the preceding 
sentence, the following days will not count as days of presence in the 
United States:
    (A) Any day that an individual is temporarily present in the United 
States under circumstances described in paragraph (c)(3)(i)(B) or (C) of 
this section;
    (B) Any day that an individual is in transit between two points 
outside the United States (as described in Sec. 301.7701(b)-3(d) of 
this chapter), and is physically present in the United States for fewer 
than 24 hours;
    (C) Any day that an individual is temporarily present in the United 
States as a professional athlete to compete in a charitable sports event 
(as described in Sec. 301.7701(b)-3(b)(5) of this chapter);
    (D) Any day that an individual is temporarily present in the United 
States as a student (as defined in section 152(f)(2)); and
    (E) In the case of an individual who is an elected representative of 
the relevant possession, or who serves full time as an elected or 
appointed official or employee of the government of the relevant 
possession (or any political subdivision thereof), any day spent serving 
the relevant possession in that role.
    (iii) If, during a single day, an individual is physically present--
    (A) In the United States and in the relevant possession, that day is 
considered a day of presence in the relevant possession;
    (B) In two possessions, that day is considered a day of presence in 
the possession where the individual's tax home is located (applying the 
rules of paragraph (d) of this section).
    (4) Qualifying medical treatment--(i) In general. The term 
qualifying medical treatment means medical treatment provided by (or 
under the supervision of) a physician (as defined in section 213(d)(4)) 
for an illness, injury, impairment, or physical or mental condition that 
satisfies the documentation and production requirements of paragraph 
(c)(4)(iii) of this section and that involves--
    (A) Any period of inpatient care in a hospital or hospice and any 
period immediately before or after that inpatient care to the extent it 
is medically necessary; or
    (B) Any temporary period of inpatient care in a residential medical 
care facility for medically necessary rehabilitation services;
    (ii) Inpatient care. The term inpatient care means care requiring an 
overnight stay in a hospital, hospice, or residential medical care 
facility, as the case may be.
    (iii) Documentation and production requirements. In order to satisfy 
the documentation and production requirements of this paragraph, an 
individual must, with respect to each qualifying medical treatment, 
prepare (or obtain), maintain, and, upon a request by the Commissioner 
(or the person responsible for tax administration in the relevant 
possession), make available within 30 days of such request:
    (A) Records that provide--
    (1) The patient's name and relationship to the individual (if the 
medical treatment is provided to a person other than the individual);
    (2) The name and address of the hospital, hospice, or residential 
medical care facility where the medical treatment was provided;
    (3) The name, address, and telephone number of the physician who 
provided the medical treatment;
    (4) The date(s) on which the medical treatment was provided; and
    (5) Receipt(s) of payment for the medical treatment;
    (B) Signed certification by the providing or supervising physician 
that the medical treatment was qualified medical treatment within the 
meaning of paragraph (c)(4)(i) of this section, and setting forth--
    (1) The patient's name;
    (2) A reasonably detailed description of the medical treatment 
provided by (or under the supervision of) the physician;
    (3) The dates on which the medical treatment was provided; and

[[Page 146]]

    (4) The medical facts that support the physician's certification and 
determination that the treatment was medically necessary; and
    (C) Such other information as the Commissioner may prescribe by 
notice, form, instructions, or other publication (see Sec. 
601.601(d)(2) of this chapter).
    (5) Significant connection. For purposes of paragraph (c)(1)(v) of 
this section--
    (i) The term significant connection to the United States means--
    (A) A permanent home in the United States;
    (B) Current registration to vote in any political subdivision of the 
United States; or
    (C) A spouse or child (as defined in section 152(f)(1)) who has not 
attained the age of 18 whose principal place of abode is in the United 
States other than--
    (1) A child who is in the United States because the child is living 
with a custodial parent under a custodial decree or multiple support 
agreement; or
    (2) A child who is in the United States as a student (as defined in 
section 152(f)(2)).
    (ii) Permanent home--(A) General rule. For purposes of paragraph 
(c)(5)(i)(A) of this section, except as provided in paragraph 
(c)(5)(ii)(B) of this section, the term permanent home has the same 
meaning as in Sec. 301.7701(b)-2(d)(2) of this chapter.
    (B) Exception for rental property. If an individual or the 
individual's spouse owns property and rents it to another person at any 
time during the taxable year, then notwithstanding that the rental 
property may constitute a permanent home under Sec. 301.7701(b)-2(d)(2) 
of this chapter, it is not a permanent home under this paragraph 
(c)(5)(ii) unless the taxpayer uses any portion of it as a residence 
during the taxable year under the principles of section 280A(d). In 
applying the principles of section 280A(d) for this purpose, an 
individual is treated as using the rental property for personal purposes 
on any day determined under the principles of section 280A(d)(2) or on 
any day that the rental property (or any portion of it) is not rented to 
another person at fair rental for the entire day. The rental property is 
not used for personal purposes on any day on which the principal purpose 
of the use of the rental property is to perform repair or maintenance 
work on the property. Whether the principal purpose of the use of the 
rental property is to perform repair or maintenance work is determined 
in light of all the facts and circumstances including, but not limited 
to, the following: The amount of time devoted to repair and maintenance 
work, the frequency of the use for repair and maintenance purposes 
during a taxable year, and the presence and activities of companions.
    (iii) For purposes of this paragraph (c)(5), the term spouse does 
not include a spouse from whom the individual is legally separated under 
a decree of divorce or separate maintenance.
    (d) Tax home test--(1) General rule. Except as provided in paragraph 
(d)(2) of this section, an individual satisfies the requirements of this 
paragraph (d) for a taxable year if that individual did not have a tax 
home outside the relevant possession during any part of the taxable 
year. For purposes of section 937 and this section, an individual's tax 
home is determined under the principles of section 911(d)(3) without 
regard to the second sentence thereof. Thus, under section 937, an 
individual's tax home is considered to be located at the individual's 
regular or principal (if more than one regular) place of business. If 
the individual has no regular or principal place of business because of 
the nature of the business, or because the individual is not engaged in 
carrying on any trade or business within the meaning of section 162(a), 
then the individual's tax home is the individual's regular place of 
abode in a real and substantial sense.
    (2) Exceptions--(i) Year of move. See paragraph (f) of this section 
for a special rule applicable to an individual who becomes or ceases to 
be a bona fide resident of the relevant possession during a taxable 
year.
    (ii) Special rule for seafarers. For purposes of section 937 and 
this section, an individual is not considered to have a tax home outside 
the relevant possession solely by reason of employment on a ship or 
other seafaring vessel that is predominantly used in local and 
international waters. For this purpose, a

[[Page 147]]

vessel is considered to be predominantly used in local and international 
waters if, during the taxable year, the aggregate amount of time it is 
used in international waters and in the waters within three miles of the 
relevant possession exceeds the aggregate amount of time it is used in 
the territorial waters of the United States, another possession, and a 
foreign country.
    (iii) Special rule for students and government officials. Any days 
described in paragraphs (c)(3)(ii)(D) and (E) of this section are 
disregarded for purposes of determining whether an individual has a tax 
home outside the relevant possession under paragraph (d)(1) of this 
section during any part of the taxable year.
    (e) Closer connection test--(1) General rule. Except as provided in 
paragraph (e)(2) of this section, an individual satisfies the 
requirements of this paragraph (e) for a taxable year if that individual 
did not have a closer connection to the United States or a foreign 
country than to the relevant possession during any part of the taxable 
year. For purposes of this paragraph (e)--
    (i) The principles of section 7701(b)(3)(B)(ii) and Sec. 
301.7701(b)-2(d) of this chapter apply (without regard to the final 
sentence of Sec. 301.7701(b)-2(b) of this chapter); and
    (ii) An individual's connections to the relevant possession are 
compared to the aggregate of the individual's connections with the 
United States and foreign countries.
    (2) Exception for year of move. See paragraph (f) of this section 
for a special rule applicable to an individual who becomes or ceases to 
be a bona fide resident of the relevant possession during a taxable 
year.
    (f) Year of move--(1) Move to a possession. For the taxable year in 
which an individual's residence changes to the relevant possession, the 
individual satisfies the requirements of paragraphs (d)(1) and (e)(1) of 
this section if--
    (i) For each of the 3 taxable years immediately preceding the 
taxable year of the change of residence, the individual is not a bona 
fide resident of the relevant possession;
    (ii) For each of the last 183 days of the taxable year of the change 
of residence, the individual does not have a tax home outside the 
relevant possession or a closer connection to the United States or a 
foreign country than to the relevant possession; and
    (iii) For each of the 3 taxable years immediately following the 
taxable year of the change of residence, the individual is a bona fide 
resident of the relevant possession.
    (2) Move from a possession--(i) General rule. Except for a bona fide 
resident of Puerto Rico to whom Sec. 1.933-1(b) and paragraph 
(f)(2)(ii) of this section apply, for the taxable year in which an 
individual ceases to be a bona fide resident of the relevant possession, 
the individual satisfies the requirements of paragraphs (d)(1) and 
(e)(1) of this section if--
    (A) For each of the 3 taxable years immediately preceding the 
taxable year of the change of residence, the individual is a bona fide 
resident of the relevant possession;
    (B) For each of the first 183 days of the taxable year of the change 
of residence, the individual does not have a tax home outside the 
relevant possession or a closer connection to the United States or a 
foreign country than to the relevant possession; and
    (C) For each of the 3 taxable years immediately following the 
taxable year of the change of residence, the individual is not a bona 
fide resident of the relevant possession.
    (ii) Year of move from Puerto Rico. Notwithstanding an individual's 
failure to satisfy the presence, tax home, or closer connection test 
prescribed under paragraph (b)(1) of this section for the taxable year, 
the individual is a bona fide resident of Puerto Rico for that part of 
the taxable year described in paragraph (f)(2)(ii)(E) of this section if 
the individual--
    (A) Is a citizen of the United States;
    (B) Is a bona fide resident of Puerto Rico for a period of at least 
2 taxable years immediately preceding the taxable year;
    (C) Ceases to be a bona fide resident of Puerto Rico during the 
taxable year;
    (D) Ceases to have a tax home in Puerto Rico during the taxable 
year; and
    (E) Has a closer connection to Puerto Rico than to the United States 
or a foreign country throughout the part of

[[Page 148]]

the taxable year preceding the date on which the individual ceases to 
have a tax home in Puerto Rico.
    (g) Examples. The principles of this section are illustrated by the 
following examples:

    Example 1. Presence test. H, a U.S. citizen, is engaged in a 
profession that requires frequent travel. H spends 195 days of each of 
the years 2005 and 2006 in Possession N. In 2007, H spends 160 days in 
Possession N. Under paragraph (c)(1)(ii), H satisfies the presence test 
of paragraph (c) of this section with respect to Possession N for 
taxable year 2007. Assuming that in 2007 H does not have a tax home 
outside of Possession N and does not have a closer connection to the 
United States or a foreign country under paragraphs (d) and (e) of this 
section respectively, then regardless of whether H was a bona fide 
resident of Possession N in 2005 and 2006, H is a bona fide resident of 
Possession N for taxable year 2007.
    Example 2. Presence test. W, a U.S. citizen, lives for part of the 
taxable year in a condominium, which she owns, located in Possession P. 
W also owns a house in State N where she lives for 120 days every year 
to be near her grown children and grandchildren. W is retired and her 
income consists solely of pension payments, dividends, interest, and 
Social Security benefits. For 2006, W is only present in Possession P 
for a total of 175 days because of a 70-day vacation to Europe and Asia. 
Thus, for taxable year 2006, W is not present in Possession P for at 
least 183 days, is present in the United States for more than 90 days, 
and has a significant connection to the United States by reason of her 
permanent home. However, under paragraph (c)(1)(iv) of this section, W 
still satisfies the presence test of paragraph (c) of this section with 
respect to Possession P because she has no earned income in the United 
States and is present for more days in Possession P than in the United 
States.
    Example 3. Presence test. T, a U.S. citizen, was born and raised in 
State A, where his mother still lives in the house in which T grew up. T 
is a sales representative for a company based in Possession V. T lives 
with his wife and minor children in their house in Possession V. T is 
registered to vote in Possession V and not in the United States. In 
2006, T spends 120 days in State A and another 120 days in foreign 
countries. When traveling on business to State A, T often stays at his 
mother's house in the bedroom he used when he was a child. T's stays are 
always of short duration, and T asks for his mother's permission before 
visiting to make sure that no other guests are using the room and that 
she agrees to have him as a guest in her house at that time. Therefore, 
under paragraph (c)(5)(ii) of this section, T's mother's house is not a 
permanent home of T. Assuming that no other accommodations in the United 
States constitute a permanent home with respect to T, then under 
paragraphs (c)(1)(v) and (c)(5) of this section, T has no significant 
connection to the United States. Accordingly, T satisfies the presence 
test of paragraph (c) of this section for taxable year 2006.
    Example 4. Alien resident of possession--presence test. F is a 
citizen of Country G. F's tax home is in Possession C and F has no 
closer connection to the United States or a foreign country than to 
Possession C. F is present in Possession C for 123 days and in the 
United States for 110 days every year. Accordingly, F is a nonresident 
alien with respect to the United States under section 7701(b), and a 
bona fide resident of Possession C under paragraphs (b), (c)(2), (d), 
and (e) of this section.
    Example 5. Seafarers--tax home. S, a U.S. citizen, is employed by a 
fishery and spends 250 days at sea on a fishing vessel in 2006. When not 
at sea, S resides with his wife at a house they own in Possession G. The 
fishing vessel upon which S works departs and arrives at various ports 
in Possession G, other possessions, and foreign countries, but is in 
international and local waters (within the meaning of paragraph (d)(2) 
of this section) for 225 days in 2006. Under paragraph (d)(2) of this 
section, for taxable year 2006, S will not be considered to have a tax 
home outside Possession G for purposes of section 937 and this section 
solely by reason of S's employment on board the fishing vessel.
    Example 6. Seasonal workers--tax home and closer connection. P, a 
U.S. citizen, is a permanent employee of a hotel in Possession I, but 
works only during the tourist season. For the remainder of each year, P 
lives with her husband and children in Possession Q, where she has no 
outside employment. Most of P's personal belongings, including her 
automobile, are located in Possession Q. P is registered to vote in, and 
has a driver's license issued by, Possession Q. P does her personal 
banking in Possession Q and P routinely lists her address in Possession 
Q as her permanent address on forms and documents. P satisfies the 
presence test of paragraph (c) of this section with respect to both 
Possession Q and Possession I, because, among other reasons, under 
paragraph (c)(1)(iii) of this section she does not spend more than 90 
days in the United States during the taxable year. P satisfies the tax 
home test of paragraph (d) of this section only with respect to 
Possession I, because her regular place of business is in Possession I. 
P satisfies the closer connection test of paragraph (e) of this section 
with respect to both Possession Q and Possession I, because she does not 
have a closer connection to the United States or to any foreign country 
(and

[[Page 149]]

possessions generally are not treated as foreign countries). Therefore, 
P is a bona fide resident of Possession I for purposes of the Internal 
Revenue Code.
    Example 7. Closer connection to United States than to possession. Z, 
a U.S. citizen, relocates to Possession V in a prior taxable year to 
start an investment consulting and venture capital business. Z's wife 
and two teenage children remain in State C to allow the children to 
complete high school. Z travels back to the United States regularly to 
see his wife and children, to engage in business activities, and to take 
vacations. He has an apartment available for his full-time use in 
Possession V, but he remains a joint owner of the residence in State C 
where his wife and children reside. Z and his family have automobiles 
and personal belongings such as furniture, clothing, and jewelry located 
at both residences. Although Z is a member of the Possession V Chamber 
of Commerce, Z also belongs to and has current relationships with 
social, political, cultural, and religious organizations in State C. Z 
receives mail in State C, including brokerage statements, credit card 
bills, and bank advices. Z conducts his personal banking activities in 
State C. Z holds a State C driver's license and is registered to vote in 
State C. Based on the totality of the particular facts and circumstances 
pertaining to Z, Z is not a bona fide resident of Possession V because 
he has a closer connection to the United States than to Possession V and 
therefore fails to satisfy the requirements of paragraphs (b)(1) and (e) 
of this section.
    Example 8. Year of move to possession. D, a U.S. citizen, files 
returns on a calendar year basis. From January 2003 through May 2006, D 
resides in State R. In June 2006, D moves to Possession N, purchases a 
house, and accepts a permanent position with a local employer. D's 
principal place of business from July 1 through December 31, 2006 is in 
Possession N, and during that period (which totals at least 183 days) D 
does not have a closer connection to the United States or a foreign 
country than to Possession N. For the remainder of 2006, and throughout 
years 2007 through 2009, D continues to live and work in Possession N 
and maintains a closer connection to Possession N than to the United 
States or any foreign country. D satisfies the tax home and closer 
connection tests for 2006 under paragraphs (d)(2), (e)(2), and (f)(1) of 
this section. Accordingly, assuming that D also satisfies the presence 
test in paragraph (c) of this section, D is a bona fide resident of 
Possession N for all of taxable year 2006.
    Example 9. Year of move from possession (other than Puerto Rico). J, 
a U.S. citizen, files returns on a calendar year basis. From January 
2007 through December 2009, J is a bona fide resident of Possession C 
because she satisfies the requirements of paragraph (b)(1) of this 
section for each year. J continues to reside in Possession C until 
September 6, 2010, when she accepts new employment and moves to State H. 
J's principal place of business from January 1 through September 5, 2010 
is in Possession C, and during that period (which totals at least 183 
days) J does not have a closer connection to the United States or a 
foreign country than to Possession C. For the remainder of 2010 and 
throughout years 2011 through 2013, D continues to live and work in 
State H and is not a bona fide resident of Possession C. J satisfies the 
tax home and closer connection tests for 2010 with respect to Possession 
C under paragraphs (d)(2)(i), (e)(2), and (f)(2)(i) of this section. 
Accordingly, assuming that J also satisfies the presence test of 
paragraph (c) of this section, J is a bona fide resident of Possession C 
for all of taxable year 2010.
    Example 10. Year of move from Puerto Rico. R, a U.S. citizen who 
files returns on a calendar year basis satisfies the requirements of 
paragraphs (b) through (e) of this section for years 2006 and 2007. From 
January through April 2008, R continues to reside and maintain his 
principal place of business in and closer connection to Puerto Rico. On 
May 5, 2008, R moves and changes his principal place of business (tax 
home) to State N and later that year establishes a closer connection to 
the United States than to Puerto Rico. R does not satisfy the presence 
test of paragraph (c) for 2008 with respect to Puerto Rico. Moreover, 
because R had a tax home outside of Puerto Rico and establishes a closer 
connection to the United States in 2008, R does not satisfy the 
requirements of paragraph (d)(1) or (e)(1) of this section for 2008. 
However, because R was a bona fide resident of Puerto Rico for at least 
two taxable years before his change of residence to State N in 2008, he 
is a bona fide resident of Puerto Rico from January 1 through May 4, 
2008 under paragraphs (b)(5) and (f)(2)(ii) of this section. See section 
933(2) and Sec. 1.933-1(b) for rules on attribution of income.

    (h) Information reporting requirement. The following individuals are 
required to file notice of their new tax status in such time and manner 
as the Commissioner may prescribe by notice, form, instructions, or 
other publication (see Sec. 601.601(d)(2) of this chapter):
    (1) Individuals who take the position for U.S. tax reporting 
purposes that they qualify as bona fide residents of a possession for a 
tax year subsequent to a tax year for which they were required to file 
Federal income tax returns as citizens or residents of the United States 
who did not so qualify.
    (2) Citizens and residents of the United States who take the 
position for U.S. tax reporting purposes that

[[Page 150]]

they do not qualify as bona fide residents of a possession for a tax 
year subsequent to a tax year for which they were required to file 
income tax returns (with the Internal Revenue Service, the tax 
authorities of a possession, or both) as individuals who did so qualify.
    (3) Bona fide residents of Puerto Rico or a section 931 possession 
(as defined in Sec. 1.931-1(c)(1)) who take a position for U.S. tax 
reporting purposes that they qualify as bona fide residents of that 
possession for a tax year subsequent to a tax year for which they were 
required to file income tax returns as bona fide residents of the U.S. 
Virgin Islands or a section 935 possession (as defined in Sec. 1.935-
1(a)(3)(i)).
    (i) Effective/applicability date. Except as provided in this 
paragraph (i), this section applies to taxable years ending after 
January 31, 2006. Paragraph (h) of this section also applies to a 
taxpayer's 3 taxable years immediately preceding the taxpayer's first 
taxable year ending after October 22, 2004. Taxpayers also may choose to 
apply this section in its entirety to all taxable years ending after 
October 22, 2004 for which the statute of limitations under section 6511 
is open.

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



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

    (a) Scope. Section 937(b) and this section set forth the rules for 
determining whether income is considered to be from sources within a 
particular possession (the relevant possession) for purposes of the 
Internal Revenue Code, including section 957(c) and Subpart D, Part III, 
Subchapter N, Chapter 1 of the Internal Revenue Code, as well as section 
7654(a) of the 1954 Internal Revenue Code (until the effective date of 
its repeal). Paragraphs (c)(1)(ii) and (c)(2) of this section do not 
apply, however, for purposes of sections 932(a) and (b) and 935(a)(3) 
(as in effect before the effective date of its repeal). In the case of a 
possession or territory that administers income tax laws that are 
identical (except for the substitution of the name of the possession or 
territory for the term ``United States'' where appropriate) to those in 
force in the United States, these rules do not apply for purposes of the 
application of such laws. These rules also do not affect the 
determination of whether income is considered to be from sources without 
the United States for purposes of the Internal Revenue Code.
    (b) In general. Except as provided in paragraphs (c) through (i) of 
this section, the principles of sections 861 through 865 and the 
regulations under those provisions (relating to the determination of the 
gross and the taxable income from sources within and without the United 
States) generally will be applied in determining the gross and the 
taxable income from sources within and without the relevant possession. 
In the application of such principles, it generally will be sufficient 
to substitute, where appropriate, the name of the relevant possession 
for the term ``United States,'' and to substitute, where appropriate, 
the term ``bona fide resident of'' followed by the name of the relevant 
possession for the term ``United States resident.'' Furthermore, the 
term domestic will be construed to mean created or organized in the 
relevant possession. In applying these principles, additional 
substitutions may be necessary to accomplish the intent of section 
937(b) and this section. For example, in applying the principles of 
sections 863(d) and (e) to individuals under this paragraph (b), the 
term ``bona fide resident of a possession'' will be used instead of the 
term ``United States person.'' In no case, however, will a bona fide 
resident or other person have, as a result of the application of these 
principles, more income from sources within the relevant possession than 
the amount of income from sources within the United States that a 
similarly situated U.S. person who is not a bona fide resident would 
have under sections 861 through 865.
    (c) U.S. income--(1) In general. Except as provided in paragraph (d) 
of this section, income from sources within the relevant possession will 
not include any item of income determined under the rules of sections 
861 through 865 and the regulations under those provisions to be--

[[Page 151]]

    (i) From sources within the United States; or
    (ii) Effectively connected with the conduct of a trade or business 
within the United States.
    (2) Conduit arrangements. Income will be considered to be from 
sources within the United States for purposes of paragraph (c)(1) of 
this section if, pursuant to a plan or arrangement--
    (i) The income is received in exchange for consideration provided to 
another person; and
    (ii) Such person (or another person) provides the same consideration 
(or consideration of a like kind) to a third person in exchange for one 
or more payments constituting income from sources within the United 
States.
    (d) Income from certain sales of inventory property. For special 
rules that apply to determine the source of income from certain sales of 
inventory property, see Sec. 1.863-3(e).
    (e) Service in the Armed Forces. In the case of a member of the 
Armed Forces of the United States, the following rules will apply for 
determining the source of compensation for services performed in 
compliance with military orders:
    (1) If the individual is a bona fide resident of a possession and 
such services are performed in the United States or in another 
possession, the compensation constitutes income from sources within the 
possession of which the individual is a bona fide resident (and not from 
sources within the United States or such other possession).
    (2) If the individual is not a bona fide resident of a possession 
and such services are performed in a possession, the compensation 
constitutes income from sources within the United States (and not from 
sources within such possession).
    (f) Gains from certain dispositions of property--(1) Property of 
former U.S. residents. (i) Except to the extent an election is made 
under paragraph (f)(1)(vi) of this section, income from sources within 
the relevant possession will not include gains from the disposition of 
property described in paragraph (f)(1)(ii) of this section by an 
individual described in paragraph (f)(1)(iii) of this section. See also 
section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 
Stat. 2085) (providing that gains from the disposition of certain 
property by individuals who acquired residency in certain possessions 
will be considered to be from sources within the United States).
    (ii) Property is described in this paragraph (f)(1)(ii) when the 
following conditions are satisfied--
    (A) The property is of a kind described in section 731(c)(3)(C)(i) 
or 954(c)(1)(B); and
    (B) The property was owned by the individual before such individual 
became a bona fide resident of the relevant possession.
    (iii) An individual is described in this paragraph (f)(1)(iii) when 
the following conditions are satisfied--
    (A) For the taxable year for which the source of the gain must be 
determined, the individual is a bona fide resident of the relevant 
possession; and
    (B) For any of the 10 years preceding such year, the individual was 
a citizen or resident of the United States (other than a bona fide 
resident of the relevant possession).
    (iv) If an individual described in paragraph (f)(1)(iii) of this 
section exchanges property described in paragraph (f)(1)(ii) of this 
section for other property in a transaction in which gain or loss is not 
required to be recognized (in whole or in part) under U.S. income tax 
principles, such other property will also be considered property 
described in paragraph (f)(1)(ii) of this section.
    (v) If an individual described in paragraph (f)(1)(iii) of this 
section owns, directly or indirectly, at least 10 percent (by value) of 
any entity to which property described in paragraph (f)(1)(ii) of this 
section is transferred in a transaction in which gain or loss is not 
required to be recognized (in whole or in part) under U.S. income tax 
principles, any gain recognized upon a disposition of the property by 
such entity will be treated as income from sources outside the relevant 
possession if any gain recognized upon a direct or indirect disposition 
of the individual's interest in such entity would have been so treated 
under paragraph (f)(1)(iv) of this section.
    (vi) Notwithstanding the general rule of paragraph (f)(1)(i) of this 
section and

[[Page 152]]

section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 
Stat. 2085), an individual described in paragraph (f)(1)(iii) of this 
section may elect to treat as gain from sources within the relevant 
possession the portion of the gain attributable to the individual's 
possession holding period. The election under this paragraph (f)(1)(vi) 
will be considered made if the individual's income tax return for the 
year of disposition of the property reports the portion of gain 
attributable to the taxpayer's possession holding period as determined 
in accordance with paragraph (f)(1)(vi)(A) or paragraph (f)(1)(vi)(B) of 
this section, as the case may be.
    (A) In the case of marketable securities, the portion of gain 
attributable to the possession holding period will be determined by 
reference to the fair market value of the marketable security at the 
close of the market on the first day of the individual's possession 
holding period. In the event that the individual is a bona fide resident 
of the relevant possession for more than a single continuous period, the 
portion of gain described in this paragraph (f)(1)(vi)(A) will be the 
aggregate of the portions of gain (or offsetting loss) attributable to 
each possession holding period.
    (B) In the case of property other than marketable securities, the 
portion of gain attributable to the possession holding period in the 
relevant possession will be determined by multiplying the total gain on 
disposition of the property by a fraction, the numerator of which is the 
number of days in the possession holding period and the denominator of 
which is the total number of days in the individual's holding period for 
the property. For purposes of the preceding sentence, in the event that 
the individual is a bona fide resident of the relevant possession for 
more than a single continuous period, the number of days in the 
numerator will be the aggregate of the number of days in each possession 
holding period. For purposes of this paragraph (f)(1)(vi)(B), the 
denominator will include days that are required to be included in an 
individual's holding period under section 735(b), section 1223, and any 
other applicable holding period rule in the Internal Revenue Code.
    (vii) For purposes of paragraph (f)(1)(vi) of this section--
    (A) The term marketable securities means property described in 
paragraph (f)(1)(ii) of this section that is, throughout the 
individual's holding period, actively traded within the meaning of Sec. 
1.1092(d)-1(a); and
    (B) The term possession holding period means the part of the 
individual's holding period for the property during which the individual 
is a bona fide resident of the relevant possession. However, for this 
purpose, the possession holding period will be considered to commence in 
all cases on the first day during such period that the individual does 
not have a tax home outside the relevant possession. In the event that 
the individual is a bona fide resident of the relevant possession for 
more than a single continuous period, each possession holding period 
prior to the one ending on the date of sale or other disposition will be 
considered to end on the first day that the individual has a tax home 
outside the relevant possession. With respect to the determination of 
tax home, see Sec. 1.937-1(d).
    (2) Special rules under section 865 for possessions--(i) Except as 
provided in paragraph (f)(1) of this section--
    (A) Gain that is considered to be derived from sources outside of 
the United States under section 865(g)(3) will be considered income from 
sources within Puerto Rico; and
    (B) Gain that is considered to be derived from sources outside of 
the United States under section 865(h)(2)(B) will be considered income 
from sources within the possession in which the liquidating corporation 
is created or organized.
    (ii) In applying the principles of section 865 and the regulations 
under that section pursuant to paragraph (b) of this section, the rules 
of section 865(g) will not apply, but the special rule of section 
865(h)(2)(B) will apply with respect to gain recognized upon the 
liquidation of corporations created or organized in the United States.
    (g) Dividends--(1) Dividends from certain possessions corporations--
(i) In general. Except as provided in paragraph (g)(1)(ii) of this 
section, with respect to

[[Page 153]]

any possessions shareholder, only the possessions source ratio of any 
dividend paid or accrued by a corporation created or organized in a 
possession (possessions corporation) will be treated as income from 
sources within such possession. For purposes of this paragraph (g)--
    (A) The possessions source ratio will be a fraction, the numerator 
of which is the gross income of the possessions corporation from sources 
within the possession in which it is created or organized (applying the 
rules of this section) for the testing period and the denominator of 
which is the total gross income of the corporation for the testing 
period; and
    (B) The term possessions shareholder means any individual who is a 
bona fide resident of the possession in which the corporation is created 
or organized and who owns, directly or indirectly, at least 10 percent 
of the total voting stock of the corporation.
    (ii) Dividends from corporations engaged in the active conduct of a 
trade or business in the relevant possession. The entire amount of any 
dividend paid or accrued by a possessions corporation will be treated as 
income from sources within the possession in which it is created or 
organized when the following conditions are met--
    (A) 80 percent or more of the gross income of the corporation for 
the testing period was derived from sources within such possession 
(applying the rules of this section) or was effectively connected with 
the conduct of a trade or business in such possession (applying the 
rules of Sec. 1.937-3); and
    (B) 50 percent or more of the gross income of the corporation for 
the testing period was derived from the active conduct of a trade or 
business within such possession.
    (iii) Testing period. For purposes of this paragraph (g)(1), the 
term testing period means the 3-year period ending with the close of the 
taxable year of the payment of the dividend (or for such part of such 
period as the corporation has been in existence).
    (iv) Subsidiary look-through rule. For purposes of this paragraph 
(g)(1), if a possessions corporation owns (directly or indirectly) at 
least 25 percent (by value) of the stock of another corporation, such 
possessions corporation will be treated as if it--
    (A) Directly received its proportionate share of the income of such 
other corporation; and
    (B) Actively conducted any trade or business actively conducted by 
such other corporation.
    (2) Dividends from other corporations. In applying the principles of 
section 861 and the regulations under that section pursuant to paragraph 
(b) of this section, the special rules relating to dividends for which 
deductions are allowable under section 243 or 245 will not apply.
    (h) Income inclusions. For purposes of determining whether an amount 
described in section 904(h)(1)(A) constitutes income from sources within 
the relevant possession--
    (1) If the individual owns (directly or indirectly) at least 10 
percent of the total voting stock of the corporation from which such 
amount is derived, the principles of section 904(h)(2) will apply. In 
the case of an individual who is not a possessions shareholder (as 
defined in paragraph (g)(1)(i)(B) of this section), the preceding 
sentence will apply only if the corporation qualifies as a ``United 
States-owned foreign corporation'' for purposes of section 904(h); and
    (2) In all other cases, the amount will be considered income from 
sources in the jurisdiction in which the corporation is created or 
organized.
    (i) Interest--(1) Interest from certain possessions corporations--
(i) In general. Except as provided in paragraph (i)(1)(ii) of this 
section, with respect to any possessions shareholder (as defined in 
paragraph (g)(1)(i)(B) of this section), interest paid or accrued by a 
possessions corporation will be treated as income from sources within 
the possession in which it is created or organized to the extent that 
such interest is allocable to assets that generate, have generated, or 
could reasonably have been expected to generate income from sources 
within such possession (under the rules of this section) or income 
effectively connected with the conduct of a trade or business within 
such possession (under the rules of Sec. 1.937-3). For purposes of the 
preceding sentence, the

[[Page 154]]

principles of Sec. Sec. 1.861-9 through 1.861-12 will apply.
    (ii) Interest from corporations engaged in the active conduct of a 
trade or business in the relevant possession. The entire amount of any 
interest paid or accrued by a possessions corporation will be treated as 
income from sources within the possession in which it is created or 
organized when the conditions of paragraphs (g)(1)(ii)(A) and (B) of 
this section are met (applying the rules of paragraphs (g)(1)(iii) and 
(iv) of this section).
    (2) Interest from partnerships. Interest paid or accrued by a 
partnership will be treated as income from sources within a possession 
only to the extent that such interest is allocable to income effectively 
connected with the conduct of a trade or business in such possession. 
For purposes of the preceding sentence, the principles of Sec. 1.882-5 
will apply (as if the partnership were a foreign corporation and as if 
the trade or business in the possession were a trade or business in the 
United States).
    (j) Indirect ownership. For purposes of this section, the rules of 
section 318(a)(2) will apply except that the language ``5 percent'' will 
be used instead of ``50 percent'' in section 318(a)(2)(C).
    (k) Examples. The provisions of this section may be illustrated by 
the following examples:

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


[[Page 155]]


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

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

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

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

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

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

    (iv) Pursuant to paragraph (g) of this section, the portion of the 
dividend of $70x that X receives from Corp A in 2010 that is treated as 
income from sources within Possession I is 72/126 of $70x, or $40x.
    Example 5. X is a U.S. citizen and a bona fide resident of the 
Northern Mariana Islands (NMI). In 2008, X receives compensation for 
services performed as a member of the crew of a fishing boat. Ten 
percent of the services for which X receives compensation are performed 
in the NMI, and 90 percent of X's services are performed in 
international waters. Under the principles of section 861(a)(3) as 
applied pursuant to paragraph (b) of this section, the compensation that 
X receives for services performed in the NMI is treated as income from 
sources within the NMI. Under the principles of section 863(d)(1)(A) as 
applied pursuant to paragraph (b) of this section, the compensation that 
X receives for services performed in international waters is treated as 
income from sources within the NMI for purposes of the Internal Revenue 
Code (including section 7654, as in effect with respect to the NMI). 
Thus, all of X's compensation for services during 2008 is treated as 
income from sources within the NMI.
    Example 6. X, a U.S. citizen, resides in State L and receives $2,500 
of compensation for services performed in Possession J during 2008 for 
Y, X's employer. X is temporarily present in Possession J in 2008 for a 
period (or periods) not exceeding a total of 90 days. Y, a U.S. citizen, 
is not a bona fide resident of Possession J and is not engaged in a 
trade or business within Possession J. Under the principles of section 
861(a)(3) as applied pursuant to paragraph (b) of this section, the 
compensation that X receives for services performed in Possession J 
during 2008 is not treated as income from sources within Possession J.
    Example 7. (i) Company Y, a corporation organized in State C, 
produces, markets, and distributes music products. Y enters into a 
recording contract with Z, a recording artist who is a bona fide 
resident of the U.S. Virgin Islands (USVI). Pursuant to the contract 
between Y and Z, Z agrees to perform services as writer, musician, and 
vocalist on the recording of a new musical composition and related music 
video. Under the contract, all songs, recordings and related artwork, 
packaging copy, and liner notes, together with copyrights and other 
intellectual property in those works, are the sole property of Y, and Z 
obtains no proprietary rights in that property. As compensation for Z's 
services, all of which are performed at a recording studio or other 
locations in the USVI, Y agrees to pay amounts designated as the 
``writer's share'' to Z based on a percentage of the music products 
sold. Y also agrees to make an upfront payment to Z as an advance 
against future portions of Z's writer's share.
    (ii) To the extent that Z performs personal services within the 
USVI, the compensation that Z receives for his services is sourced to 
the USVI under the principles of section

[[Page 156]]

861(a)(3) and Sec. 1.861-4 as applied pursuant to Sec. 1.937-2(b). If 
all of Z's services are performed in the USVI, none of the writer's 
share is derived from sources within the United States under section 
861(a)(3) and Sec. 1.861-4, nor is it effectively connected with the 
conduct of a trade or business in the United States under section 
864(c)(3). Accordingly, the U.S. income rule of section 937(b)(2) and 
paragraph (c)(1) of this section would not operate to prevent Z's 
services income from being USVI source or USVI effectively connected 
income within the meaning of section 937(b)(1). If Z also performs 
services in the United States, however, then the U.S. income rule would 
apply to the part of Z's compensation that is sourced to the United 
States under section 861(a)(3) and Sec. 1.861-4. In the event that Y 
and Z are controlled taxpayers within the meaning of Sec. 1.482-
1(i)(5), section 482 and the regulations under that section, including 
Sec. 1.482-9T(i), would apply to evaluate the arm's length amount 
charged for Z's controlled services.

    (l) Effective/applicability dates. Except as otherwise provided in 
this paragraph (l), this section applies to income earned in taxable 
years ending after April 9, 2008. Taxpayers may choose to apply 
paragraph (b) of this section to income earned in open taxable years 
ending after October 22, 2004. Taxpayers may choose to apply paragraph 
(f)(1) of this section to dispositions made after April 11, 2005.

[T.D. 9391, 73 FR 19370, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 
27728, May 14, 2008; T.D. 9391, 73 FR 36594, June 27, 2008; T.D. 9921, 
85 FR 79853, Dec. 11, 2020]



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

    (a) Scope. Section 937(b) and this section set forth the rules for 
determining whether income is effectively connected with the conduct of 
a trade or business within a particular possession (the relevant 
possession) for purposes of the Internal Revenue Code, including 
sections 881(b) and 957(c) and Subpart D, Part III, Subchapter N, 
Chapter 1 of the Internal Revenue Code. Paragraph (c) of this section 
does not apply, however, for purposes of section 881(b). In the case of 
a possession or territory that administers income tax laws that are 
identical (except for the substitution of the name of the possession or 
territory for the term ``United States'' where appropriate) to those in 
force in the United States, these rules do not apply for purposes of the 
application of such laws.
    (b) In general. Except as provided in paragraphs (c) and (d) of this 
section, the principles of section 864(c) and the regulations under that 
section (relating to the determination of income, gain or loss that is 
effectively connected with the conduct of a trade or business within the 
United States) generally will be applied in determining whether income 
is effectively connected with the conduct of a trade or business within 
the relevant possession, without regard to whether the taxpayer 
qualifies as a nonresident alien individual or a foreign corporation 
with respect to such possession. Subject to the rules of this section, 
the principles of section 864(c)(4) will apply for purposes of 
determining whether income from sources without the relevant possession 
is effectively connected with the conduct of a trade or business in the 
relevant possession. For purposes of the preceding sentence, all income 
other than income from sources within the relevant possession (as 
determined under the rules of Sec. 1.937-2) will be considered income 
from sources without the relevant possession in the application of the 
principles of section 864(c) under this paragraph (b), it generally will 
be sufficient to substitute the name of the relevant possession for the 
term ``United States'' where appropriate, but additional substitutions 
may be necessary to accomplish the intent of section 937(b) and this 
section. In no case, however, will a bona fide resident or other person 
have, as a result of the application of these principles, more income 
effectively connected with the conduct of a trade or business in the 
relevant possession than the amount of U.S. effectively connected income 
that a similarly situated U.S. person who is not a bona fide resident 
would have under section 864(c).
    (c) U.S. income--(1) In general. Except as provided in paragraph (d) 
of this section, income considered to be effectively connected with the 
conduct of a trade or business within the relevant possession will not 
include any item of income determined under the rules of

[[Page 157]]

sections 861 through 865 and the regulations under those provisions to 
be--
    (i) From sources within the United States; or
    (ii) Effectively connected with the conduct of a trade or business 
within the United States.
    (2) Conduit arrangements. Income will be considered to be from 
sources within the United States for purposes of paragraph (c)(1) of 
this section if, pursuant to a plan or arrangement--
    (i) The income is received in exchange for consideration provided to 
another person; and
    (ii) Such person (or another person) provides the same consideration 
(or consideration of a like kind) to a third person in exchange for one 
or more payments constituting income from sources within the United 
States.
    (d) Income from certain sales of inventory property. Paragraph (c) 
of this section will not apply to income from sales of inventory 
property described in Sec. 1.863-3(e).
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

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

[[Page 158]]

United States for other purposes of the Internal Revenue Code under 
generally applicable conduit principles will depend on the facts and 
circumstances. See, for example, Aiken Indus., Inc. v. Commissioner, 56 
T.C. 925 (1971).
    (iii) If Possession I administers income tax laws that are identical 
(except for the substitution of the name of the possession for the term 
``United States'' where appropriate) to those in force in the United 
States, the interest received by G may be treated as income effectively 
connected with the conduct of a trade or business in Possession I under 
mirrored section 864(c)(4) for purposes of determining the Possession I 
territorial income tax liability of N under mirrored section 871.
    Example 4. (i) Corporation A, a corporation organized in Possession 
X, is engaged in a business consisting of the development of computer 
software and the sale of that software. Corporation A has its sole place 
of business in Possession X and is not engaged in the conduct of a trade 
or business in the United States. Corporation A receives orders for its 
software from customers in the United States and around the world. After 
orders are accepted, Corporation A's software is either loaded onto 
compact discs at Corporation A's Possession X facility and shipped via 
common carrier, or downloaded from Corporation A's server in Possession 
X. The sales contract provides that the rights, title, and interest in 
the product will pass from Corporation A to the customer either at 
Corporation A's place of business in Possession X (if shipped in compact 
disc form) or at Corporation A's server in Possession X (if 
electronically downloaded). Assume for purposes of this example that 
each transaction is classified as a sale of a copyrighted article under 
Sec. 1.861-18(c)(1)(ii) and (f)(2).
    (ii) Under the principles of section 863(a), as applied pursuant to 
Sec. 1.937-2(b), because Corporation A passes the rights, title, and 
interest to the copyrighted articles in Possession X, Corporation A's 
sales income is sourced to Possession X. Corporation A's sales income is 
also effectively connected with the conduct of a trade or business in 
Possession X, under the principles of section 864(c)(3) as applied 
pursuant to Sec. 1.937-3(b). Corporation A's income is not from sources 
within the United States, nor is it effectively connected with the 
conduct of a trade or business in the United States. Accordingly, the 
U.S. income rule of section 937(b)(2), Sec. 1.937-2(c)(1), and 
paragraph (c)(1) of this section does not operate to prevent Corporation 
A's sales income from being Possession X source and Possession X 
effectively connected income under section 937(b)(1).
    Example 5. (i) Corporation B, a corporation organized in Possession 
X, has its sole place of business in Possession X and is not engaged in 
the conduct of a trade or business in the United States. Corporation B 
employs a software business model generally referred to as an 
application service provider. Employees of Corporation B in Possession X 
develop software and maintain it on Corporation B's server in Possession 
X. Corporation B's customers in the United States and around the world 
transmit detailed data about their own customers to Corporation B's 
server and electronic storage facility in Possession X. The customers 
pay a monthly fee to Corporation B under a Subscription Agreement, and 
they can use the software to generate reports analyzing the data at any 
time but do not receive a copy of the software. Corporation B's software 
allows its customers to generate the reports from their location and to 
keep track of their relationships with their own customers. Assume for 
purposes of this example that Corporation B's income from these 
transactions is derived from the provision of services.
    (ii) Under the principles of section 861(a)(3) and Sec. 1.861-4(a), 
as applied pursuant to Sec. 1.937-2(b), because Corporation B performs 
personal services wholly within Possession X, the compensation 
Corporation B receives for services is sourced to Possession X. 
Corporation B's services income is also effectively connected with the 
conduct of a trade or business in Possession X, under the principles of 
section 864(c)(3) as applied pursuant to Sec. 1.937-3(b). Corporation 
B's income is not from sources within the United States, nor is it 
effectively connected with the conduct of a trade or business in the 
United States. Accordingly, the U.S. income rule of section 937(b)(2), 
Sec. 1.937-2(c)(1), and paragraph (c)(1) of this section does not 
operate to prevent Corporation B's services income from being Possession 
X source or Possession X effectively connected income within the meaning 
of section 937(b)(1).

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

[T.D. 9391, 73 FR 19374, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 
27728, May 14, 2008; T.D. 9921, 85 FR 79853, Dec. 11, 2020]

                     controlled foreign corporations



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

    (a) In general. If a foreign corporation is a controlled foreign 
corporation (within the meaning of section 957) at any time during any 
taxable year of such corporation, every person--

[[Page 159]]

    (1) Who is a United States shareholder (as defined in section 951(b) 
and paragraph (g) of this section) of such corporation at any time 
during such taxable year, and
    (2) Who owns (within the meaning of section 958(a)) stock in such 
corporation on the last day, in such year, on which such corporation is 
a controlled foreign corporation shall include in his gross income for 
his taxable year in which or with which such taxable year of the 
corporation ends, the sum of--
    (i) Such shareholder's pro rata share (determined under paragraph 
(b) of this section) of the corporation's subpart F income (as defined 
in section 952) for such taxable year of the corporation,
    (ii) Such shareholder's pro rata share (determined under paragraph 
(c)(1) of this section) of the corporation's previously excluded subpart 
F income withdrawn from investment in less developed countries for such 
taxable year of the corporation,
    (iii) Such shareholder's pro rata share (determined under paragraph 
(c)(2) of this section) of the corporation's previously excluded subpart 
F income withdrawn from investment in foreign base company shipping 
operations for such taxable year of the corporation, and
    (iv) The amount determined under section 956 with respect to such 
shareholder for such taxable year of the corporation (but only to the 
extent not excluded from gross income under section 959(a)(2)).
    (3) For purposes of determining whether a United States shareholder 
which is a domestic corporation is a personal holding company under 
section 542 and Sec. 1.542-1, the character of the amount includible in 
gross income of such domestic corporation under this paragraph shall be 
determined as if such amount were realized directly by such corporation 
from the source from which it is realized by the controlled foreign 
corporation. See paragraph (a) of Sec. 1.957-2 for special limitation 
on the amount of subpart F income in the case of a controlled foreign 
corporation described in section 957(b). See section 970(a) and Sec. 
1.970-1 which provides for the reduction of subpart F income of export 
trade corporations.
    (b) Limitation on a United States shareholder's pro rata share of 
subpart F income--(1) In general. For purposes of paragraph (a)(2)(i) of 
this section, a United States shareholder's pro rata share (determined 
in accordance with the rules of paragraph (e) of this section) of the 
foreign corporation's subpart F income for the taxable year of such 
corporation is--
    (i) The amount which would have been distributed with respect to the 
stock which such shareholder owns (within the meaning of section 958(a)) 
in such corporation if on the last day, in such corporation's taxable 
year, on which such corporation is a controlled foreign corporation it 
had distributed pro rata to its shareholders an amount which bears the 
same ratio to its subpart F income for such taxable year as the part of 
such year during which such corporation is a controlled foreign 
corporation bears to the entire taxable year, reduced by--
    (ii) The lesser of--
    (A) The amount of distributions received by any other person during 
such taxable year as a dividend with respect to such stock multiplied by 
a fraction, the numerator of which is the subpart F income of such 
corporation for the taxable year and the denominator of which is the sum 
of the subpart F income and the tested income (as defined in section 
951A(c)(2)(A) and Sec. 1.951A-2(b)(1)) of such corporation for the 
taxable year, and
    (B) The dividend which would have been received by such other person 
if the distributions by such corporation to all its shareholders had 
been the amount which bears the same ratio to the subpart F income of 
such corporation for the taxable year as the part of such year during 
which such shareholder did not own (within the meaning of section 
958(a)) such stock bears to the entire taxable year.
    (2) Examples. The following examples illustrate the application of 
this paragraph (b).
    (i) Facts. The following facts are assumed for purposes of the 
examples.
    (A) A is a United States shareholder.
    (B) M is a foreign corporation that has only one class of stock 
outstanding.

[[Page 160]]

    (C) B is a nonresident alien individual, and stock owned by B is not 
considered owned by a domestic entity under section 958(b).
    (D) P and R are foreign corporations.
    (E) All persons use the calendar year as their taxable year.
    (F) Year 1 ends on or after October 3, 2018, and has 365 days.
    (ii) Example 1--(A) Facts. A owns 100% of the stock of M throughout 
Year 1. For Year 1, M derives $100x of subpart F income, has $100x of 
earnings and profits, and makes no distributions.
    (B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this 
section, A's pro rata share of the subpart F income of M for Year 1 is 
$100x.
    (iii) Example 2--(A) Facts. The facts are the same as in paragraph 
(b)(2)(ii)(A) of this section (the facts in Example 1), except that 
instead of holding 100% of the stock of M for the entire year, A sells 
60% of such stock to B on May 26, Year 1. Thus, M is a controlled 
foreign corporation for the period January 1, Year 1, through May 26, 
Year 1.
    (B) Analysis. Under section 951(a)(2)(A) and paragraph (b)(1)(i) of 
this section, A's pro rata share of the subpart F income of M is limited 
to the subpart F income of M which bears the same ratio to its subpart F 
income for such taxable year ($100x) as the part of such year during 
which M is a controlled foreign corporation bears to the entire taxable 
year (146/365). Accordingly, under section 951(a)(2) and paragraph 
(b)(1) of this section, A's pro rata share of the subpart F income of M 
for Year 1 is $40x ($100x x 146/365).
    (iv) Example 3--(A) Facts. The facts are the same as in paragraph 
(b)(2)(ii)(A) of this section (the facts in Example 1), except that 
instead of holding 100% of the stock of M for the entire year, A holds 
60% of such stock on December 31, Year 1, having acquired such stock on 
May 26, Year 1, from B, who owned such stock from January 1, Year 1. 
Before A's acquisition of the stock, M had distributed a dividend of 
$15x to B in Year 1 with respect to the stock so acquired by A. M has no 
tested income for Year 1.
    (B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this 
section, A's pro rata share of the subpart F income of M for Year 1 is 
$21x, such amount being determined as follows:

                   Table 1 to paragraph (b)(2)(iv)(B)
 
 
 
M's subpart F income for Year 1.................................   $100x
Less: Reduction under section 951(a)(2)(A) for period (1-1           40x
 through 5-26) during which M is not a controlled foreign
 corporation ($100x x 146/365)..................................
Subpart F income for Year 1 as limited by section 951(a)(2)(A)..     60x
A's pro rata share of subpart F income as determined under           36x
 section 951(a)(2)(A) (0.6 x $60x)..............................
Less: Reduction under section 951(a)(2)(B) for dividends
 received by B during Year 1 with respect to the stock of M
 acquired by A:
  (i) Dividend received by B ($15x), multiplied by a         15x
   fraction ($100x/$100x), the numerator of which is the
   subpart F income of such corporation for the taxable
   year ($100x) and the denominator of which is the sum
   of the subpart F income and the tested income of such
   corporation for the taxable year ($100x) ($15x x
   ($100x/$100x)).......................................
  (ii) B's pro rata share (60%) of the amount which          24x
   bears the same ratio to the subpart F income of such
   corporation for the taxable year ($100x) as the part
   of such year during which A did not own (within the
   meaning of section 958(a)) such stock bears to the
   entire taxable year (146/365) (0.6 x $100x x (146/
   365))................................................
  (iii) Amount of reduction under section 951(a)(2)(B)               15x
   (lesser of (i) or (ii))..............................
A's pro rata share of subpart F income as determined under           21x
 section 951(a)(2)..............................................
 

    (v) Example 4--(A) Facts. A owns 100% of the only class of stock of 
P throughout Year 1, and P owns 100% of the only class of stock of R 
throughout Year 1. For Year 1, R derives $100x of subpart F income, has 
$100x of earnings and profits, and distributes a dividend of $20x to P. 
R has no gross tested income. P has no income for Year 1 other than the 
dividend received from R.
    (B) Analysis. Under section 951(a)(2) and paragraph (b)(1) of this 
section, A's pro rata share of the subpart F income of R for Year 1 is 
$100x. A's pro rata share of the subpart F income of R is

[[Page 161]]

not reduced under section 951(a)(2)(B) and paragraph (b)(1)(ii) of this 
section for the dividend of $20x paid to P because there was no part of 
Year 1 during which A did not own (within the meaning of section 958(a)) 
the stock of R. Under section 959(b), the $20x distribution from R to P 
is not again includible in the gross income of A under section 951(a). 
The $20x distribution from R to P is not includible in the gross tested 
income of P.
    (vi) Example 5--(A) Facts. The facts are the same as in paragraph 
(b)(2)(v)(A) of this section (the facts in Example 4), except that 
instead of holding 100% of the stock of R for the entire year, P holds 
60% of such stock on December 31, Year 1, having acquired such stock on 
March 14, Year 1, from B. Before P's acquisition of the stock, R had 
distributed a dividend of $100x to B in Year 1 with respect to the stock 
so acquired by P. The stock interest so acquired by P was owned by B 
from January 1, Year 1, until acquired by P. R also has $300x of tested 
income for Year 1.
    (B) Analysis--(1) Limitation of pro rata share of subpart F income. 
Under section 951(a)(2) and paragraph (b)(1) of this section, A's pro 
rata share of the subpart F income of M for Year 1 is $28x, such amount 
being determined as follows:

                  Table 1 to paragraph (b)(2)(vi)(B)(1)
 
 
 
R's subpart F income for Year 1.................................   $100x
Less: Reduction under section 951(a)(2)(A) for period (1-1           20x
 through 3-14) during which R is not a controlled foreign
 corporation ($100x x 73/365)...................................
Subpart F income for Year 1 as limited by section 951(a)(2)(A)..     80x
A's pro rata share of subpart F income as determined under           48x
 section 951(a)(2)(A) (0.6 x $80x)..............................
Less: Reduction under section 951(a)(2)(B) for dividends
 received by B during Year 1 with respect to the stock of R
 indirectly acquired by A:
  (i) Dividend received by B ($100x) multiplied by a         25x
   fraction ($100x/$400x), the numerator of which is the
   subpart F income of such corporation for the taxable
   year ($100x) and the denominator of which is the sum
   of the subpart F income and the tested income of such
   corporation for the taxable year ($400x) ($100x x
   ($100x/$400x)).......................................
  (ii) B's pro rata share (60%) of the amount which          12x
   bears the same ratio to the subpart F income of such
   corporation for the taxable year ($100x) as the part
   of such year during which A did not own (within the
   meaning of section 958(a)) such stock bears to the
   entire taxable year (73/365) (0.6 x $100x x (73/365))
  (iii) Amount of reduction under section 951(a)(2)(B)               12x
   (lesser of (i) or (ii))..............................
A's pro rata share of subpart F income as determined under           36x
 section 951(a)(2)..............................................
 

    (2) Limitation of pro rata share of tested income. Under section 
951A(e)(1) and Sec. 1.951A-1(d)(2), A's pro rata share of the tested 
income of M for Year 1 is $108x, such amount being determined as 
follows:

                  Table 1 to paragraph (b)(2)(vi)(B)(2)
 
 
 
R's tested income for Year 1....................................   $300x
Less: Reduction under section 951(a)(2)(A) for period (1-1           60x
 through 3-14) during which R is not a controlled foreign
 corporation ($300x x 73/365)...................................
Tested income for Year 1 as limited by under section                240x
 951(a)(2)(A)...................................................
A's pro rata share of tested income as determined under Sec. 144x
 1.951A-1(d)(2) (0.6 x $240x)...................................
Less: Reduction under section 951(a)(2)(B for dividends received
 by B during Year 1 with respect to the stock of R indirectly
 acquired by A:

[[Page 162]]

 
  (i) Dividend received by B ($100x) multiplied by a         75x
   fraction ($300x/$400x), the numerator of which is the
   tested income of such corporation for the taxable
   year ($300x) and the denominator of which is the sum
   of the subpart F income and the tested income of such
   corporation for the taxable year ($400x) ($100x x
   ($300x/$400x)).......................................
  (ii) B's pro rata share (60%) of the amount which          36x
   bears the same ratio to the tested income of such
   corporation for the taxable year ($300x) as the part
   of such year during which A did not own (within the
   meaning of section 958(a)) such stock bears to the
   entire taxable year (73/365) (0.6 x $300x x (73/365))
  (iii) Amount of reduction under section 951(a)(2)(B)               36x
   (lesser of (i) or (ii))..............................
A's pro rata share of tested income under section 951A(e)(1)....    108x
 

    (c)-(d) [Reserved]
    (e) Pro rata share of subpart F income defined--(1) In general--(i) 
Hypothetical distribution. For purposes of paragraph (b) of this 
section, a United States shareholder's pro rata share of a controlled 
foreign corporation's subpart F income for a taxable year is the amount 
that bears the same ratio to the corporation's subpart F income for the 
taxable year as the amount of the corporation's allocable earnings and 
profits that would be distributed with respect to the stock of the 
corporation which the United States shareholder owns (within the meaning 
of section 958(a)) for the taxable year bears to the total amount of the 
corporation's allocable earnings and profits that would be distributed 
with respect to the stock owned by all the shareholders of the 
corporation if all the allocable earnings and profits of the corporation 
for the taxable year (not reduced by actual distributions during the 
year) were distributed (hypothetical distribution) on the last day of 
the corporation's taxable year on which such corporation is a controlled 
foreign corporation (hypothetical distribution date).
    (ii) Definition of allocable earnings and profits. For purposes of 
this paragraph (e), the term allocable earnings and profits means, with 
respect to a controlled foreign corporation for a taxable year, the 
amount that is the greater of--
    (A) The earnings and profits of the corporation for the taxable year 
determined under section 964; and
    (B) The sum of the subpart F income (as determined under section 952 
after the application of section 951A(c)(2)(B)(ii) and Sec. 1.951A-
6(b)) of the corporation for the taxable year and the tested income (as 
defined in section 951A(c)(2)(A) and Sec. 1.951A-2(b)(1)) of the 
corporation for the taxable year.
    (2) One class of stock. If a controlled foreign corporation for a 
taxable year has only one class of stock outstanding on the hypothetical 
distribution date, the amount of the corporation's allocable earnings 
and profits distributed in the hypothetical distribution with respect to 
each share in the class of stock is determined as if the hypothetical 
distribution were made pro rata with respect to each share in the class 
of stock.
    (3) More than one class of stock. If a controlled foreign 
corporation for a taxable year has more than one class of stock 
outstanding on the hypothetical distribution date, the amount of the 
corporation's allocable earnings and profits distributed in the 
hypothetical distribution with respect to each class of stock is 
determined based on the distribution rights of each class of stock on 
the hypothetical distribution date, which amount is then further 
distributed pro rata with respect to each share in the class of stock. 
Subject to paragraphs (e)(4) through (6) of this section, the 
distribution rights of a class of stock are determined taking into 
account all facts and circumstances related to the economic rights and 
interest in the allocable earnings and profits of the corporation of 
each class, including the terms of the class of stock, any agreement 
among the shareholders and, if and to the extent appropriate, the 
relative fair market value of shares of stock. For purposes of this 
paragraph (e)(3), facts and circumstances do not include actual 
distributions (including distributions by redemption) or any

[[Page 163]]

amount treated as a dividend under any other provision of subtitle A of 
the Internal Revenue Code (for example, under section 78, 356(a)(2), 
367(b), or 1248) made during the taxable year that includes the 
hypothetical distribution date.
    (4) Special rules--(i) Redemptions, liquidations, and returns of 
capital. No amount of allocable earnings and profits is distributed in 
the hypothetical distribution with respect to a particular class of 
stock based on the terms of the class of stock of the controlled foreign 
corporation or any agreement or arrangement with respect thereto that 
would result in a redemption (even if such redemption would be treated 
as a distribution of property to which section 301 applies pursuant to 
section 302(d)), a distribution in liquidation, or a return of capital.
    (ii) Certain cumulative preferred stock. If a controlled foreign 
corporation has outstanding a class of redeemable preferred stock with 
cumulative dividend rights and dividend arrearages on such stock do not 
compound at least annually at a rate that equals or exceeds the 
applicable Federal rate (as defined in section 1274(d)(1)) that applies 
on the date the stock is issued for the term from such issue date to the 
mandatory redemption date based on a comparable compounding assumption 
(the relevant AFR), the amount of the corporation's allocable earnings 
and profits distributed in the hypothetical distribution with respect to 
the class of stock may not exceed the amount of dividends actually paid 
during the taxable year with respect to the class of stock plus the 
present value at the end of the controlled foreign corporation's taxable 
year of the unpaid current dividends with respect to the class 
determined using the relevant AFR and assuming the dividends will be 
paid at the mandatory redemption date. For purposes of this paragraph 
(e)(4)(ii), if the class of preferred stock does not have a mandatory 
redemption date, the mandatory redemption date is the date that the 
class of preferred stock is expected to be redeemed based on all facts 
and circumstances.
    (iii) Dividend arrearages. If there is an arrearage in dividends for 
prior taxable years with respect to a class of preferred stock of a 
controlled foreign corporation, an amount of the corporation's allocable 
earnings and profits is distributed in the hypothetical distribution to 
the class of preferred stock by reason of the arrearage only to the 
extent the arrearage exceeds the accumulated earnings and profits of the 
controlled foreign corporation remaining from prior taxable years 
beginning after December 31, 1962, as of the beginning of the taxable 
year, or the date on which such stock was issued, whichever is later 
(the applicable date). If there is an arrearage in dividends for prior 
taxable years with respect to more than one class of preferred stock, 
the previous sentence is applied to each class in order of priority, 
except that the accumulated earnings and profits remaining after the 
applicable date are reduced by the allocable earnings and profits 
necessary to satisfy arrearages with respect to classes of stock with a 
higher priority. For purposes of this paragraph (e)(4)(iii), the amount 
of any arrearage with respect to stock described in paragraph (e)(4)(ii) 
of this section is determined in the same manner as the present value of 
unpaid current dividends on such stock under paragraph (e)(4)(ii) of 
this section.
    (5) Restrictions or other limitations on distributions--(i) In 
general. A restriction or other limitation on distributions of an amount 
of earnings and profits by a controlled foreign corporation is not taken 
into account in determining the amount of the corporation's allocable 
earnings and profits distributed in a hypothetical distribution to a 
class of stock of the controlled foreign corporation.
    (ii) Definition. For purposes of paragraph (e)(5)(i) of this 
section, a restriction or other limitation on distributions includes any 
limitation that has the effect of limiting the distribution of an amount 
of earnings and profits by a controlled foreign corporation with respect 
to a class of stock of the corporation, other than currency or other 
restrictions or limitations imposed under the laws of any foreign 
country as provided in section 964(b).
    (iii) Exception for certain preferred distributions. For purposes of 
paragraph

[[Page 164]]

(e)(5)(i) of this section, the right to receive periodically a fixed 
amount (whether determined by a percentage of par value, a reference to 
a floating coupon rate, a stated return expressed in terms of a certain 
amount of U.S. dollars or foreign currency, or otherwise) with respect 
to a class of stock the distribution of which is a condition precedent 
to a further distribution of earnings and profits that year with respect 
to any class of stock (not including a distribution in partial or 
complete liquidation) is not a restriction or other limitation on the 
distribution of earnings and profits by a controlled foreign 
corporation.
    (iv) Illustrative list of restrictions and limitations. Except as 
provided in paragraph (e)(5)(iii) of this section, restrictions or other 
limitations on distributions include, but are not limited to--
    (A) An arrangement that restricts the ability of a controlled 
foreign corporation to pay dividends on a class of stock of the 
corporation until a condition or conditions are satisfied (for example, 
until another class of stock is redeemed);
    (B) A loan agreement entered into by a controlled foreign 
corporation that restricts or otherwise affects the ability to make 
distributions on its stock until certain requirements are satisfied; or
    (C) An arrangement that conditions the ability of a controlled 
foreign corporation to pay dividends to its shareholders on the 
financial condition of the corporation.
    (6) Transactions and arrangements with a principal purpose of 
changing pro rata shares. Appropriate adjustments must be made to the 
allocation of allocable earnings and profits that would be distributed 
(without regard to this paragraph (e)(6)) in a hypothetical distribution 
with respect to any share of stock outstanding as of the hypothetical 
distribution date to disregard the effect on the hypothetical 
distribution of any transaction or arrangement that is undertaken as 
part of a plan a principal purpose of which is the avoidance of Federal 
income taxation by changing the amount of allocable earnings and profits 
distributed in any hypothetical distribution with respect to such share. 
This paragraph (e)(6) also applies for purposes of the pro rata share 
rules described in Sec. 1.951A-1(d) that reference this paragraph (e), 
including the rules in Sec. 1.951A-1(d)(3) that determine the pro rata 
share of qualified business asset investment based on the pro rata share 
of tested income.
    (7) Examples. The following examples illustrate the application of 
this paragraph (e).
    (i) Facts. Except as otherwise stated, the following facts are 
assumed for purposes of the examples:
    (A) FC1 is a controlled foreign corporation.
    (B) USP1 and USP2 are domestic corporations.
    (C) Individual A is a foreign individual, and FC2 is a foreign 
corporation that is not a controlled foreign corporation.
    (D) All persons use the calendar year as their taxable year.
    (E) Any ownership of FC1 by any shareholder is for all of Year 1.
    (F) The common shareholders of FC1 are entitled to dividends when 
declared by FC1's board of directors.
    (G) There are no accrued but unpaid dividends with respect to 
preferred shares, the preferred stock is not described in paragraph 
(e)(4)(ii) of this section, and common shares have positive liquidation 
value.
    (H) There are no other facts and circumstances related to the 
economic rights and interest of any class of stock in the allocable 
earnings and profits of a foreign corporation, and no transaction or 
arrangement was entered into as part of a plan a principal purpose of 
which is the avoidance of Federal income taxation.
    (I) FC1 has neither tested income within the meaning of section 
951A(c)(2)(A) and Sec. 1.951A-2(b)(1) nor tested loss within the 
meaning of section 951A(c)(2)(B)(i) and Sec. 1.951A-2(b)(2).
    (ii) Example 1: Single class of stock--(A) Facts. FC1 has 
outstanding 100 shares of one class of stock. USP1 owns 60 shares of 
FC1. USP2 owns 40 shares of FC1. For Year 1, FC1 has $1,000x of earnings 
and profits and $100x of subpart F income within the meaning of section 
952.
    (B) Analysis. FC1 has one class of stock. Therefore, under paragraph 
(e)(2) of this section, FC1's allocable

[[Page 165]]

earnings and profits of $1,000x are distributed in the hypothetical 
distribution pro rata to each share of stock. Accordingly, under 
paragraph (e)(1) of this section, for Year 1, USP1's pro rata share of 
FC1's subpart F income is $60x ($100x x $600x/$1,000x) and USP2's pro 
rata share of FC1's subpart F income is $40x ($100x x $400x/$1,000x).
    (iii) Example 2: Common and preferred stock--(A) Facts. FC1 has 
outstanding 70 shares of common stock and 30 shares of 4% 
nonparticipating, voting preferred stock with a par value of $10x per 
share. USP1 owns all of the common shares. Individual A owns all of the 
preferred shares. For Year 1, FC1 has $100x of earnings and profits and 
$50x of subpart F income within the meaning of section 952.
    (B) Analysis. The distribution rights of the preferred shares are 
not a restriction or other limitation within the meaning of paragraph 
(e)(5) of this section. Under paragraph (e)(3) of this section, the 
amount of FC1's allocable earnings and profits distributed in the 
hypothetical distribution with respect to Individual A's preferred 
shares is $12x (0.04 x $10x x 30) and with respect to USP1's common 
shares is $88x ($100x-$12x). Accordingly, under paragraph (e)(1) of this 
section, USP1's pro rata share of FC1's subpart F income is $44x ($50x - 
$88x/$100x) for Year 1.
    (iv) Example 3: Restriction based on cumulative income--(A) Facts. 
FC1 has outstanding 10 shares of common stock and 400 shares of 2% 
nonparticipating, voting preferred stock with a par value of $1x per 
share. USP1 owns all of the common shares. FC2 owns all of the preferred 
shares. USP1 and FC2 cause the governing documents of FC1 to provide 
that no dividends may be paid to the common shareholders until FC1 
cumulatively earns $100,000x of income. For Year 1, FC1 has $50x of 
earnings and profits and $50x of subpart F income within the meaning of 
section 952.
    (B) Analysis. The agreement restricting FC1's ability to pay 
dividends to common shareholders until FC1 cumulatively earns $100,000x 
of income is a restriction or other limitation within the meaning of 
paragraph (e)(5) of this section. Therefore, the restriction is 
disregarded for purposes of determining the amount of FC1's allocable 
earnings and profits distributed in the hypothetical distribution to a 
class of stock. The distribution rights of the preferred shares are not 
a restriction or other limitation within the meaning of paragraph (e)(5) 
of this section. Under paragraph (e)(3) of this section, the amount of 
FC1's allocable earnings and profits distributed in the hypothetical 
distribution with respect to FC2's preferred shares is $8x (0.02 x $1x x 
400) and with respect to USP1's common shares is $42x ($50x - $8x). 
Accordingly, under paragraph (e)(1) of this section, USP1's pro rata 
share of FC1's subpart F income is $42x for Year 1.
    (v) Example 4: Redemption rights--(A) Facts. FC1 has outstanding 40 
shares of common stock and 10 shares of 4% nonparticipating, preferred 
stock with a par value of $50x per share. Pursuant to the terms of the 
preferred stock, FC1 has the right to redeem at any time, in whole or in 
part, the preferred stock. FC2 owns all of the preferred shares. USP1, 
wholly owned by FC2, owns all of the common shares. Pursuant to the 
governing documents of FC1, no dividends may be paid to the common 
shareholders while the preferred stock is outstanding. For Year 1, FC1 
has $100x of earnings and profits and $100x of subpart F income within 
the meaning of section 952.
    (B) Analysis. The agreement restricting FC1's ability to pay 
dividends to common shareholders while the preferred stock is 
outstanding is a restriction or other limitation within the meaning of 
paragraph (e)(5) of this section. Therefore, the restriction is 
disregarded for purposes of determining the amount of FC1's allocable 
earnings and profits distributed in the hypothetical distribution to a 
class of stock. Under paragraph (e)(4)(i) of this section, no amount of 
allocable earnings and profits is distributed in the hypothetical 
distribution to the preferred shareholders on the hypothetical 
distribution date as a result of FC1's right to redeem the preferred 
shares. This is the case regardless of the restriction on paying 
dividends to the common shareholders while the preferred stock is 
outstanding, and regardless of the fact that a redemption of FC2's 
preferred shares would be treated

[[Page 166]]

as a distribution to which section 301 applies under section 302(d) (due 
to FC2's constructive ownership of the common shares). Thus, neither the 
restriction on paying dividends to the common shareholders while the 
preferred stock is outstanding nor FC1's redemption rights with respect 
to the preferred shares affects the distribution of allocable earnings 
and profits in the hypothetical distribution to FC1's shareholders. 
However, the distribution rights of the preferred shares are not a 
restriction or other limitation within the meaning of paragraph (e)(5) 
of this section. As a result, the amount of FC1's allocable earnings and 
profits distributed in the hypothetical distribution with respect to 
FC2's preferred shares is $20x (0.04 x $50x x 10) and with respect to 
USP1's common shares is $80x ($100x-$20x). Accordingly, under paragraph 
(e)(1) of this section, USP1's pro rata share of FC1's subpart F income 
is $80x for Year 1.
    (vi) Example 5: Shareholder owns common and preferred stock--(A) 
Facts. FC1 has outstanding 40 shares of common stock and 60 shares of 6% 
nonparticipating, nonvoting preferred stock with a par value of $100x 
per share. USP1 owns 30 shares of the common stock and 15 shares of the 
preferred stock during Year 1. The remaining 10 shares of common stock 
and 45 shares of preferred stock of FC1 are owned by Individual A. For 
Year 1, FC1 has $1,000x of earnings and profits and $500x of subpart F 
income within the meaning of section 952.
    (B) Analysis. The right of the holder of the preferred stock to 
receive 6% of par value is not a restriction or other limitation within 
the meaning of paragraph (e)(5) of this section. The amount of FC1's 
allocable earnings and profits distributed in the hypothetical 
distribution with respect to FC1's preferred shares is $360x (0.06 x 
$100x x 60) and with respect to its common shares is $640x ($1,000x-
$360x). As a result, the amount of FC1's allocable earnings and profits 
distributed in the hypothetical distribution to USP1 is $570x, the sum 
of $90x ($360x x 15/60) with respect to its preferred shares and $480x 
($640x x 30/40) with respect to its common shares. Accordingly, under 
paragraph (e)(1) of this section, USP1's pro rata share of the subpart F 
income of FC1 is $285x ($500x x $570x/$1,000x).
    (vii) Example 6: Subpart F income and tested income--(A) Facts. FC1 
has outstanding 700 shares of common stock and 300 shares of 4% 
nonparticipating, voting preferred stock with a par value of $100x per 
share. USP1 owns all of the common shares. USP2 owns all of the 
preferred shares. For Year 1, FC1 has $10,000x of earnings and profits, 
$2,000x of subpart F income within the meaning of section 952, and 
$9,000x of tested income within the meaning of section 951A(c)(2)(A) and 
Sec. 1.951A-2(b)(1).
    (B) Analysis--(1) Hypothetical distribution. The allocable earnings 
and profits of FC1 determined under paragraph (e)(1)(ii) of this section 
are $11,000x, the greater of FC1's earnings and profits as determined 
under section 964 ($10,000x) or the sum of FC1's subpart F income and 
tested income ($2,000x + $9,000x). The amount of FC1's allocable 
earnings and profits distributed in the hypothetical distribution with 
respect to USP2's preferred shares is $1,200x (0.04 x $100x x 300) and 
with respect to USP1's common shares is $9,800x ($11,000x-$1,200x).
    (2) Pro rata share of subpart F income. Accordingly, under paragraph 
(e)(1) of this section, USP1's pro rata share of FC1's subpart F income 
is $1,782x ($2,000x x $9,800x/$11,000x), and USP2's pro rata share of 
FC1's subpart F income is $218x ($2,000x x $1,200x/$11,000x).
    (3) Pro rata share of tested income. Accordingly, under Sec. 
1.951A-1(d)(2), USP1's pro rata share of FC1's tested income is $8,018x 
($9,000x x $9,800x/$11,000x), and USP2's pro rata share of FC1's tested 
income is $982x ($9,000x x $1,200x/$11,000x) for Year 1.
    (viii) Example 7: Subpart F income and tested loss--(A) Facts. The 
facts are the same as in paragraph (e)(7)(vii)(A) of this section (the 
facts in Example 6), except that for Year 1, FC1 has $8,000x of earnings 
and profits, $10,000x of subpart F income within the meaning of section 
952 (but without regard to the limitation in section 952(c)(1)(A)), and 
$2,000x of tested loss within the meaning of section 951A(c)(2)(B)(i) 
and Sec. 1.951A-2(b)(2). Under section 951A(c)(2)(B)(ii) and Sec. 
1.951A-6(b), the earnings and profits of FC1 are increased for purposes 
of section

[[Page 167]]

952(c)(1)(A) by the amount of FC1's tested loss. Accordingly, after the 
application of section 951A(c)(2)(B)(ii) and Sec. 1.951A-6(b), the 
subpart F income of FC1 is $10,000x.
    (B) Analysis--(1) Pro rata share of subpart F income. The allocable 
earnings and profits determined under paragraph (e)(1)(ii) of this 
section are $10,000x, the greater of the earnings and profits of FC1 
determined under section 964 ($8,000x) or the sum of FC1's subpart F 
income and tested income ($10,000x + $0). The amount of FC1's allocable 
earnings and profits distributed in the hypothetical distribution with 
respect to USP2's preferred shares is $1,200x (.04 x $100x x 300) and 
with respect to USP1's common shares is $8,800x ($10,000x-$1,200x). 
Accordingly, under paragraph (e)(1) of this section, for Year 1, USP1's 
pro rata share of FC1's subpart F income is $8,800x and USP2's pro rata 
share of FC1's subpart F income is $1,200x.
    (2) Pro rata share of tested loss. The allocable earnings and 
profits determined under Sec. 1.951A-1(d)(4)(i)(B) are $2,000x, the 
amount of FC1's tested loss. Under Sec. 1.951A-1(d)(4)(i)(C), the 
entire $2,000x of tested loss is allocated in the hypothetical 
distribution to USP1's common shares. Accordingly, USP1's pro rata share 
of the tested loss is $2,000x.
    (f) Determination of holding period. For purposes of sections 951 
through 964, the holding period of an asset (including stock of a 
controlled foreign corporation) shall be determined by excluding the day 
on which such asset is acquired and including the day on which such 
asset is disposed of. The application of this paragraph may be 
illustrated by the following example:

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

    (g) United States shareholder defined--(1) In general. For purposes 
of sections 951 through 964, the term United States shareholder means, 
with respect to a foreign corporation, a United States person (as 
defined in section 957(c)) who owns within the meaning of section 
958(a), or is considered as owning by applying the rules of ownership of 
section 958(b), 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote of such foreign corporation, or 10 
percent or more of the total value of shares of all classes of stock of 
such foreign corporation.
    (2) Percentage of total combined voting power owned by United States 
person--(i) Meaning of combined voting power. In determining for 
purposes of subparagraph (1) of this paragraph whether a United States 
person owns the requisite percentage of voting power of all classes of 
stock entitled to vote, consideration will be given to all the facts and 
circumstances in each case. In any case where--
    (a) A foreign corporation has more than one class of stock 
outstanding, and
    (b) One or more United States persons own (within the meaning of 
section 958) shares of any one class of stock which possesses the power 
to elect, appoint, or replace a person, or persons, who with respect to 
such corporation, exercise the powers ordinarily exercised by a member 
of the board of directors of a domestic corporation, the percentage of 
the total combined voting power with respect to such corporation owned 
by any such United States person shall be his proportionate share of the 
percentage of the persons exercising the powers ordinarily exercised by 
members of the board of directors of a domestic corporation (described 
in (b) of this subdivision) which such class of stock (as a class) 
possesses the power to elect, appoint, or replace. In all cases, 
however, a United States person will be deemed to own 10 percent or more 
of the total combined voting power with respect to a foreign corporation 
if such person owns (within the meaning of section 958) 20 percent or 
more of the total number of shares of a class of

[[Page 168]]

stock of such corporation possessing one or more powers enumerated in 
paragraph (b)(1) of Sec. 1.957-1. Whether a foreign corporation is a 
controlled foreign corporation for purposes of sections 951 through 964 
shall be determined by applying the rules of section 957 and Sec. Sec. 
1.957-1 through 1.957-4.
    (ii) Illustration. The application of this paragraph may be 
illustrated by the following examples:

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

    (h) Special rule for partnership blocker structures--(1) In general. 
For purposes of sections 951 through 964, other than for purposes of 
951A, a controlled domestic partnership is treated as a foreign 
partnership in determining the stock of a controlled foreign corporation 
owned (within the meaning of section 958(a)) by a United States person 
if the following conditions are satisfied--
    (i) Without regard to paragraph (h) of this section, the controlled 
domestic partnership owns (within the meaning of section 958(a)) stock 
of a controlled foreign corporation; and
    (ii) If the controlled domestic partnership (and all other 
controlled domestic partnerships in the chain of ownership of the 
controlled foreign corporation) were treated as foreign--
    (A) The controlled foreign corporation would continue to be a 
controlled foreign corporation; and
    (B) At least one United States shareholder of the controlled foreign 
corporation would be treated as owning (within the meaning of section 
958(a)) stock of the controlled foreign corporation through another 
foreign corporation that is a direct or indirect partner in the 
controlled domestic partnership.
    (2) Definition of a controlled domestic partnership. For purposes of 
paragraph (h)(1) of this section, the term controlled domestic 
partnership means a domestic partnership that is controlled by a United 
States shareholder described in paragraph (h)(1)(ii)(B) of this section 
and persons related to the United States shareholder. For purposes of 
this paragraph (h)(2), control

[[Page 169]]

is determined based on all the facts and circumstances, except that a 
partnership will be deemed to be controlled by a United States 
shareholder and related persons in any case in which those persons, in 
the aggregate, own (directly or indirectly through one or more 
partnerships) more than 50 percent of the interests in the partnership 
capital or profits. For purposes of this paragraph (h)(2), a related 
person is, with respect to a United States shareholder, a person that is 
related to the United States shareholder within the meaning of section 
267(b) or 707(b)(1).
    (3) Example--(i) Facts. USP, a domestic corporation, owns all of the 
stock of CFC1 and CFC2. CFC1 and CFC2 own 60% and 40%, respectively, of 
the interests in the capital and profits of DPS, a domestic partnership. 
DPS owns all of the stock of CFC3. Each of CFC1, CFC2, and CFC3 is a 
controlled foreign corporation. USP, DPS, CFC1, CFC2, and CFC3 all use 
the calendar year as their taxable year. For Year 1, CFC3 has $100x of 
subpart F income and $100x of earnings and profits.
    (ii) Analysis. DPS is a controlled domestic partnership within the 
meaning of paragraph (h)(2) of this section because more than 50% of the 
interests in its capital or profits are owned by persons related to USP 
within the meaning of section 267(b) (that is, CFC1 and CFC2), and thus 
DPS is controlled by USP and related persons. The conditions of 
paragraph (h)(1) of this section are satisfied because, without regard 
to paragraph (h) of this section, DPS is a United States shareholder 
that owns (within the meaning of section 958(a)) stock of CFC3, a 
controlled foreign corporation, and if DPS were treated as foreign, CFC3 
would continue to be a controlled foreign corporation, and USP would be 
treated as owning (within the meaning of section 958(a)) stock of CFC3 
through CFC1 and CFC2, which are both partners in DPS. Thus, under 
paragraph (h)(1) of this section, DPS is treated as a foreign 
partnership for purposes of determining the stock of CFC3 owned (within 
the meaning of section 958(a)) by USP. Accordingly, USP's pro rata share 
of CFC3's subpart F income for Year 1 is $100x, and USP includes in its 
gross income $100x under section 951(a)(1)(A). DPS is not a United 
States shareholder of CFC3 for purposes of sections 951 through 964.
    (i) Applicability dates. Paragraphs (a), (b)(1)(ii), (b)(2), 
(e)(1)(ii)(B), and (g)(1) of this section apply to taxable years of 
foreign corporations beginning after December 31, 2017, and to taxable 
years of United States shareholders in which or with which such taxable 
years of foreign corporations end. Except for paragraph (e)(1)(ii)(B) of 
this section, paragraph (e) of this section applies to taxable years of 
United States shareholders ending on or after October 3, 2018. Paragraph 
(h) of this section applies to taxable years of domestic partnerships 
ending on or after May 14, 2010.

[T.D. 6795, 30 FR 935, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22507, May 19, 1983; T.D. 9222, 70 FR 49866, Aug. 25, 2005; 70 FR 67906, 
Nov. 9, 2005; T.D. 9251, 71 FR 8944, Feb. 22, 2006; T.D. 9866, 84 FR 
29337, June 21, 2019; 84 FR 44223, Aug. 23, 2019; 84 FR 53052, Oct. 4, 
2019]



Sec. 1.951-2  [Reserved]



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

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

[[Page 170]]

deemed to be that amount which bears the same ratio to its earnings and 
profits for the taxable year as such part of the taxable year bears to 
the entire taxable year. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 100 percent of the 
only class of stock of controlled foreign corporation M which, in turn, 
owns 100 percent of the only class of stock of controlled foreign 
corporation N. A and Corporations M and N use the calendar year as a 
taxable year. During 1963, N Corporation derives $40,000 of gross income 
all of which is foreign personal holding company income within the 
meaning of section 553; thus, N Corporation is a foreign personal 
holding company for such year within the meaning of section 552(a). For 
1963, N Corporation has undistributed foreign personal holding company 
income (as defined in section 556(a)) of $30,000, derives $25,000 of 
subpart F income, and has earnings and profits of $32,000. During 1963, 
M Corporation derives $100,000 of gross income (including as a dividend 
under section 555(c)(2) the $30,000 of N Corporation's undistributed 
foreign personal holding company income), 65 percent of which is foreign 
personal holding company income within the meaning of section 553. 
Therefore, M Corporation is a foreign personal holding company for such 
year. For 1963, M Corporation has undistributed foreign personal holding 
company income (as defined in section 556(a)) of $90,000, determined by 
taking into account under section 552(c)(1) N Corporation's $30,000 of 
undistributed foreign personal holding company income for such year; in 
addition, M Corporation derives $50,000 of subpart F income and has 
earnings and profits of $92,000. Neither M Corporation nor N Corporation 
makes any actual distributions during 1963. A is required under section 
551(b) to include in his gross income for 1963 as a dividend the $90,000 
of M Corporation's undistributed foreign personal holding company income 
for such year. For 1963, A is not required to include in his gross 
income under section 951(a) any of the $50,000 subpart F income of M 
Corporation or of the $25,000 subpart F income of N Corporation.
    Example 2. The facts are the same as in example 1, except that only 
45 percent of M Corporation's gross income (determined by including 
under section 555(c)(2) the $30,000 of N Corporation's undistributed 
foreign personal holding company income) is foreign personal holding 
company income within the meaning of section 553; accordingly, M 
Corporation is not a foreign personal holding company for 1963. Since 
for such year M Corporation is not a foreign personal holding company, 
the undistributed foreign personal holding company income ($30,000) of N 
Corporation is not required under section 555(b) to be included in the 
gross income of M Corporation for 1963; as a result, such income is not 
required under section 551(b) to be included in the gross income of A 
for such year even though N Corporation is a foreign personal holding 
company for that year. For 1963, A is required to include $75,000 in his 
gross income under section 951(a)(1)(A)(i) and paragraph (a) of Sec. 
1.951-1, consisting of the $50,000 subpart F income of M Corporation and 
the $25,000 subpart F income of N Corporation.
    Example 3. The facts are the same as in example 1, except that in 
1963 N Corporation actually distributes $30,000 to M Corporation and M 
Corporation, in turn, actually distributes $90,000 to A. Under section 
556 the undistributed foreign personal holding company income of both M 
corporation and N Corporation is thus reduced to zero; accordingly, no 
amount is included in the gross income of A under section 551(b) by 
reason of his interest in corporations M and N. A must include $75,000 
in his gross income for 1963 under section 951(a)(1)(A)(i) and paragraph 
(a) of Sec. 1.951-1, consisting of the $50,000 subpart F income of M 
Corporation and the $25,000 subpart F income of N Corporation. Of the 
$90,000 distribution received by A from M Corporation, $75,000 is 
excludable from his gross income under section 959(a)(1) as previously 
taxed earnings and profits; the remaining $15,000 is includible in his 
gross income for 1963 as a dividend.
    Example 4. (a) A, a United States shareholder, owns 100 percent of 
the only class of stock of controlled foreign corporation P, organized 
on January 1, 1963. Both A and P Corporation use the calendar year as a 
taxable year. During 1963, 1964, and 1965, P Corporation is not a 
foreign personal holding company as defined in section 552(a); in each 
of such years, P Corporation derives dividend income of $10,000 which 
constitutes foreign personal holding company income (within the meaning 
of Sec. 1.954-2) but under 26 CFR 1.954-1(b)(1) (Revised as of April 1, 
1975) excludes such amounts from foreign base company income as 
dividends received from, and reinvested in, qualified investments in 
less developed countries. Corporation P's earnings and profits 
accumulated for 1963, 1964, and 1965 and determined under paragraph 
(b)(2) of Sec. 1.955-1 are $40,000. For 1966, P Corporation is a 
foreign personal holding company, has predistribution earnings and 
profits of $10,000, derives $10,000 of income which is both foreign 
personal holding company income within the meaning of section 553 and 
subpart F income within the meaning of section 952, distributes $8,000 
to A, and has undistributed foreign personal holding company income of 
$2,000 within the meaning of

[[Page 171]]

section 556. In addition, for 1966 P Corporation has a withdrawal 
(determined under section 955(a) as in effect before the enactment of 
the Tax Reduction Act of 1975 but without regard to its earnings and 
profits for such year) of $25,000 of previously excluded subpart F 
income from investment in less developed countries. A is required under 
section 551(b) to include in his gross income for 1966 as a dividend the 
$2,000 undistributed foreign personal holding company income. The $8,000 
distribution is includible in A's gross income for 1966 under sections 
61(a)(7) and 301 as a distribution to which section 316(a)(2) applies. 
Corporation P's $25,000 withdrawal of previously excluded subpart F 
income from investment in less developed countries is includible in A's 
gross income for 1966 under section 951(a)(1)(A)(ii) and paragraph 
(a)(2) of Sec. 1.951-1.
    (b) If P Corporation's earnings and profits accumulated for 1963, 
1964, and 1965 were $15,000, instead of $40,000, the result would be the 
same as in paragraph (a) of this example, except that a withdrawal of 
only $15,000 of previously excluded subpart F income from investment in 
less developed countries would be includible in A's gross income for 
1966 under section 951(a)(1)(A)(ii) and paragraph (a)(2) of Sec. 1.951-
1.
    (c) The principles of this example also apply to withdrawals 
(determined under section 955(a), as in effect before the enactment of 
the Tax Reduction Act of 1975) of previously excluded subpart F income 
from investment in less developed countries effected after the effective 
date of such Act, and to withdrawals (determined under section 955(a), 
as amended by such Act) of previously excluded subpart F income from 
investment in foreign base company shipping operations.
    Example 5. (a) The facts are the same as in paragraph (a) of example 
4, except that, instead of having a $25,000 decrease in qualified 
investments in less developed countries for 1966, P Corporation invests 
$20,000 in tangible property (not described in section 956(b)(2)) 
located in the United States and such investment constitutes an increase 
(determined under section 956(a) but without regard to the earnings and 
profits of P Corporation for 1966) in earnings invested in United States 
property. Corporation P's earnings and profits accumulated for 1963, 
1964, and 1965 and determined under paragraph (b)(1) of Sec. 1.956-1 
are $22,000. The result is the same as in paragraph (a) of example 4, 
except that instead of including the $25,000 withdrawal, A must include 
$20,000 in his gross income for 1966 under section 951(a)(1)(B) and 
paragraph (a)(2)(iv) of Sec. 1.951-1 as an investment of earnings in 
United States property.
    (b) If P Corporation's earnings and profits accumulated for 1963, 
1964, and 1965 were $9,000 instead of $22,000, the result would be the 
same as in paragraph (a) of this example, except that only $9,000 would 
be includible in A's gross income for 1966 under section 951(a)(1)(B) 
and paragraph (a)(2)(iv) of Sec. 1.951-1 as an investment of earnings 
in United States property.

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



Sec. 1.951A-1  General provisions.

    (a) Overview--(1) In general. This section and Sec. Sec. 1.951A-2 
through 1.951A-7 (collectively, the section 951A regulations) provide 
rules to determine a United States shareholder's income inclusion under 
section 951A, describe certain consequences of an income inclusion under 
section 951A with respect to controlled foreign corporations and their 
United States shareholders, and define certain terms for purposes of 
section 951A and the section 951A regulations. This section provides 
general rules for determining a United States shareholder's inclusion of 
global intangible low-taxed income, including a rule relating to the 
application of section 951A and the section 951A regulations to domestic 
partnerships and their partners. Section 1.951A-2 provides rules for 
determining a controlled foreign corporation's tested income or tested 
loss. Section 1.951A-3 provides rules for determining a controlled 
foreign corporation's qualified business asset investment. Section 
1.951A-4 provides rules for determining a controlled foreign 
corporation's tested interest expense and tested interest income. 
Section 1.951A-5 provides rules relating to the treatment of the 
inclusion of global intangible low-taxed income for certain purposes. 
Section 1.951A-6 provides certain adjustments to earnings and profits 
and basis of a controlled foreign corporation related to a tested loss. 
Section 1.951A-7 provides dates of applicability.
    (2) Scope. Paragraph (b) of this section provides the general rule 
requiring a United States shareholder to include in gross income its 
global intangible low-taxed income for a U.S. shareholder inclusion 
year. Paragraph (c) of this section provides rules for determining the 
amount of a United States shareholder's global intangible low-taxed 
income for the U.S. shareholder inclusion year, including a rule for the 
application of section 951A and the section 951A regulations to 
consolidated

[[Page 172]]

groups. Paragraph (d) of this section provides rules for determining a 
United States shareholder's pro rata share of certain items for purposes 
of determining the United States shareholder's global intangible low-
taxed income. Paragraph (e) of this section provides rules for the 
treatment of a domestic partnership and its partners for purposes of 
section 951A and the section 951A regulations. Paragraph (f) of this 
section provides additional definitions for purposes of this section and 
the section 951A regulations.
    (b) Inclusion of global intangible low-taxed income. Each person who 
is a United States shareholder of any controlled foreign corporation and 
owns section 958(a) stock of any such controlled foreign corporation 
includes in gross income in the U.S. shareholder inclusion year the 
shareholder's GILTI inclusion amount, if any, for the U.S. shareholder 
inclusion year.
    (c) Determination of GILTI inclusion amount--(1) In general. Except 
as provided in paragraph (c)(4) of this section, the term GILTI 
inclusion amount means, with respect to a United States shareholder and 
a U.S. shareholder inclusion year, the excess (if any) of--
    (i) The shareholder's net CFC tested income (as defined in paragraph 
(c)(2) of this section) for the year, over
    (ii) The shareholder's net deemed tangible income return (as defined 
in paragraph (c)(3) of this section) for the year.
    (2) Definition of net CFC tested income. The term net CFC tested 
income means, with respect to a United States shareholder and a U.S. 
shareholder inclusion year, the excess (if any) of--
    (i) The aggregate of the shareholder's pro rata share of the tested 
income of each tested income CFC (as defined in Sec. 1.951A-2(b)(1)) 
for a CFC inclusion year that ends with or within the U.S. shareholder 
inclusion year, over
    (ii) The aggregate of the shareholder's pro rata share of the tested 
loss of each tested loss CFC (as defined in Sec. 1.951A-2(b)(2)) for a 
CFC inclusion year that ends with or within the U.S. shareholder 
inclusion year.
    (3) Definition of net deemed tangible income return--(i) In general. 
The term net deemed tangible income return means, with respect to a 
United States shareholder and a U.S. shareholder inclusion year, the 
excess (if any) of--
    (A) The shareholder's deemed tangible income return (as defined in 
paragraph (c)(3)(ii) of this section) for the U.S. shareholder inclusion 
year, over
    (B) The shareholder's specified interest expense (as defined in 
paragraph (c)(3)(iii) of this section) for the U.S. shareholder 
inclusion year.
    (ii) Definition of deemed tangible income return. The term deemed 
tangible income return means, with respect to a United States 
shareholder and a U.S. shareholder inclusion year, 10 percent of the 
aggregate of the shareholder's pro rata share of the qualified business 
asset investment (as defined in Sec. 1.951A-3(b)) of each tested income 
CFC for a CFC inclusion year that ends with or within the U.S. 
shareholder inclusion year.
    (iii) Definition of specified interest expense. The term specified 
interest expense means, with respect to a United States shareholder and 
a U.S. shareholder inclusion year, the excess (if any) of--
    (A) The aggregate of the shareholder's pro rata share of the tested 
interest expense (as defined in Sec. 1.951A-4(b)(1)) of each controlled 
foreign corporation for a CFC inclusion year that ends with or within 
the U.S. shareholder inclusion year, over
    (B) The aggregate of the shareholder's pro rata share of the tested 
interest income (as defined in Sec. 1.951A-4(b)(2)) of each controlled 
foreign corporation for a CFC inclusion year that ends with or within 
the U.S. shareholder inclusion year.
    (4) Determination of GILTI inclusion amount for consolidated groups. 
For purposes of section 951A and the section 951A regulations, a member 
of a consolidated group (as defined in Sec. 1.1502-1(h)) determines its 
GILTI inclusion amount taking into account the rules provided in Sec. 
1.1502-51.
    (d) Determination of pro rata share--(1) In general. For purposes of 
paragraph (c) of this section, each United States shareholder that owns 
section 958(a) stock of a controlled foreign corporation as of a 
hypothetical distribution date determines its pro rata share (if any) of 
each tested item of the controlled foreign corporation for the CFC

[[Page 173]]

inclusion year that includes the hypothetical distribution date and ends 
with or within the U.S. shareholder inclusion year. Except as otherwise 
provided in this paragraph (d), a United States shareholder's pro rata 
share of each tested item is determined independently of its pro rata 
share of each other tested item. In no case may the sum of the pro rata 
share of any tested item of a controlled foreign corporation for a CFC 
inclusion year allocated to stock under this paragraph (d) exceed the 
amount of such tested item of the controlled foreign corporation for the 
CFC inclusion year. Except as modified in this paragraph (d), a United 
States shareholder's pro rata share of any tested item is determined 
under the rules of section 951(a)(2) and Sec. 1.951-1(b) and (e) in the 
same manner as those provisions apply to subpart F income. Under section 
951(a)(2) and Sec. 1.951-1(b) and (e), as modified by this paragraph 
(d), a United States shareholder's pro rata share of any tested item for 
a U.S. shareholder inclusion year is determined with respect to the 
section 958(a) stock of the controlled foreign corporation owned by the 
United States shareholder on a hypothetical distribution date with 
respect to a CFC inclusion year that ends with or within the U.S. 
shareholder inclusion year. A United States shareholder's pro rata share 
of any tested item is translated into United States dollars using the 
average exchange rate for the CFC inclusion year of the controlled 
foreign corporation. Paragraphs (d)(2) through (5) of this section 
provide rules for determining a United States shareholder's pro rata 
share of each tested item of a controlled foreign corporation.
    (2) Tested income--(i) In general. Except as provided in paragraph 
(d)(2)(ii) of this section, a United States shareholder's pro rata share 
of the tested income of each tested income CFC for a U.S. shareholder 
inclusion year is determined under section 951(a)(2) and Sec. 1.951-
1(b) and (e), substituting ``tested income'' for ``subpart F income'' 
each place it appears, other than in Sec. 1.951-1(e)(1)(ii)(B) and the 
denominator of the fraction described in Sec. 1.951-1(b)(1)(ii)(A).
    (ii) Special rule for prior allocation of tested loss. In any case 
in which tested loss has been allocated to any class of stock in a prior 
CFC inclusion year under paragraph (d)(4)(iii) of this section, tested 
income is first allocated to each such class of stock in the order of 
its liquidation priority to the extent of the excess (if any) of the sum 
of the tested loss allocated to each such class of stock for each prior 
CFC inclusion year under paragraph (d)(4)(iii) of this section, over the 
sum of the tested income allocated to each such class of stock for each 
prior CFC inclusion year under this paragraph (d)(2)(ii). Paragraph 
(d)(2)(i) of this section applies for purposes of determining a United 
States shareholder's pro rata share of the remainder of the tested 
income, except that, for purposes of the hypothetical distribution of 
section 951(a)(2)(A) and Sec. 1.951-1(b)(1)(i) and (e)(1)(i), the 
amount of allocable earnings and profits of the tested income CFC is 
reduced by the amount of tested income allocated under the first 
sentence of this paragraph (d)(2)(ii). For an example of the application 
of this paragraph (d)(2), see paragraph (d)(4)(iv)(B) of this section 
(Example 2).
    (3) Qualified business asset investment--(i) In general. Except as 
provided in paragraphs (d)(3)(ii) of this section, a United States 
shareholder's pro rata share of the qualified business asset investment 
of a tested income CFC for a U.S. shareholder inclusion year bears the 
same ratio to the total qualified business asset investment of the 
tested income CFC for the CFC inclusion year as the United States 
shareholder's pro rata share of the tested income of the tested income 
CFC for the U.S. shareholder inclusion year bears to the total tested 
income of the tested income CFC for the CFC inclusion year.
    (ii) Special rule for excess hypothetical tangible return--(A) In 
general. If the tested income of a tested income CFC for a CFC inclusion 
year is less than the hypothetical tangible return of the tested income 
CFC for the CFC inclusion year, a United States shareholder's pro rata 
share of the qualified business asset investment of the tested income 
CFC for a United States shareholder inclusion year bears the same

[[Page 174]]

ratio to the qualified business asset investment of the tested income 
CFC as the United States shareholder's pro rata share of the 
hypothetical tangible return of the CFC for the U.S. shareholder 
inclusion year bears to the total hypothetical tangible return of the 
CFC for the CFC inclusion year.
    (B) Determination of pro rata share of hypothetical tangible return. 
For purposes of paragraph (d)(3)(ii)(A) of this section, a United States 
shareholder's pro rata share of the hypothetical tangible return of a 
CFC for a CFC inclusion year is determined in the same manner as the 
United States shareholder's pro rata share of the tested income of the 
CFC for the CFC inclusion year under paragraph (d)(2) of this section by 
treating the amount of the hypothetical tangible return as the amount of 
tested income.
    (C) Definition of hypothetical tangible return. For purposes of this 
paragraph (d)(3)(ii), the term hypothetical tangible return means, with 
respect to a tested income CFC for a CFC inclusion year, 10 percent of 
the qualified business asset investment of the tested income CFC for the 
CFC inclusion year.
    (iii) Examples. The following examples illustrate the application of 
paragraphs (d)(2) and (3) of this section. See also Sec. 1.951-
1(e)(7)(vii) (Example 6) (illustrating a United States shareholder's pro 
rata share of tested income).
    (A) Example 1--(1) Facts. FS, a controlled foreign corporation, has 
outstanding 70 shares of common stock and 30 shares of 4% 
nonparticipating, cumulative preferred stock with a par value of $10x 
per share. P Corp, a domestic corporation and a United States 
shareholder of FS, owns all of the common shares. Individual A, a United 
States citizen and a United States shareholder, owns all of the 
preferred shares. Individual A, FS, and P Corp use the calendar year as 
their taxable year. Individual A and P Corp are shareholders of FS for 
all of Year 4. At the beginning of Year 4, FS had no dividend arrearages 
with respect to its preferred stock. For Year 4, FS has $100x of 
earnings and profits, $120x of tested income, and no subpart F income 
within the meaning of section 952. FS also has $750x of qualified 
business asset investment for Year 4.
    (2) Analysis--(i) Determination of pro rata share of tested income. 
For purposes of determining P Corp's pro rata share of FS's tested 
income under paragraph (d)(2) of this section, the amount of FS's 
allocable earnings and profits for purposes of the hypothetical 
distribution described in Sec. 1.951-1(e)(1)(i) is $120x, the greater 
of its earnings and profits as determined under section 964 ($100x) and 
the sum of its subpart F income and tested income ($0 + $120x). Under 
paragraph (d)(2) of this section and Sec. 1.951-1(e)(3), the amount of 
FS's allocable earnings and profits distributed in the hypothetical 
distribution with respect to Individual A's preferred shares is $12x 
(0.04 x $10x x 30) and the amount distributed with respect to P Corp's 
common shares is $108x ($120x - $12x). Accordingly, under paragraph 
(d)(2) of this section and Sec. 1.951-1(e)(1), Individual A's pro rata 
share of FS's tested income is $12x, and P Corp's pro rata share of FS's 
tested income is $108x for Year 4.
    (ii) Determination of pro rata share of qualified business asset 
investment. The special rule of paragraph (d)(3)(ii)(A) of this section 
does not apply because FS's tested income of $120x is not less than FS's 
hypothetical tangible return of $75x, which is 10% of FS's qualified 
business asset investment of $750x. Accordingly, under the general rule 
of paragraph (d)(3)(i) of this section, Individual A's and P Corp's 
respective pro rata shares of FS's qualified business asset investment 
bears the same ratio to FS's total qualified business asset investment 
as their respective pro rata shares of FS's tested income bears to FS's 
total tested income. Thus, Individual A's pro rata share of FS's 
qualified business asset investment is $75x ($750x x $12x/$120x), and P 
Corp's pro rata share of FS's qualified business asset investment is 
$675x ($750x x $108x/$120x).
    (B) Example 2--(1) Facts. The facts are the same as in paragraph 
(d)(3)(iv)(A)(1) of this section (the facts in Example 1 of this 
section), except that FS has $1,500x of qualified business asset 
investment for Year 4.
    (2) Analysis--(i) Determination of pro rata share of tested income. 
The analysis and the result are the same as in paragraph 
(d)(3)(iv)(A)(2)(i) of this section

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(paragraph (i) of the analysis in Example 1 of this section).
    (ii) Determination of pro rata share of qualified business asset 
investment. The special rule of paragraph (d)(3)(ii)(A) of this section 
applies because FS's tested income of $120x is less than FS's 
hypothetical tangible return of $150x, which is 10% of FS's qualified 
business asset investment of $1,500x. Under paragraph (d)(3)(ii)(A) of 
this section, Individual A's and P Corp's respective pro rata shares of 
FS's qualified business asset investment bears the same ratio to FS's 
qualified business asset investment as their respective pro rata shares 
of the hypothetical tangible return of FS bears to the total 
hypothetical tangible return of FS. Under paragraph (d)(3)(ii)(B) of 
this section, P Corp's and Individual A's respective pro rata share of 
FS's hypothetical tangible return is determined under paragraph (d)(2) 
of this section in the same manner as their respective pro rata shares 
of the tested income of FS by treating the hypothetical tangible return 
as the amount of tested income. The amount of FS's allocable earnings 
and profits for purposes of the hypothetical distribution described in 
Sec. 1.951-1(e)(1)(i) is $150x, the greater of its earnings and profits 
as determined under section 964 ($100x) and the sum of its subpart F 
income and hypothetical tangible return ($0 + $150x). The amount of FS's 
allocable earnings and profits distributed in the hypothetical 
distribution is $12x (.04 x $10x x 30) with respect to Individual A's 
preferred shares and $138x ($150x - $12x) with respect to P Corp's 
common shares. Accordingly, Individual A's pro rata share of FS's 
qualified business asset investment is $120x ($1,500x x $12x/$150x), and 
P Corp's pro rata share of FS's qualified business asset investment is 
$1,380x ($1,500x x $138x/$150x).
    (C) Example 3--(1) Facts. P Corp, a domestic corporation and a 
United States shareholder, owns 100% of the only class of stock of FS, a 
controlled foreign corporation, from January 1 of Year 1, until May 26 
of Year 1. On May 26 of Year 1, P Corp sells all of its FS stock to R 
Corp, a domestic corporation that is not related to P Corp, and 
recognizes no gain or loss on the sale. R Corp, a United States 
shareholder of FS, owns 100% of the stock of FS from May 26 through 
December 31 of Year 1. For Year 1, FS has $50x of earnings and profits, 
$50x of tested income, and no subpart F income within the meaning of 
section 952. FS also has $1,500x of qualified business asset investment 
for Year 1. On May 1 of Year 1, FS distributes a $20x dividend to P 
Corp. P Corp, R Corp, and FS all use the calendar year as their taxable 
year.
    (2) Analysis--(i) Determination of pro rata share of tested income. 
For purposes of determining R Corp's pro rata share of FS's tested 
income under paragraph (d)(2) of this section, the amount of FS's 
allocable earnings and profits for purposes of the hypothetical 
distribution described in Sec. 1.951-1(e)(1)(i) is $50x, the greater of 
its earnings and profits as determined under section 964 ($50x) or the 
sum of its subpart F income and tested income ($0 + $50x). Under 
paragraph (d)(2) of this section and Sec. 1.951-1(e)(1), FS's allocable 
earnings and profits of $50x are distributed in the hypothetical 
distribution pro rata to each share of stock. R Corp's pro rata share of 
FS's tested income for Year 1 is its pro rata share under section 
951(a)(2)(A) and Sec. 1.951-1(b)(1)(i) ($50x), reduced under section 
951(a)(2)(B) and Sec. 1.951-1(b)(1)(ii) by $20x, which is the lesser of 
$20x, the dividend received by P Corp during Year 1 with respect to the 
FS stock acquired by R Corp ($20x), multiplied by a fraction, the 
numerator of which is the tested income ($50x) of FS for Year 1 and the 
denominator of which is the sum of the subpart F income ($0) and the 
tested income ($50x) of FS for Year 1 ($20x x $50x/$50x), and $20x, 
which is P Corp's pro rata share (100%) of the amount which bears the 
same ratio to FS's tested income for Year 1 ($50x) as the period during 
which R Corp did not own (within the meaning of section 958(a)) the FS 
stock (146 days) bears to the entire taxable year(1 x $50x x 146/365). 
Accordingly, R Corp's pro rata share of tested income of FS for Year 1 
is $30x ($50x - $20x).
    (ii) Determination of pro rata share of qualified business asset 
investment. The special rule of paragraph (d)(3)(ii) of this section 
applies because FS's tested income of $50x is less than FS's 
hypothetical tangible return of $150x, which

[[Page 176]]

is 10% of FS's qualified business asset investment of $1,500x. Under 
paragraph (d)(3)(ii) of this section, R Corp's pro rata share of FS's 
qualified business asset investment is the amount that bears the same 
ratio to FS's qualified business asset investment as R Corp's pro rata 
share of the hypothetical tangible return of FS bears to the total 
hypothetical tangible return of FS. R Corp's pro rata share of FS's 
hypothetical tangible return is its pro rata share under section 
951(a)(2)(A) and Sec. 1.951-1(b)(1)(i) ($150x), reduced under section 
951(a)(2)(B) and Sec. 1.951-1(b)(1)(ii) by $20x, which is the lesser of 
$20x, the dividend received by P Corp during Year 1 with respect to the 
FS stock acquired by R Corp ($20x) multiplied by a fraction, the 
numerator of which is the hypothetical tangible return ($150x) of FS for 
Year 1 and the denominator of which is the sum of the subpart F income 
($0) and the hypothetical tangible return ($150x) of FS for Year 1 ($20x 
x $150x/$150x), and $60x, which is P Corp's pro rata share (100%) of the 
amount which bears the same ratio to FS's hypothetical tangible return 
for Year 1 ($150x) as the period during which R Corp did not own (within 
the meaning of section 958(a)) the FS stock (146 days) bears to the 
entire taxable year (1 x $150x x 146/365). Accordingly, R Corp's pro 
rata share of the hypothetical tangible return of FS for Year 1 is $130x 
($150x - $20x), and R Corp's pro rata share of FS's qualified business 
asset investment is $1,300x ($1,500x x $130x/$150x).
    (4) Tested loss--(i) In general. A United States shareholder's pro 
rata share of the tested loss of each tested loss CFC for a U.S. 
shareholder inclusion year is determined under section 951(a)(2) and 
Sec. 1.951-1(b) and (e) with the following modifications--
    (A) ``Tested loss'' is substituted for ``subpart F income'' each 
place it appears;
    (B) For purposes of the hypothetical distribution described in 
section 951(a)(2)(A) and Sec. 1.951-1(b)(1)(i) and (e)(1)(i), the 
amount of allocable earnings and profits of a controlled foreign 
corporation for a CFC inclusion year is treated as being equal to the 
tested loss of the tested loss CFC for the CFC inclusion year;
    (C) Except as provided in paragraphs (d)(4)(ii) and (iii) of this 
section, the hypothetical distribution described in section 951(a)(2)(A) 
and Sec. 1.951-1(b)(1)(i) and (e)(1)(i) is treated as made solely with 
respect to the common stock of the tested loss CFC; and
    (D) In lieu of applying section 951(a)(2)(B) and Sec. 1.951-
1(b)(1)(ii), the United States shareholder's pro rata share of the 
tested loss allocated to section 958(a) stock of the tested loss CFC is 
reduced by an amount that bears the same ratio to the amount of the 
tested loss as the part of such year during which such shareholder did 
not own (within the meaning of section 958(a)) such stock bears to the 
entire taxable year.
    (ii) Special rule in case of accrued but unpaid dividends. If a 
tested loss CFC's earnings and profits that have accumulated since the 
issuance of preferred shares are reduced below the amount necessary to 
satisfy any accrued but unpaid dividends with respect to such preferred 
shares, then the amount by which the tested loss reduces the earnings 
and profits below the amount necessary to satisfy the accrued but unpaid 
dividends is allocated in the hypothetical distribution described in 
section 951(a)(2)(A) and Sec. 1.951-1(b)(1)(i) and (e)(1)(i) to the 
preferred stock of the tested loss CFC and the remainder of the tested 
loss is allocated in the hypothetical distribution to the common stock 
of the tested loss CFC.
    (iii) Special rule for stock with no liquidation value. If a tested 
loss CFC's common stock has a liquidation value of zero and there is at 
least one other class of equity with a liquidation preference relative 
to the common stock, then the tested loss is allocated in the 
hypothetical distribution described in section 951(a)(2)(A) and Sec. 
1.951-1(b)(1)(i) and (e)(1)(i) to the most junior class of equity with a 
positive liquidation value to the extent of such liquidation value. 
Thereafter, tested loss is allocated to the next most junior class of 
equity to the extent of its liquidation value and so on. All 
determinations of liquidation value are to be made as of the beginning 
of the CFC inclusion year of the tested loss CFC.

[[Page 177]]

    (iv) Examples. The following examples illustrate the application of 
this paragraph (d)(4). See also Sec. 1.951-1(e)(7)(viii) (Example 7) 
(illustrating a United States shareholder's pro rata share of subpart F 
income and tested loss).
    (A) Example 1--(1) Facts. FS, a controlled foreign corporation, has 
outstanding 70 shares of common stock and 30 shares of 4% 
nonparticipating, cumulative preferred stock with a par value of $10x 
per share. P Corp, a domestic corporation and a United States 
shareholder of FS, owns all of the common shares. Individual A, a United 
States citizen and a United States shareholder, owns all of the 
preferred shares. FS, Individual A, and P Corp all use the calendar year 
as their taxable year. Individual A and P Corp are shareholders of FS 
for all of Year 5. At the beginning of Year 5, FS had earnings and 
profits of $120x, which accumulated after the issuance of the preferred 
stock. At the end of Year 5, the accrued but unpaid dividends with 
respect to the preferred stock are $36x. For Year 5, FS has a $100x 
tested loss, and no other items of income, gain, deduction or loss. At 
the end of Year 5, FS has earnings and profits of $20x.
    (2) Analysis. FS is a tested loss CFC for Year 5. Before taking into 
account the tested loss in Year 5, FS had sufficient earnings and 
profits to satisfy the accrued but unpaid dividends of $36x. The amount 
of the reduction in earnings below the amount necessary to satisfy the 
accrued but unpaid dividends attributable to the tested loss is $16x 
($36x - ($120x - $100x)). Accordingly, under paragraph (d)(4)(ii) of 
this section, $16x of the tested loss is allocated to Individual A's 
preferred stock in the hypothetical distribution described in section 
951(a)(2)(A) and Sec. 1.951-1(b)(1)(i) and (e)(1)(i), and $84x ($100x - 
$16x) of the tested loss is allocated to P Corp's common shares in the 
hypothetical distribution.
    (B) Example 2--(1) Facts. FS, a controlled foreign corporation, has 
outstanding 100 shares of common stock and 50 shares of 4% 
nonparticipating, cumulative preferred stock with a par value of $100x 
per share. P Corp, a domestic corporation and a United States 
shareholder of FS, owns all of the common shares. Individual A, a United 
States citizen and a United States shareholder, owns all of the 
preferred shares. FS, Individual A, and P Corp all use the calendar year 
as their taxable year. Individual A and P Corp are shareholders of FS 
for all of Year 1 and Year 2. At the beginning of Year 1, the common 
stock has no liquidation value and the preferred stock has a liquidation 
value of $5,000x and no accrued but unpaid dividends. In Year 1, FS has 
a tested loss of $1,000x and no other items of income, gain, deduction, 
or loss. In Year 2, FS has tested income of $3,000x and no other items 
of income, gain, deduction, or loss. FS has earnings and profits of 
$3,000x for Year 2. At the end of Year 2, FS has accrued but unpaid 
dividends of $400x with respect to the preferred stock, the sum of $200x 
for Year 1 (0.04 x $100x x 50) and $200x for Year 2 (0.04 x $100x x 50).
    (2) Analysis--(i) Year 1. FS is a tested loss CFC in Year 1. The 
common stock of FS has liquidation value of zero, and the preferred 
stock has a liquidation preference relative to the common stock. The 
tested loss ($1,000x) does not exceed the liquidation value of the 
preferred stock ($5,000x). Accordingly, under paragraph (d)(4)(iii) of 
this section, the tested loss is allocated to the preferred stock in the 
hypothetical distribution described in section 951(a)(2)(A) and Sec. 
1.951-1(b)(1)(i) and (e)(1)(i). Individual A's pro rata share of the 
tested loss is $1,000x, and P Corp's pro rata share of the tested loss 
is $0.
    (ii) Year 2. FS is a tested income CFC in Year 2. Because $1,000x of 
tested loss was allocated to the preferred stock in Year 1 under 
paragraph (d)(4)(iii) of this section, the first $1,000x of tested 
income in Year 2 is allocated to the preferred stock under paragraph 
(d)(2)(ii) of this section. P Corp's and Individual A's pro rata shares 
of the remaining $2,000x of tested income are determined under the 
general rule of paragraph (d)(2)(i) of this section, except that for 
purposes of the hypothetical distribution the amount of FS's allocable 
earnings and profits is reduced by the tested income allocated under 
paragraph (d)(2)(ii) of this section to $2,000x ($3,000x - $1,000x). 
Accordingly, under paragraph (d)(2)(i) of this section and Sec. 1.951-
1(e), the amount

[[Page 178]]

of FS's allocable earnings and profits distributed in the hypothetical 
distribution with respect to Individual A's preferred stock is $400x 
($400x of accrued but unpaid dividends) and with respect to P Corp's 
common stock is $1,600x ($2,000x - $400x). Individual A's pro rata share 
of the tested income is $1,400x ($1,000x + $400x), and P Corp's pro rata 
share of the tested income is $1,600x.
    (5) Tested interest expense. A United States shareholder's pro rata 
share of tested interest expense of a controlled foreign corporation for 
a U.S. shareholder inclusion year is equal to the amount by which the 
tested interest expense reduces the shareholder's pro rata share of 
tested income of the controlled foreign corporation for the U.S. 
shareholder inclusion year, increases the shareholder's pro rata share 
of tested loss of the controlled foreign corporation for the U.S. 
shareholder inclusion year, or both.
    (6) Tested interest income. A United States shareholder's pro rata 
share of tested interest income of a controlled foreign corporation for 
a U.S. shareholder inclusion year is equal to the amount by which the 
tested interest income increases the shareholder's pro rata share of 
tested income of the controlled foreign corporation for the U.S. 
shareholder inclusion year, reduces the shareholder's pro rata share of 
tested loss of the controlled foreign corporation for the U.S. 
shareholder inclusion year, or both.
    (e) Treatment of domestic partnerships--(1) In general. For purposes 
of section 951A and the section 951A regulations, and for purposes of 
any other provision that applies by reference to section 951A or the 
section 951A regulations, a domestic partnership is not treated as 
owning stock of a foreign corporation within the meaning of section 
958(a). When the preceding sentence applies, a domestic partnership is 
treated in the same manner as a foreign partnership under section 
958(a)(2) for purposes of determining the persons that own stock of the 
foreign corporation within the meaning of section 958(a).
    (2) Non-application for determination of status as United States 
shareholder and controlled foreign corporation. Paragraph (e)(1) of this 
section does not apply for purposes of determining whether any United 
States person is a United States shareholder (as defined in section 
951(b)), whether any United States shareholder is a controlling domestic 
shareholder (as defined in Sec. 1.964-1(c)(5)), or whether any foreign 
corporation is a controlled foreign corporation (as defined in section 
957(a)).
    (3) Examples. The following examples illustrate the application of 
this paragraph (e).
    (i) Example 1--(A) Facts. USP, a domestic corporation, and 
Individual A, a United States citizen unrelated to USP, own 95% and 5%, 
respectively, of PRS, a domestic partnership. PRS owns 100% of the 
single class of stock of FC, a foreign corporation.
    (B) Analysis--(1) CFC and United States shareholder determinations. 
Under paragraph (e)(2) of this section, the determination of whether 
PRS, USP, and Individual A (each a United States person) are United 
States shareholders of FC and whether FC is a controlled foreign 
corporation is made without regard to paragraph (e)(1) of this section. 
PRS, a United States person, owns 100% of the total combined voting 
power or value of the FC stock within the meaning of section 958(a). 
Accordingly, PRS is a United States shareholder under section 951(b), 
and FC is a controlled foreign corporation under section 957(a). USP is 
a United States shareholder of FC because it owns 95% of the total 
combined voting power or value of the FC stock under sections 958(b) and 
318(a)(2)(A). Individual A, however, is not a United States shareholder 
of FC because Individual A owns only 5% of the total combined voting 
power or value of the FC stock under sections 958(b) and 318(a)(2)(A).
    (2) Application of section 951A. Under paragraph (e)(1) of this 
section, for purposes of determining a GILTI inclusion amount under 
section 951A and paragraph (b) of this section, PRS is not treated as 
owning (within the meaning of section 958(a)) the FC stock; instead, PRS 
is treated in the same manner as a foreign partnership for purposes of 
determining the FC stock owned by USP and Individual A under section 
958(a)(2). Therefore, for purposes of determining the GILTI inclusion 
amount

[[Page 179]]

of USP and Individual A, USP is treated as owning 95% of the FC stock 
under section 958(a), and Individual A is treated as owning 5% of the FC 
stock under section 958(a). USP is a United States shareholder of FC, 
and therefore USP determines its pro rata share of any tested item of FC 
based on its ownership of section 958(a) stock of FC. However, because 
Individual A is not a United States shareholder of FC, Individual A does 
not have a pro rata share of any tested item of FC.
    (ii) Example 2--(A) Facts. USP, a domestic corporation, and 
Individual A, a United States citizen, own 90% and 10%, respectively, of 
PRS1, a domestic partnership. PRS1 and Individual B, a nonresident alien 
individual, own 90% and 10%, respectively, of PRS2, a domestic 
partnership. PRS2 owns 100% of the single class of stock of FC, a 
foreign corporation. USP, Individual A, and Individual B are unrelated 
to each other.
    (B) Analysis--(1) CFC and United States shareholder determination. 
Under paragraph (e)(2) of this section, the determination of whether 
PRS1, PRS2, USP, and Individual A (each a United States person) are 
United States shareholders of FC and whether FC is a controlled foreign 
corporation is made without regard to paragraph (e)(1) of this section. 
PRS2 owns 100% of the total combined voting power or value of the FC 
stock within the meaning of section 958(a). Accordingly, PRS2 is a 
United States shareholder under section 951(b), and FC is a controlled 
foreign corporation under section 957(a). Under sections 958(b) and 
318(a)(2)(A), PRS1 is treated as owning 90% of the FC stock owned by 
PRS2. Accordingly, PRS1 is a United States shareholder under section 
951(b). Further, under section 958(b)(2), PRS1 is treated as owning 100% 
of the FC stock for purposes of determining the FC stock treated as 
owned by USP and Individual A under section 318(a)(2)(A). Therefore, USP 
is treated as owning 90% of the FC stock under section 958(b) (100% x 
100% x 90%), and Individual A is treated as owning 10% of the FC stock 
under section 958(b) (100% x 100% x 10%). Accordingly, both USP and 
Individual A are United States shareholders of FC under section 951(b).
    (2) Application of section 951A. Under paragraph (e)(1) of this 
section, for purposes of determining a GILTI inclusion amount under 
section 951A and paragraph (b) of this section, PRS1 and PRS2 are not 
treated as owning (within the meaning of section 958(a)) the FC stock; 
instead, PRS1 and PRS2 are treated in the same manner as foreign 
partnerships for purposes of determining the FC stock owned by USP and 
Individual A under section 958(a)(2). Therefore, for purposes of 
determining the GILTI inclusion of USP and Individual A, USP is treated 
as owning 81% (100% x 90% x 90%) of the FC stock under section 958(a), 
and Individual A is treated as owning 9% (100% x 90% x 10%) of the FC 
stock under section 958(a). Because USP and Individual A are both United 
States shareholders of FC, USP and Individual A determine their 
respective pro rata shares of any tested item of FC based on their 
ownership of section 958(a) stock of FC.
    (f) Definitions. This paragraph (f) provides additional definitions 
that apply for purposes of this section and the section 951A 
regulations. Other definitions relevant to the section 951A regulations 
are included in Sec. Sec. 1.951A-2 through 1.951A-4.
    (1) CFC inclusion year. The term CFC inclusion year means any 
taxable year of a foreign corporation beginning after December 31, 2017, 
at any time during which the corporation is a controlled foreign 
corporation.
    (2) Controlled foreign corporation. The term controlled foreign 
corporation has the meaning set forth in section 957(a).
    (3) Hypothetical distribution date. The term hypothetical 
distribution date has the meaning set forth in Sec. 1.951-1(e)(1)(i).
    (4) Section 958(a) stock. The term section 958(a) stock means stock 
of a controlled foreign corporation owned (directly or indirectly) by a 
United States shareholder within the meaning of section 958(a), as 
modified by paragraph (e)(1) of this section.
    (5) Tested item. The term tested item means tested income, tested 
loss, qualified business asset investment, tested interest expense, or 
tested interest income.

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    (6) United States shareholder. The term United States shareholder 
has the meaning set forth in section 951(b).
    (7) U.S. shareholder inclusion year. The term U.S. shareholder 
inclusion year means any taxable year of a United States shareholder in 
which or with which a CFC inclusion year of a controlled foreign 
corporation ends.

[T.D. 9866, 84 FR 29341, June 21, 2019]



Sec. 1.951A-2  Tested income and tested loss.

    (a) Scope. This section provides rules for determining the tested 
income or tested loss of a controlled foreign corporation for purposes 
of determining a United States shareholder's net CFC tested income under 
Sec. 1.951A-1(c)(2). Paragraph (b) of this section provides definitions 
related to tested income and tested loss. Paragraph (c) of this section 
provides rules for determining the gross tested income of a controlled 
foreign corporation and the deductions that are properly allocable to 
gross tested income.
    (b) Definitions related to tested income and tested loss--(1) Tested 
income and tested income CFC. The term tested income means the excess 
(if any) of a controlled foreign corporation's gross tested income for a 
CFC inclusion year, over the allowable deductions (including taxes) 
properly allocable to the gross tested income for the CFC inclusion year 
(a controlled foreign corporation with tested income for a CFC inclusion 
year, a tested income CFC).
    (2) Tested loss and tested loss CFC. The term tested loss means the 
excess (if any) of a controlled foreign corporation's allowable 
deductions (including taxes) properly allocable to gross tested income 
(or that would be allocable to gross tested income if there were gross 
tested income) for a CFC inclusion year, over the gross tested income of 
the controlled foreign corporation for the CFC inclusion year (a 
controlled foreign corporation without tested income for a CFC inclusion 
year, a tested loss CFC).
    (c) Rules relating to the determination of tested income and tested 
loss--(1) Definition of gross tested income. The term gross tested 
income means the gross income of a controlled foreign corporation for a 
CFC inclusion year determined without regard to--
    (i) Items of income described in section 952(b),
    (ii) Gross income taken into account in determining the subpart F 
income of the corporation,
    (iii) Gross income excluded from the foreign base company income (as 
defined in section 954) or the insurance income (as defined in section 
953) of the corporation by reason of the exception described in section 
954(b)(4) pursuant to an election under Sec. 1.954-1(d)(5), or a 
tentative gross tested income item of the corporation that qualifies for 
the exception described in section 954(b)(4) pursuant to an election 
under paragraph (c)(7) of this section,
    (iv) Dividends received by the corporation from related persons (as 
defined in section 954(d)(3)), and
    (v) Foreign oil and gas extraction income (as defined in section 
907(c)(1)) of the corporation.
    (2) Determination of gross income and allowable deductions--(i) In 
general. For purposes of determining tested income and tested loss, the 
gross income and allowable deductions of a controlled foreign 
corporation for a CFC inclusion year are determined under the rules of 
Sec. 1.952-2 for determining the subpart F income of the controlled 
foreign corporation, except, for a controlled foreign corporation which 
is engaged in the business of reinsuring or issuing insurance or annuity 
contracts and which, if it were a domestic corporation engaged only in 
such business, would be taxable as an insurance company to which 
subchapter L of chapter 1 of the Code applies, substituting ``the rules 
of sections 953 and 954(i)'' for ``the principles of Sec. Sec. 1.953-4 
and 1.953-5'' in Sec. 1.952-2(b)(2).
    (ii) Deemed payment under section 367(d). The allowable deductions 
of a controlled foreign corporation include a deemed payment of the 
controlled foreign corporation under section 367(d)(2)(A).
    (3) Allocation of deductions to gross tested income--(i) In general. 
Except as provided in paragraph (c)(5) of this section, any deductions 
of a controlled foreign corporation allowable under paragraph (c)(2) of 
this section are allocated and apportioned to gross tested

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income under the principles of section 954(b)(5) and Sec. 1.954-1(c), 
by treating gross tested income that falls within a single separate 
category (as defined in Sec. 1.904-5(a)(4)(v)) as a single item of 
gross income, separate and in addition to the items set forth in Sec. 
1.954-1(c)(1)(iii). Losses in other separate categories of income 
resulting from the application of Sec. 1.954-1(c)(1)(i) cannot reduce 
any separate category of gross tested income, and losses in a separate 
category of gross tested income cannot reduce income in a category of 
subpart F income. In addition, deductions of a controlled foreign 
corporation that are allocated and apportioned to gross tested income 
under this paragraph (c)(3) are not taken into account for purposes of 
determining a qualified deficit as defined in section 952(c)(1)(B)(ii).
    (ii) Coordination with the high-tax exclusion--(A) In general. In 
the case of a taxpayer that has made an election under paragraph (c)(7) 
of this section, in allocating and apportioning deductions under this 
paragraph (c)(3), the taxpayer must apply the rules of sections 861 
through 865 and 904(d) (taking into account the rules of section 
954(b)(5) and Sec. 1.954-1(c)) in a manner that achieves results 
consistent with those under paragraph (c)(7) of this section.
    (B) Application of consistency rule to deductions allocated and 
apportioned to the residual grouping in applying the high-tax exclusion. 
Deductions that are allocated and apportioned to the residual income 
group under paragraph (c)(7)(iii)(A) of this section for purposes of 
applying the high-tax exclusion to a controlled foreign corporation's 
tentative gross tested income items are allocated and apportioned for 
purposes of determining the controlled foreign corporation's net income 
in each relevant statutory grouping using a method that provides for a 
consistent allocation and apportionment of deductions to gross income in 
the relevant groupings. See Sec. Sec. 1.954-1(c) and 1.960-1(d)(3) for 
rules relating to the allocation and apportionment of expenses for 
purposes of determining subpart F income, which is included in the 
residual grouping for purposes of applying the high-tax exclusion of 
sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(7) of 
this section. Therefore, for example, interest expense that is 
apportioned under the modified gross income method to a tentative gross 
tested income item of a lower-tier corporation under paragraph 
(c)(7)(iii)(A) of this section may be allocated and apportioned to the 
tested income of the upper-tier corporation or to the residual grouping, 
depending on whether the lower-tier corporation's tentative gross tested 
income item is an item of gross tested income or is excluded from gross 
tested income under the high-tax exclusion. See paragraph (c)(8)(iii)(C) 
(Example 3) of this section for an example illustrating the rules of 
this paragraph (c)(3).
    (4) Gross income taken into account in determining subpart F 
income--(i) In general. Except as provided in paragraph (c)(4)(iii) of 
this section, gross income of a controlled foreign corporation for a CFC 
inclusion year described in section 951A(c)(2)(A)(i)(II) and paragraph 
(c)(1)(ii) of this section is gross income described in paragraphs 
(c)(4)(ii)(A) through (E) of this section.
    (ii) Items of gross income included in subpart F income--(A) 
Insurance income. Gross income described in this paragraph (c)(4)(ii)(A) 
is any item of gross income included in the insurance income (adjusted 
net insurance income as defined in Sec. 1.954-1(a)(6)) of the 
controlled foreign corporation for the CFC inclusion year.
    (B) Foreign base company income. Gross income described in this 
paragraph (c)(4)(ii)(B) is any item of gross income included in the 
foreign base company income (adjusted net foreign base company income as 
defined in Sec. 1.954-1(a)(5)) of the controlled foreign corporation 
for the CFC inclusion year.
    (C) International boycott income. Gross income described in this 
paragraph (c)(4)(ii)(C) is the product of the gross income of the 
controlled foreign corporation for the CFC inclusion year that gives 
rise to the income described in section 952(a)(3)(A) multiplied by the 
international boycott factor described in section 952(a)(3)(B).
    (D) Illegal bribes, kickbacks, or other payments. Gross income 
described in this paragraph (c)(4)(ii)(D) is the sum

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of the amounts of the controlled foreign corporation for the CFC 
inclusion year described in section 952(a)(4).
    (E) Income earned in certain foreign countries. Gross income 
described in this paragraph (c)(4)(ii)(E) is income of the controlled 
foreign corporation for the CFC inclusion year described in section 
952(a)(5).
    (iii) Coordination rules--(A) Coordination with E&P limitation. 
Gross income of a controlled foreign corporation for a CFC inclusion 
year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) 
of this section includes any item of gross income that is excluded from 
subpart F income of the controlled foreign corporation for the CFC 
inclusion year, or that is otherwise excluded from the amount included 
under section 951(a)(1)(A) in the gross income of a United States 
shareholder of the controlled foreign corporation for the U.S. 
shareholder inclusion year in which or with which the CFC inclusion year 
ends, under section 952(c)(1) and Sec. 1.952-1(c), (d), or (e).
    (B) Coordination with E&P recapture. Gross income of a controlled 
foreign corporation for a CFC inclusion year described in section 
951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section does not 
include any item of gross income that results in the recharacterization 
of earnings and profits as subpart F income of the controlled foreign 
corporation for the CFC inclusion year under section 952(c)(2) and Sec. 
1.952-1(f)(2).
    (C) Coordination with full inclusion rule and high tax exception. 
Gross income of a controlled foreign corporation for a CFC inclusion 
year described in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) 
of this section does not include full inclusion foreign base company 
income that is excluded from subpart F income under Sec. 1.954-1(d)(6). 
Full inclusion foreign base company income that is excluded from subpart 
F income under Sec. 1.954-1(d)(6) is also not included in gross income 
of a controlled foreign corporation for a CFC inclusion year described 
in section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this 
section.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(4).
    (A) Example 1--(1) Facts. A Corp, a domestic corporation, owns 100% 
of the single class of stock of FS, a controlled foreign corporation. 
Both A Corp and FS use the calendar year as their taxable year. In Year 
1, FS has passive category foreign personal holding company income of 
$100x, a general category loss in foreign oil and gas extraction income 
of $100x, and earnings and profits of $0. FS has no other income. In 
Year 2, FS has general category gross income of $100x and earnings and 
profits of $100x. Without regard to section 952(c)(2), in Year 2 FS has 
no income described in any of the categories of income excluded from 
gross tested income in paragraphs (c)(1)(i) through (v) of this section. 
FS has no allowable deductions properly allocable to gross tested income 
for Year 2.
    (2) Analysis--(i) Year 1. As a result of the earnings and profits 
limitation of section 952(c)(1)(A), FS has no subpart F income in Year 
1, and A Corp has no inclusion with respect to FS under section 
951(a)(1)(A). Under paragraph (c)(4)(iii)(A) of this section, gross 
income described in section 951A(c)(2)(A)(i)(II) and paragraph 
(c)(1)(ii) of this section includes any item of gross income excluded 
from the subpart F income of FS for Year 1 under section 952(c)(1)(A) 
and Sec. 1.952-1(c). Therefore, the $100x foreign personal holding 
company income of FS in Year 1 is excluded from gross tested income by 
reason of section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this 
section, and FS has no gross tested income in Year 1.
    (ii) Year 2. In Year 2, under section 952(c)(2) and Sec. 1.952-
1(f)(2), FS's general category earnings and profits ($100x) in excess of 
its subpart F income ($0) give rise to the recharacterization of its 
passive category recapture account as subpart F income. Therefore, FS 
has passive category subpart F income of $100x in Year 2, and A Corp has 
an inclusion of $100x with respect to FS under section 951(a)(1)(A). 
Under paragraph (c)(4)(iii)(B) of this section, gross income described 
in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section 
does not include any item of gross income that results in the 
recharacterization of earnings and profits as subpart F income in FS's 
taxable year under section 952(c)(2) and Sec. 1.952-1(f)(2). 
Accordingly,

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the $100x of general category gross income of FS in Year 2 is not 
excluded from gross tested income by reason of section 
951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, and FS 
has $100x of general category gross tested income in Year 2.
    (B) Example 2--(1) Facts. A Corp, a domestic corporation, owns 100% 
of the single class of stock of FC1 and FC2, controlled foreign 
corporations. A Corp, FC1, and FC2 use the calendar year as their 
taxable year. In Year 1, FC1 has gross income of $290x from product 
sales to unrelated persons within its country of incorporation, gross 
interest income of $10x (an amount that is less than $1,000,000) that 
does not qualify for an exception to foreign personal holding company 
income, and earnings and profits of $300x. In Year 1, FC2 has gross 
income of $45x for performing consulting services within its country of 
incorporation for unrelated persons, gross interest income of $150x (an 
amount that is not less than $1,000,000) that does not qualify for an 
exception to foreign personal holding company income, and earnings and 
profits of $195x.
    (2) Analysis--(i) FC1. In Year 1, by application of the de minimis 
rule of section 954(b)(3)(A) and Sec. 1.954-1(b)(1)(i), the $10x of 
gross interest income earned by FC1 is not treated as foreign base 
company income ($10x of gross foreign base company income is less than 
$15x, the lesser of 5% of $300x, FC's total gross income for Year 1, or 
$1,000,000). Accordingly, FC1 has no subpart F income in Year 1, and A 
Corp has no inclusion with respect to FC1 under section 951(a)(1)(A). 
Under paragraph (c)(4)(i) of this section, gross income described in 
section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section is 
any item of gross income included in foreign base company income, and 
thus gross income described in section 951A(c)(2)(A)(i)(II) and 
paragraph (c)(1)(ii) of this section does not include any item of gross 
income excluded from foreign base company income under the de minimis 
rule in section 954(b)(3)(A) and Sec. 1.954-1(b)(1)(i). Accordingly, 
FS's $10x of gross interest income in Year 1 is not excluded from gross 
tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph 
(c)(1)(ii) of this section, and FC1 has $300x ($290x of gross sales 
income and $10x of gross interest income) of gross tested income in Year 
1.
    (ii) FC2. In Year 1, by application of the full inclusion rule in 
section 954(b)(3)(B) and Sec. 1.954-1(b)(1)(ii), the $45x of gross 
income earned by FC2 for performing consulting services within its 
country of incorporation for unrelated persons is treated as foreign 
base company income ($150x of gross foreign base company income exceeds 
$136.5x, which is 70% of $195x, FC2's total gross income for Year 1). 
Therefore, FC2 has $195x of foreign base company income in Year 1, 
including $45x of full inclusion foreign base company income as defined 
in Sec. 1.954-1(b)(2), and A Corp has an inclusion of $195x with 
respect to FC2 under section 951(a)(1)(A). Under paragraph (c)(4)(i) of 
this section, gross income described in section 951A(c)(2)(A)(i)(II) and 
paragraph (c)(1)(ii) of this section is any item of gross income 
included in foreign base company income, and thus gross income described 
in section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section 
includes any item of gross income included as foreign base company 
income under the full inclusion rule in section 954(b)(3)(B) and Sec. 
1.954-1(b)(1)(ii). Accordingly, FC2's $45x of gross services income and 
its $150x of gross interest income in Year 1 are excluded from gross 
tested income by reason of section 951A(c)(2)(A)(i)(II) and paragraph 
(c)(1)(ii) of this section, and FC2 has no gross tested income in Year 
1.
    (C) Example 3--(1) Facts. A Corp, a domestic corporation, owns 100% 
of the single class of stock of FS, a controlled foreign corporation. A 
Corp and FS use the calendar year as their taxable year. In Year 1, FS 
has gross income of $1,000x, of which $720x is general category foreign 
base company sales income and $280x is general category income from 
sales within its country of incorporation; FS has expenses of $650x 
(including creditable foreign income taxes), of which $500x are 
allocated and apportioned to foreign base company sales income and $150x 
are allocated and apportioned to sales income from

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sales within FS's country of incorporation; and FS has earnings and 
profits of $350x for Year 1. Foreign income tax of $55x is considered 
imposed on the $220x ($720x-$500x) of net foreign base company sales 
income, and $26x is considered imposed on the $130x ($280x-$150x) of net 
income from sales within FS's country of operation. The maximum rate of 
tax in section 11 for the taxable year is 21%, and FS elects the high 
tax exception of section 954(b)(4) under Sec. 1.954-1(d)(1) for Year 1 
for its foreign base company sales income. In a prior taxable year, FS 
had losses with respect to income other than foreign base company or 
insurance income that, by reason of the limitation in section 
952(c)(1)(A), reduced the subpart F income of FS (consisting entirely of 
foreign source general category income) by $600x; as of the beginning of 
Year 1, such amount has not been recharacterized as subpart F income in 
a subsequent taxable year under section 952(c)(2).
    (2) Analysis--(i) Foreign base company income. In Year 1, by 
application of the full inclusion rule in section 954(b)(3)(B) and Sec. 
1.954-1(b)(1)(ii), the $280x of gross income earned by FS for sales 
within its country of incorporation is treated as foreign base company 
income ($720x of gross foreign base company income exceeds $700x, which 
is 70% of $1,000x, FS's total gross income for the taxable year). 
However, the $220x of foreign base company sales income qualifies for 
the high tax exception of section 954(b)(4) and Sec. 1.954-1(d)(1), 
because the effective rate of tax with respect to the net foreign base 
company sales income ($220x) is 20% ($55x/($220x + $55x)) which is 
greater than 18.9% (90% of 21%, the maximum rate of tax in section 11 
for the taxable year). Because the $220x of net foreign base company 
sales income qualifies for the high tax exception of section 954(b)(4) 
and Sec. 1.954-1(d)(1), the $130x of full inclusion foreign base 
company income is also excluded from subpart F income under Sec. 1.954-
1(d)(6).
    (ii) Recapture of subpart F income. Under section 952(c)(2) and 
Sec. 1.952-1(f)(2), FS's general category earnings and profits ($350x) 
in excess of its subpart F income ($0) give rise to the 
recharacterization of its general category recapture account ($600x) as 
subpart F income to the extent of current year earnings and profits. 
Therefore, FS has general category subpart F income of $350x in Year 1, 
and A Corp has an inclusion of $350x with respect to FS under section 
951(a)(1)(A).
    (iii) Gross tested income. The $720x of gross foreign base company 
income is excluded from gross tested income under section 
951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section. 
However, the $280x of gross sales income earned from sales within FS's 
country of incorporation is not excluded from gross tested income under 
either section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this 
section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of 
this section. Under paragraph (c)(4)(iii)(B) of this section, the $280x 
of gross sales income earned from sales within FS's country of 
incorporation is not excluded from gross tested income under section 
951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section, because 
gross income described in paragraph (c)(1)(ii) of this section does not 
include any item of gross income that results in the recharacterization 
of earnings and profits as subpart F income under section 952(c)(2) and 
Sec. 1.952-1(f)(2). Further, under paragraph (c)(4)(iii)(C) of this 
section, the $280x of gross sales income earned from sales within FS's 
country of incorporation is not excluded from gross tested income under 
either section 951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this 
section or section 951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of 
this section, because gross income described in section 
951A(c)(2)(A)(i)(II) and paragraph (c)(1)(ii) of this section or section 
951A(c)(2)(A)(i)(III) and paragraph (c)(1)(iii) of this section does not 
include full inclusion foreign base company income that is excluded from 
subpart F income under Sec. 1.954-1(d)(6). Accordingly, FS has $280x of 
gross tested income for Year 1.
    (5) Allocation of deduction or loss attributable to disqualified 
basis--(i) In general. A deduction or loss attributable to disqualified 
basis is allocated and apportioned solely to residual CFC gross income, 
and any depreciation,

[[Page 185]]

amortization, or cost recovery allowances attributable to disqualified 
basis is not properly allocable to property produced or acquired for 
resale under section 263, 263A, or 471.
    (ii) Determination of deduction or loss attributable to disqualified 
basis. Except as otherwise provided in this paragraph (c)(5)(ii), in the 
case of a depreciation or amortization deduction with respect to 
property with disqualified basis and adjusted basis other than 
disqualified basis, the deduction or loss is treated as attributable to 
the disqualified basis in the same proportion that the disqualified 
basis bears to the total adjusted basis in the property. In the case of 
a loss from a taxable sale or exchange of property with disqualified 
basis and adjusted basis other than disqualified basis, the loss is 
treated as attributable to disqualified basis to the extent thereof.
    (iii) Definitions. The following definitions apply for purposes of 
this paragraph (c)(5).
    (A) Disqualified basis. The term disqualified basis has the meaning 
set forth in Sec. 1.951A-3(h)(2)(ii).
    (B) Residual CFC gross income. The term residual CFC gross income 
means gross income other than gross tested income, gross income taken 
into account in determining subpart F income, or gross income that is 
effectively connected, or treated as effectively connected, with the 
conduct of a trade or business in the United States (as described in 
Sec. 1.882-4(a)(1)).
    (iv) Reductions to disqualified basis pursuant to coordination 
rules. See Sec. 1.245A-7(b) or Sec. 1.245A-8(b), as applicable, for 
reductions to disqualified basis resulting from the application of Sec. 
1.245A-5.
    (v) Examples. The following examples illustrate the application of 
this paragraph (c)(5).
    (A) Example 1: Sale of intangible property during the disqualified 
period--(1) Facts. USP, a domestic corporation, owns all of the stock in 
CFC1 and CFC2, each a controlled foreign corporation. Both USP and CFC2 
use the calendar year as their taxable year. CFC1 uses a taxable year 
ending November 30. On November 1, 2018, before the start of its first 
CFC inclusion year, CFC1 sells Asset A to CFC2 in exchange for $100x of 
cash. Asset A is intangible property that is amortizable under section 
197. Immediately before the sale, the adjusted basis in Asset A is $20x, 
and CFC1 recognizes $80x of gain as a result of the sale ($100x-$20x). 
CFC1's gain is not subject to U.S. tax or taken into account in 
determining an inclusion to USP under section 951(a)(1)(A).
    (2) Analysis. The sale by CFC1 is a disqualified transfer (within 
the meaning of Sec. 1.951A-3(h)(2)(ii)(C)(2)) because it is a transfer 
of property in which gain was recognized by CFC1, CFC1 and CFC2 are 
related persons, and the transfer occurs during the disqualified period 
(within the meaning of Sec. 1.951A-3(h)(2)(ii)(C)(1)). The disqualified 
basis in Asset A is $80x, the excess of CFC2's adjusted basis in Asset A 
immediately after the disqualified transfer ($100x), over the sum of 
CFC1's basis in Asset A immediately before the transfer ($20x) and the 
qualified gain amount (as defined in Sec. 1.951A-3(h)(2)(ii)(C)(3)) 
($0). Accordingly, under paragraph (c)(5)(i) of this section, any 
deduction or loss of CFC2 attributable to the disqualified basis is 
allocated and apportioned solely to residual CFC gross income of CFC2 
and, therefore, is not taken into account in determining the tested 
income, tested loss, subpart F income, or effectively connected income 
of CFC2 for any CFC inclusion year.
    (B) Example 2: Related party transfer after the disqualified period; 
gain recognition--(1) Facts. The facts are the same as in paragraph 
(c)(5)(v)(A)(1) of this section (the facts in Example 1), except that, 
on November 30, 2020, CFC2 sells Asset A to CFC3, a controlled foreign 
corporation wholly-owned by CFC2, in exchange for $120x of cash. 
Immediately before the sale, the adjusted basis in Asset A is $90x, $72x 
of which is disqualified basis. The gain recognized by CFC2 on the sale 
of Asset A is not described in paragraphs (c)(1)(i) through (v) of this 
section.
    (2) Analysis. Paragraph (c)(5)(i) of this section does not apply to 
the sale of Asset A from CFC2 to CFC3 because the sale does not give 
rise to a deduction or loss attributable to disqualified basis, but 
instead gives rise to gain. Therefore, CFC2 recognizes $30x ($120x-$90x) 
of gain that is included in gross tested

[[Page 186]]

income for its CFC inclusion year ending November 30, 2019. Under Sec. 
1.951A-3(h)(2)(ii)(B)(1)(ii), because CFC2 sold Asset A to CFC3, a 
related person, and CFC2 did not recognize a deduction or loss on the 
sale, the disqualified basis in Asset A is not reduced or eliminated by 
reason of the sale. Accordingly, under paragraph (c)(5)(i) of this 
section, any deduction or loss of CFC3 attributable to the $72x of 
disqualified basis in Asset A is allocated and apportioned solely to 
residual CFC gross income of CFC3.
    (C) Example 3: Related party transfer after the disqualified period; 
loss recognition--(1) Facts. The facts are the same as in paragraph 
(c)(5)(v)(B)(1) of this section (the facts in Example 2), except that 
CFC2 sells Asset A to CFC3 in exchange for $70x of cash.
    (2) Analysis. Under paragraph (c)(5)(ii) of this section, the $20x 
loss recognized by CFC2 on the sale is attributable to disqualified 
basis, to the extent thereof, notwithstanding that the loss may be 
deferred under section 267(f). Thus, under paragraph (c)(5)(i) of this 
section, the loss is allocated and apportioned solely to residual CFC 
gross income of CFC2 in the CFC inclusion year in which the loss is 
taken into account pursuant to section 267(f). Under Sec. 1.951A-
3(h)(2)(ii)(B)(1)(ii), the disqualified basis in Asset A is reduced by 
$20x, the loss of CFC2 that is attributable to disqualified basis under 
paragraph (c)(5)(ii) of this section. Accordingly, under paragraph 
(c)(5)(i) of this section, any deduction or loss of CFC3 attributable to 
the remaining $52x of disqualified basis in Asset A is allocated and 
apportioned solely to residual CFC gross income of CFC3.
    (6) Allocation of deductions attributable to disqualified payments--
(i) In general. A deduction related directly or indirectly to a 
disqualified payment is allocated and apportioned solely to residual CFC 
gross income, and any deduction related to a disqualified payment is not 
properly allocable to property produced or acquired for resale under 
section 263, 263A, or 471.
    (ii) Definitions. The following definitions apply for purposes of 
this paragraph (c)(6).
    (A) Disqualified payment. The term disqualified payment means a 
payment made by a person to a related recipient CFC during the 
disqualified period with respect to the related recipient CFC, to the 
extent the payment would constitute income described in section 
951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to 
whether section 951A applies.
    (B) Disqualified period. The term disqualified period has the 
meaning provided in Sec. 1.951A-3(h)(2)(ii)(C)(1), substituting 
``related recipient CFC'' for ``transferor CFC.''
    (C) Related recipient CFC. The term related recipient CFC means, 
with respect to a payment by a person, a recipient of the payment that 
is a controlled foreign corporation that bears a relationship to the 
payor described in section 267(b) or 707(b) immediately before or after 
the payment.
    (iii) Treatment of partnerships. For purposes of determining whether 
a payment is made by a person to a related recipient CFC for purposes of 
paragraph (c)(6)(ii)(A) of this section, a payment by or to a 
partnership is treated as made proportionately by or to its partners, as 
applicable.
    (iv) Reductions to disqualified payments pursuant to coordination 
rules. See Sec. Sec. 1.245A-5(j)(8) and 1.245A-7(b) or Sec. 1.245A-
8(b), as applicable, for reductions to disqualified payments resulting 
from the application of Sec. 1.245A-5.
    (v) Examples. The following examples illustrate the application of 
this paragraph (c)(6).
    (A) Example 1: Deduction related directly to disqualified payment to 
related recipient CFC--(1) Facts. USP, a domestic corporation, owns all 
of the stock in CFC1 and CFC2, each a controlled foreign corporation. 
Both USP and CFC2 use the calendar year as their taxable year. CFC1 uses 
a taxable year ending November 30. On October 15, 2018, before the start 
of its first CFC inclusion year, CFC1 receives and accrues a payment 
from CFC2 of $100x of prepaid royalties with respect to a license. The 
$100x payment is excluded from subpart F income pursuant to section 
954(c)(6) and would constitute income described in section 
951A(c)(2)(A)(i) and paragraph (c)(1) of this section without regard to 
whether section 951A applies.

[[Page 187]]

    (2) Analysis. CFC1 is a related recipient CFC (within the meaning of 
paragraph (c)(6)(ii)(C) of this section) with respect to the royalty 
prepayment by CFC2 because it is related to CFC2 within the meaning of 
section 267(b). The royalty prepayment is received by CFC1 during its 
disqualified period (within the meaning of paragraph (c)(6)(ii)(B) of 
this section) because it is received during the period beginning January 
1, 2018, and ending November 30, 2018. Because it would constitute 
income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of 
this section without regard to whether section 951A applies, the payment 
is a disqualified payment. Accordingly, CFC2's deductions related to 
such payment accrued during taxable years ending on or after April 7, 
2020, are allocated and apportioned solely to residual CFC gross income 
under paragraph (c)(6)(i) of this section.
    (B) Example 2: Deduction related indirectly to disqualified payment 
to partnership in which related recipient CFC is a partner--(1) Facts. 
The facts are the same as in paragraph (c)(6)(v)(A)(1) of this section 
(the facts in Example 1), except that CFC1 and USP own 99% and 1%, 
respectively of FPS, a foreign partnership, which has a taxable year 
ending November 30. USP receives a prepayment of $110x from CFC2 for the 
performance of future services. USP subcontracts the performance of 
these future services to FPS for which FPS receives and accrues a $100x 
prepayment from USP. The services will be performed in the same country 
under the laws of which CFC1 and FPS are created or organized, and the 
$100x prepayment is not foreign base company services income under 
section 954(e) and Sec. 1.954-4(a). The $100x prepayment would 
constitute income described in section 951A(c)(2)(A)(i) and paragraph 
(c)(1) of this section without regard to whether section 951A applies.
    (2) Analysis. CFC1 is a related recipient CFC (within the meaning of 
paragraph (c)(6)(ii)(C) of this section) with respect to the services 
prepayment by USP because, under paragraph (c)(6)(iii) of this section, 
it is treated as receiving $99x (99% of $100x) of the services 
prepayment from USP, and it is related to USP within the meaning of 
section 267(b). The services prepayment is received by CFC1 during its 
disqualified period (within the meaning of paragraph (c)(6)(ii)(B) of 
this section) because it is received during the period beginning January 
1, 2018, and ending November 30, 2018. Because it would constitute 
income described in section 951A(c)(2)(A)(i) and paragraph (c)(1) of 
this section without regard to whether section 951A applies, the 
prepayment is a disqualified payment. In addition, CFC2's deductions 
related to its prepayment to USP are indirectly related to the 
disqualified payment by USP. Accordingly, CFC2's deductions related to 
such payment accrued during taxable years ending on or after April 7, 
2020 are allocated and apportioned solely to residual CFC gross income 
under paragraph (c)(6)(i) of this section.
    (7) Election to apply high-tax exception of section 954(b)(4)--(i) 
In general. For purposes of section 951A(c)(2)(A)(i)(III) and paragraph 
(c)(1)(iii) of this section, a tentative gross tested income item of a 
controlled foreign corporation for a CFC inclusion year qualifies for 
the exception described in section 954(b)(4) only if--
    (A) An election made under paragraph (c)(7)(viii) of this section is 
effective with respect to the controlled foreign corporation for the CFC 
inclusion year; and
    (B) The tentative tested income item with respect to the tentative 
gross tested income item was subject to an effective rate of foreign 
tax, as determined under paragraph (c)(7)(vi) of this section, that is 
greater than 90 percent of the maximum rate of tax specified in section 
11.
    (ii) Calculation of tentative gross tested income item--(A) In 
general. A tentative gross tested income item with respect to a 
controlled foreign corporation for a CFC inclusion year is the aggregate 
of all items of gross income of the controlled foreign corporation 
attributable to a tested unit (as defined in paragraph (c)(7)(iv) of 
this section) of the controlled foreign corporation in the CFC inclusion 
year that would be gross tested income without regard to this paragraph 
(c)(7) and would be in a single tested income group (as defined in Sec. 
1.960-1(d)(2)(ii)(C)). A controlled

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foreign corporation may have multiple tentative gross tested income 
items. See paragraphs (c)(8)(iii)(A)(2)(i) (Example 1) and 
(c)(8)(iii)(B)(2)(i) (Example 2) of this section for illustrations of 
the application of the rule set forth in this paragraph (c)(7)(ii)(A).
    (B) Gross income attributable to a tested unit--(1) Items properly 
reflected on separate set of books and records. Items of gross income of 
a controlled foreign corporation are attributable to a tested unit of 
the controlled foreign corporation to the extent they are properly 
reflected on the separate set of books and records of the tested unit, 
as modified under paragraph (c)(7)(ii)(B)(2) of this section. Each item 
of gross income of a controlled foreign corporation is attributable to a 
tested unit (and not to more than one tested unit) of the controlled 
foreign corporation. See paragraphs (c)(8)(iii)(D)(2) and 
(c)(8)(iii)(D)(5) (Example 4) of this section for illustrations of the 
application of the rule set forth in this paragraph (c)(7)(ii)(B).
    (2) Gross income determined under federal income tax principles, as 
adjusted for disregarded payments. For purposes of paragraph 
(c)(7)(ii)(B)(1) of this section, gross income must be determined under 
federal income tax principles, except that the principles of Sec. 
1.904-4(f)(2)(vi) apply to adjust gross income of the tested unit, to 
the extent thereof, to reflect disregarded payments. For purposes of 
this paragraph (c)(7)(ii)(B)(2), the principles of Sec. 1.904-
4(f)(2)(vi) are applied taking into account the rules in paragraphs 
(c)(7)(ii)(B)(2)(i) through (v) of this section.
    (i) The controlled foreign corporation is treated as the foreign 
branch owner and any other tested units of the controlled foreign 
corporation are treated as foreign branches.
    (ii) The principles of the rules in Sec. 1.904-4(f)(2)(vi)(A) apply 
in the case of disregarded payments between a foreign branch and another 
foreign branch without regard to whether either foreign branch makes a 
disregarded payment to, or receives a disregarded payment from, the 
foreign branch owner.
    (iii) The exclusion for interest and interest equivalents described 
in Sec. 1.904-4(f)(2)(vi)(C)(1) does not apply to the extent of the 
amount of a disregarded payment that is deductible in the country of tax 
residence (or location, in the case of a branch) of the tested unit that 
is the payor.
    (iv) In the case of an amount described in paragraph 
(c)(7)(ii)(B)(2)(iii) of this section, the rules for determining how a 
disregarded payment is allocated to gross income of a foreign branch or 
foreign branch owner in Sec. 1.904-4(f)(2)(vi)(B) are applied by 
treating the disregarded payment as allocated and apportioned ratably to 
all of the gross income attributable to the tested unit that is making 
the disregarded payment. If a tested unit is both a payor and payee of 
an amount described in paragraph (c)(7)(ii)(B)(2)(iii) of this section, 
gross income to which the disregarded payments are allocable include 
gross income allocated to the payor tested unit as a result of the 
receipt of amounts described in paragraph (c)(7)(ii)(B)(2)(iii) of this 
section, to the extent thereof. If a tested unit makes and receives 
payments described in paragraph (c)(7)(ii)(B)(2)(iii) of this section to 
and from the same tested unit, the payments are netted so that paragraph 
(c)(7)(ii)(B)(2)(iii) of this section and the principles of Sec. 1.904-
4(f)(2)(vi) apply only to the net amount of such payments between the 
two tested units.
    (v) In the case of multiple disregarded payments, in lieu of Sec. 
1.904-4(f)(2)(vi)(F), disregarded payments are taken into account under 
paragraph (c)(7)(ii)(B)(2) of this section and the principles of Sec. 
1.904-4(f)(2)(vi) under the rules provided in this paragraph 
(c)(7)(ii)(B)(2)(v). Adjustments are made with respect to a disregarded 
payment received by a tested unit before payments made by that tested 
unit. Except as provided in paragraph (c)(7)(ii)(B)(2)(iv) of this 
section, if a tested unit both makes and receives disregarded payments, 
adjustments are first made with respect to disregarded payments that 
would be definitely related to a single class of gross income under the 
principles of Sec. 1.861-8; second, adjustments are made with respect 
to disregarded payments that would be definitely related to multiple 
classes of gross income under the principles of

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Sec. 1.861-8, but that are not definitely related to all gross income 
of the tested unit; third, adjustments are made with respect to 
disregarded payments (other than interest described in paragraph 
(c)(7)(ii)(B)(2)(iii) of this section) that would be definitely related 
to all gross income under the principles of Sec. 1.861-8; and fourth, 
adjustments are made with respect to interest described in paragraph 
(c)(7)(ii)(B)(2)(iii) and disregarded payments that would not be 
definitely related to any gross income under the principles of Sec. 
1.861-8.
    (iii) Calculation of tentative tested income item--(A) In general. A 
tentative tested income item with respect to the tentative gross tested 
income item described in paragraph (c)(7)(ii)(A) of this section is 
determined by allocating and apportioning deductions for the CFC 
inclusion year (including expense for current year taxes (as defined in 
Sec. 1.960-1(b)(4)), and not including any items described in Sec. 
1.951A-2(c)(5) or (c)(6)) to the tentative gross tested income item 
under the principles of Sec. 1.960-1(d)(3). For purposes of this 
paragraph (c)(7)(iii), each tentative gross tested income item (if any) 
is treated as assigned to a separate tested income group, as that term 
is described in Sec. 1.960-1(d)(2)(ii)(C), and all other income is 
treated as assigned to a residual income group. For purposes of applying 
Sec. Sec. 1.861-9 and 1.861-9T under the principles of Sec. 1.960-
1(d)(3), the amount of interest deductions that are allocated and 
apportioned to the assets (or gross income, in the case of a taxpayer 
that has elected the modified gross income method) of a lower-tier 
corporation, such as a corporation the stock of which is owned by the 
controlled foreign corporation indirectly through the tested unit, are 
allocated and apportioned to the residual income category and not to any 
tentative gross tested income item of the controlled foreign 
corporation. See paragraphs (c)(8)(iii)(A)(2)(iii) (Example 1), 
(c)(8)(iii)(B)(2)(iv) (Example 2), and (c)(8)(iii)(C)(2)(iv) (Example 3) 
of this section for illustrations of the application of the rules set 
forth in this paragraph (c)(7)(iii)(A).
    (B) Allocation and apportionment of current year taxes imposed by 
reason of disregarded payments. The principles of Sec. 1.904-6(a)(2) 
apply to allocate and apportion the expense for current year taxes 
imposed by reason of disregarded payments to a tentative gross tested 
income item. For purposes of this paragraph (c)(7)(iii)(B), the 
principles of Sec. 1.904-6(a)(2) apply by--
    (1) Treating the CFC as the foreign branch owner and any other 
tested unit as a foreign branch;
    (2) In the case of payments to a tested unit that is treated as a 
foreign branch under paragraph (c)(7)(iii)(B)(1) of this section, 
applying the principles of Sec. 1.904-6(a)(2)(ii) and (iii) as if the 
tested unit receiving the payment were a foreign branch owner (and as if 
the tested unit making the payment were a foreign branch); and
    (3) Treating any portion of a disregarded payment between individual 
tested units that does not result in a reallocation of gross income 
under paragraph (c)(7)(ii)(B)(2) of this section (because the amount of 
the payment exceeds the gross income of the individual tested unit 
making the payment) as a payment that is described in Sec. 1.904-
4(f)(2)(vi)(C)(4) (to which Sec. 1.904-6(a)(2)(iii) applies). See 
paragraph (c)(8)(iii)(B)(2)(iii) (Example 2) of this section for 
illustrations of the application of the rules set forth in this 
paragraph (c)(7)(iii)(B).
    (C) Effect of potential and actual changes in taxes paid or accrued. 
Except as otherwise provided in this paragraph (c)(7)(iii)(C), the 
amount of current year taxes paid or accrued by a controlled foreign 
corporation for purposes of this paragraph (c)(7) does not take into 
account any potential reduction in foreign income taxes that may occur 
by reason of a future distribution to shareholders of all or part of 
such income. However, to the extent the foreign income taxes paid or 
accrued by the controlled foreign corporation are reasonably certain to 
be returned to a shareholder by the foreign country imposing such taxes, 
directly or indirectly, through any means (including, but not limited 
to, a refund, credit, payment, discharge of an obligation, or any other 
method) on a subsequent distribution to such shareholder, the foreign 
income taxes are not treated as paid or accrued for purposes of this 
paragraph (c)(7). In addition, foreign

[[Page 190]]

income taxes that have not been paid or accrued because they are 
contingent on a future distribution of earnings (or other similar 
transaction, such as a loan to a shareholder) are not taken into account 
for purposes of this paragraph (c)(7). If, pursuant to section 905(c) 
and Sec. 1.905-3, a redetermination of U.S. tax liability is required 
to account for the effect of a foreign tax redetermination (as defined 
in Sec. 1.905-3(a)), this paragraph (c)(7) is applied in the adjusted 
year taking into account the adjusted amount of the redetermined foreign 
tax.
    (iv) Tested unit rules--(A) In general. Subject to the combination 
rule in paragraph (c)(7)(iv)(C) of this section, the term tested unit 
means any corporation, interest, or branch described in paragraphs 
(c)(7)(iv)(A)(1) through (3) of this section. See paragraph 
(c)(8)(iii)(D) (Example 4) of this section for an example that 
illustrates the application of the tested unit rules set forth in this 
paragraph (c)(7)(iv).
    (1) A controlled foreign corporation (as defined in section 957(a)).
    (2) An interest held directly or indirectly by a controlled foreign 
corporation in a pass-through entity that is--
    (i) A tax resident (as described in Sec. 1.267A-5(a)(23)(i)) of any 
foreign country; or
    (ii) Not treated as fiscally transparent (as determined under the 
principles of Sec. 1.267A-5(a)(8)) for purposes of the tax law of the 
foreign country of which the controlled foreign corporation is a tax 
resident or, in the case of an interest in a pass-through entity held by 
a controlled foreign corporation indirectly through one or more other 
tested units, for purposes of the tax law of the foreign country of 
which the tested unit that directly (or indirectly through the fewest 
number of transparent interests) owns the interest is a tax resident.
    (3) A branch (as described in Sec. 1.267A-5(a)(2)) the activities 
of which are carried on directly or indirectly (through one or more 
pass-through entities) by a controlled foreign corporation. However, in 
the case of a branch that does not give rise to a taxable presence under 
the tax law of the foreign country where the branch is located, the 
branch is a tested unit only if, under the tax law of the foreign 
country of which the controlled foreign corporation is a tax resident 
(or, if applicable, under the tax law of a foreign country of which the 
tested unit that directly (or indirectly, through the fewest number of 
transparent interests) carries on the activities of the branch is a tax 
resident), an exclusion, exemption, or other similar relief (such as a 
preferential rate) applies with respect to income attributable to the 
branch. For purposes of this paragraph (c)(7)(iv)(A)(3), similar relief 
does not include a credit (for example, a foreign tax credit) against 
the tax imposed under such tax law. If a controlled foreign corporation 
carries on directly or indirectly (through one or more pass-through 
entities) less than all of the activities of a branch (for example, if 
the activities are carried on indirectly through an interest in a 
partnership), then the rules in this paragraph apply separately with 
respect to the portion (or portions, if carried on indirectly through 
more than one chain of pass-through entities) of the activities carried 
on by the controlled foreign corporation. See paragraphs 
(c)(8)(iii)(D)(3) and (c)(8)(iii)(D)(4) (Example 4) of this section for 
illustrations of the application of the rules set forth in this 
paragraph (c)(7)(iv)(A)(3).
    (B) Items attributable to only one tested unit. For purposes of 
paragraph (c)(7) of this section, if an item is attributable to more 
than one tested unit in a tier of tested units, the item is considered 
attributable only to the lowest-tier tested unit. Thus, for example, if 
a controlled foreign corporation directly owns a branch tested unit 
described in paragraph (c)(7)(iv)(A)(3) of this section, and an item of 
gross income is (under the rules of paragraph (c)(7)(ii)(B) of this 
section) attributable to both the branch tested unit and the controlled 
foreign corporation tested unit, then the item is considered 
attributable only to the branch tested unit.
    (C) Combination rule--(1) In general. Except as provided in 
paragraph (c)(7)(iv)(C)(2) of this section, tested units of a controlled 
foreign corporation (including the controlled foreign corporation tested 
unit) are treated as a single tested unit if the tested units

[[Page 191]]

are tax residents of, or located in (in the case of a tested unit that 
is a branch, or a portion of the activities of a branch, that gives rise 
to a taxable presence under the tax law of a foreign country), the same 
foreign country. For purposes of this paragraph (c)(7)(iv)(C)(1), in the 
case of a tested unit that is an interest in a pass-through entity or a 
portion of the activities of a branch, a reference to the tax residency 
or location of the tested unit means the tax residency of the entity the 
interest in which is the tested unit or the location of the branch, as 
applicable. See paragraphs (c)(8)(iii)(D)(2) and (c)(8)(iii)(D)(5) 
(Example 4) of this section for illustrations of the application of the 
rule set forth in this paragraph (c)(7)(iv)(C)(1).
    (2) Exception for nontaxed branches. The rule in paragraph 
(c)(7)(iv)(C)(1) of this section does not apply to a tested unit that is 
described in paragraph (c)(7)(iv)(A)(3) of this section if the branch 
described in paragraph (c)(7)(iv)(A)(3) of this section does not give 
rise to a taxable presence under the tax law of the foreign country 
where the branch is located. See paragraph (c)(8)(iii)(D)(4) (Example 4) 
of this section for an illustration of the application of the rule set 
forth in this paragraph (c)(7)(v)(C)(2).
    (3) Effect of combination rule. If, pursuant to paragraph 
(c)(7)(iv)(C)(1) of this section, tested units are treated as a single 
tested unit, then, solely for purposes of paragraph (c)(7) of this 
section, items of gross income attributable to such tested units, and 
items of deduction and foreign taxes allocated and apportioned to such 
gross income, are aggregated for purposes of determining the combined 
tested unit's tentative gross tested income item, tentative tested 
income item, and foreign income taxes paid or accrued with respect to 
such tentative tested income item.
    (v) Separate set of books and records--(A) In general. For purposes 
of this paragraph (c)(7), the term separate set of books and records has 
the meaning set forth in Sec. 1.989(a)-1(d). In addition, for purposes 
of this paragraph (c)(7), in the case of a tested unit or a transparent 
interest that is an interest in a pass-through entity or a portion of 
the activities of a branch, a reference to the separate set of books and 
records of the tested unit or the transparent interest means the 
separate set of books and records of the entity or the branch, as 
applicable.
    (B) Failure to maintain separate set of books and records. If a 
separate set of books and records is not maintained for a tested unit or 
transparent interest, the items of gross income, disregarded payments, 
and any other items required to apply paragraph (c)(7) of this section 
that would be reflected on a separate set of books and records of the 
tested unit or transparent interest must be determined. Such items are 
treated as properly reflected on the separate set of books and records 
of the tested unit or transparent interest for purposes of applying 
paragraph (c)(7) of this section.
    (C) Transparent interests. If a tested unit of a controlled foreign 
corporation or an entity an interest in which is a tested unit of a 
controlled foreign corporation holds a transparent interest, either 
directly or indirectly through one or more other transparent interests, 
then, for purposes of paragraph (c)(7) of this section (and subject to 
the rule of paragraph (c)(7)(iv)(C) of this section), items of the 
controlled foreign corporation properly reflected on the separate set of 
books and records of the transparent interest are treated as being 
properly reflected on the separate set of books and records of the 
tested unit, as modified under paragraph (c)(7)(ii)(B)(2) of this 
section. See paragraph (c)(8)(iii)(D)(6) (Example 4) of this section for 
an illustration of the application of the rule set forth in this 
paragraph (c)(7)(v)(C).
    (D) Items not taken into account for financial accounting purposes. 
For purposes of this paragraph (c)(7), an item of gross income in a CFC 
inclusion year that is not taken into account in such year for financial 
accounting purposes, and therefore not properly reflected on a separate 
set of books and records of a tested unit or a transparent interest, or 
an entity an interest in which is a tested unit or a transparent 
interest, is treated as properly reflected on a separate set of books 
and records to the extent it would have been so reflected if the item 
were taken into account for

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financial accounting purposes in such CFC inclusion year.
    (vi) Effective rate at which foreign taxes are imposed. For a CFC 
inclusion year of a controlled foreign corporation, the effective rate 
of foreign tax with respect to the tentative tested income items of the 
controlled foreign corporation is determined separately for each such 
item. See paragraphs (c)(8)(iii)(A)(2)(v) (Example 1), 
(c)(8)(iii)(B)(2)(vi) (Example 2), and (c)(8)(iii)(C)(2)(vi) (Example 3) 
of this section for illustrations of the application of the rules set 
forth in this paragraph (c)(7)(vi). The effective rate at which foreign 
income taxes are imposed on a tentative tested income item is--
    (A) The U.S. dollar amount of foreign income taxes paid or accrued 
with respect to the tentative tested income item, determined by applying 
paragraph (c)(7)(vii) of this section; divided by
    (B) The U.S. dollar amount of the tentative tested income item, 
increased by the amount of foreign income taxes referred to in paragraph 
(c)(7)(vi)(A) of this section.
    (vii) Foreign income taxes paid or accrued with respect to a 
tentative tested income item. For a CFC inclusion year, the amount of 
foreign income taxes paid or accrued by a controlled foreign corporation 
with respect to a tentative tested income item of the controlled foreign 
corporation for purposes of this paragraph (c)(7) is the U.S. dollar 
amount of the controlled foreign corporation's current year taxes (as 
defined in Sec. 1.960-1(b)(4)) that are allocated and apportioned to 
the related tentative gross tested income item under the rules of 
paragraph (c)(7)(iii) of this section. See paragraphs 
(c)(8)(iii)(A)(2)(iv) (Example 1), (c)(8)(iii)(B)(2)(v) (Example 2), and 
(c)(8)(iii)(C)(2)(v) (Example 3) of this section for illustrations of 
the application of the rule set forth in this paragraph (c)(7)(vii).
    (viii) Rules regarding the high-tax election--(A) Manner--(1) An 
election is made under this paragraph (c)(7)(viii) by the controlling 
domestic shareholders (as defined in Sec. 1.964-1(c)(5)) with respect 
to a controlled foreign corporation for a CFC inclusion year (a high-tax 
election) in accordance with the rules provided in forms or instructions 
and by--
    (i) Filing the statement required under Sec. 1.964-1(c)(3)(ii) with 
a timely filed original federal income tax return, or with an amended 
federal income tax return in accordance with paragraph 
(c)(7)(viii)(A)(2) of this section, for the U.S. shareholder inclusion 
year of each controlling domestic shareholder in which or with which 
such CFC inclusion year ends;
    (ii) Providing any notices required under Sec. 1.964-1(c)(3)(iii); 
and
    (iii) Providing any additional information required by applicable 
administrative pronouncements.
    (2) In the case of an election (or revocation) made with an amended 
federal income tax return--
    (i) The election (or revocation) must be made on an amended federal 
income tax return duly filed within 24 months of the unextended due date 
of the original federal income tax return for the U.S. shareholder 
inclusion year with or within which the CFC inclusion year ends;
    (ii) Each United States shareholder that owns within the meaning of 
section 958(a) (including both domestic partnerships that are United 
States shareholders that own stock within the meaning of section 958(a) 
without regard to Sec. 1.951A-1(e)(1) and partners of a domestic 
partnership that are United States shareholders that are treated as 
owning stock withing the meaning of section 958(a) by reason of Sec. 
1.951A-1(e)(1)) stock of the controlled foreign corporation as of the 
end of the CFC's taxable year to which the election relates must file 
amended Federal income tax returns (or timely original federal income 
tax returns if a return has not yet been filed) reflecting the effect of 
such election (or revocation) for the U.S. shareholder inclusion year 
with or within which the CFC inclusion year ends as well as for any 
other taxable year in which the U.S. tax liability of the United States 
shareholder would be increased by reason of the election (or revocation) 
(or in the case of a partnership if any item reported by the partnership 
or any partnership-related item would change as a result of the election 
(or revocation)) within

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a single period no greater than six months within the 24-month period 
described in paragraph (c)(7)(viii)(A)(2)(i) of this section; and
    (iii) Each United States shareholder in the controlled foreign 
corporation as of the end of the controlled foreign corporation's 
taxable year to which the election relates must pay any tax due as a 
result of such adjustments within a single period no greater than six 
months within the 24-month period described in paragraph 
(c)(7)(viii)(A)(2)(i) of this section.
    (3) In the case of a United States shareholder that is a 
partnership, paragraphs (c)(7)(viii)(A)(1) and (2) and (c)(7)(viii)(C) 
of this section are applied by substituting ``Form 1065 (or successor 
form)'' for ``federal income tax return'' and by substituting ``amended 
Form 1065 (or successor form) or administrative adjustment request (as 
described in Sec. 301.6227-1), as applicable,'' for ``amended federal 
income tax return'', each place that it appears.
    (4) A United States shareholder that is a partner in a partnership 
that is also a United States shareholder in the controlled foreign 
corporation must generally file an amended return, as required under 
paragraph (c)(7)(viii)(A)(2)(ii) of this section, and must generally pay 
any additional tax owed as required under paragraph 
(c)(7)(viii)(A)(2)(iii) of this section. However, in the case of a 
United States shareholder that is a partner in a partnership that duly 
files an administrative adjustment request under paragraph 
(c)(7)(viii)(A)(2) of this section, the partner is treated as having 
satisfied the requirements of paragraphs (c)(7)(viii)(A)(2)(ii) and 
(iii) of this section with respect to the interest held through that 
partnership if:
    (i) The partnership timely files an administrative adjustment 
request described in paragraph (c)(7)(viii)(A)(2)(i) or (ii) of this 
section, as applicable; and,
    (ii) Both the partnership and its partners timely comply with the 
requirements of section 6227 with respect to the administrative 
adjustment request. See Sec. Sec. 301.6227-1 through -3 for rules 
relating to administrative adjustment requests.
    (B) Scope. A high-tax election applies with respect to each 
tentative gross tested income item of the controlled foreign corporation 
for the CFC inclusion year and is binding on all United States 
shareholders of the controlled foreign corporation.
    (C) Revocation. A high-tax election may be revoked by the 
controlling domestic shareholders of the controlled foreign corporation 
in the same manner as prescribed for an election made on an amended 
return as described in paragraph (c)(7)(viii)(A) of this section.
    (D) Failure to satisfy election requirements. A high-tax election 
(or revocation) is valid only if all of the requirements in paragraph 
(c)(7)(viii)(A) of this section, including the requirement to provide 
notice under paragraph (c)(7)(viii)(A)(1)(ii) of this section, are 
satisfied.
    (E) Rules applicable to CFC groups--(1) In general. In the case of a 
controlled foreign corporation that is a member of a CFC group, a high-
tax election is made under paragraph (c)(7)(viii)(A) of this section, or 
revoked under paragraph (c)(7)(viii)(C) of this section, with respect to 
all controlled foreign corporations that are members of the CFC group 
and the rules in paragraphs (c)(7)(viii)(A) through (D) of this section 
apply by reference to the CFC group.
    (2) Determination of the CFC group--(i) Definition. Subject to the 
rules in paragraphs (c)(7)(viii)(E)(2)(ii) and (iii) of this section, 
the term CFC group means an affiliated group as defined in section 
1504(a) without regard to section 1504(b)(1) through (6), except that 
section 1504(a) is applied by substituting ``more than 50 percent'' for 
``at least 80 percent'' each place it appears, and section 1504(a)(2)(A) 
is applied by substituting ``or'' for ``and.'' For purposes of this 
paragraph (c)(7)(viii)(E)(2)(i), stock ownership is determined by 
applying the constructive ownership rules of section 318(a), other than 
section 318(a)(3)(A) and (B), by applying section 318(a)(4) only to 
options (as defined in Sec. 1.1504-4(d)) that are reasonably certain to 
be exercised as described in Sec. 1.1504-4(g), and by substituting in 
section 318(a)(2)(C) ``5 percent'' for ``50 percent.

[[Page 194]]

    (ii) Member of a CFC group. The determination of whether a 
controlled foreign corporation is included in a CFC group is made as of 
the close of the CFC inclusion year of the controlled foreign 
corporation that ends with or within the taxable years of the 
controlling domestic shareholders. One or more controlled foreign 
corporations are members of a CFC group if the requirements of paragraph 
(c)(7)(viii)(E)(2) of this section are satisfied as of the end of the 
CFC inclusion year of at least one of the controlled foreign 
corporations, even if the requirements are not satisfied as of the end 
of the CFC inclusion year of all controlled foreign corporations. If the 
controlling domestic shareholders do not have the same taxable year, the 
determination of whether a controlled foreign corporation is a member of 
a CFC group is made with respect to the CFC inclusion year that ends 
with or within the taxable year of the majority of the controlling 
domestic shareholders (determined based on voting power) or, if no such 
majority taxable year exists, the calendar year. See paragraph 
(c)(8)(iii)(E) (Example 5) of this section for an example that 
illustrates the application of the rule set forth in this paragraph 
(c)(7)(viii)(E)(2)(ii). Notwithstanding the rule set forth in this 
paragraph (c)(7)(viii)(E)(2)(ii), a controlled foreign corporation is 
not a member of a CFC group if, as of the close of its CFC inclusion 
year, the controlled foreign corporation does not have a controlling 
domestic shareholder.
    (iii) Controlled foreign corporations included in only one CFC 
group. A controlled foreign corporation cannot be a member of more than 
one CFC group. If a controlled foreign corporation would be a member of 
more than one CFC group under paragraph (c)(7)(viii)(E)(2) of this 
section, then ownership of stock of the controlled foreign corporation 
is determined by applying paragraph (c)(7)(viii)(E)(2) of this section 
without regard to section 1504(a)(2)(B) or, if applicable, by reference 
to the ownership existing as of the end of the first CFC inclusion year 
of a controlled foreign corporations that would cause a CFC group to 
exist.
    (ix) Definitions. The following definitions apply for purposes of 
this paragraph (c)(7).
    (A) Indirectly. The term indirectly, when used in reference to 
ownership, means ownership through one or more pass-through entities.
    (B) Pass-through entity. The term pass-through entity means a 
partnership, a disregarded entity, or any other person (whether domestic 
or foreign) other than a corporation to the extent that income, gain, 
deduction or loss of the person is taken into account in determining the 
income or loss of a controlled foreign corporation that owns, directly 
or indirectly, interests in the person.
    (C) Transparent interest. The term transparent interest means an 
interest in a pass-through entity (or the activities of a branch) that 
is not a tested unit.
    (8) Examples--(i) Scope. This paragraph (c)(8) provides examples 
illustrating the application of the rules in paragraph (c)(7) of this 
section.
    (ii) Presumed facts. For purposes of the examples in paragraph 
(c)(8)(iii) of this section, except as otherwise stated, the following 
facts are presumed:
    (A) USP is a domestic corporation.
    (B) CFC1X and CFC2X are controlled foreign corporations organized 
in, and tax residents of, Country X.
    (C) CFC3Z is a controlled foreign corporation organized in, and tax 
resident of, Country Z.
    (D) FDEX is a disregarded entity that is a tax resident of Country 
X.
    (E) FDE1Y and FDE2Y are disregarded entities that are tax residents 
of Country Y.
    (F) FPSY is an entity that is organized in, and a tax resident of, 
Country Y but is classified as a partnership for federal income tax 
purposes.
    (G) CFC1X, CFC2X, CFC3Z, and the interests in FDEX, FDE1Y, FDE2Y, 
and FPSY are tested units (the CFC1X tested unit, CFC2X tested unit, 
CFC3Z tested unit, FDEX tested unit, FDE1Y tested unit, FDE2Y tested 
unit, and FPSY tested unit, respectively).
    (H) CFC1X, CFC2X, CFC3Z, FDEX, FDE1Y, and FDE2Y conduct activities 
in the foreign country in which they are tax resident, and properly 
reflect items of income, gain, deduction, and

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loss on separate sets of books and records.
    (I) All entities have calendar taxable years (for both federal 
income tax purposes and for purposes of the relevant foreign country) 
and use the Euro ([euro]) as their functional currency. At all relevant 
times [euro]1 = $1.
    (J) The maximum rate of tax specified in section 11 for the CFC 
inclusion year is 21 percent.
    (K) Neither CFC1X, CFC2X, nor CFC3Z directly or indirectly earns 
income described in section 952(b), has any items of income, gain, 
deduction, or loss, or makes or receives disregarded payments. In 
addition, no tested unit of CFC1X, CFC2X, or CFC3Z makes or receives 
disregarded payments.
    (L) An election made under section 954(b)(4) and paragraph 
(c)(7)(viii) of this section is effective with respect to CFC1X and 
CFC2X, as applicable, for the CFC inclusion year.
    (iii) Examples--(A) Example 1: Effect of disregarded interest--(1) 
Facts--(i) Ownership. USP owns all of the stock of CFC1X, and CFC1X owns 
all of the interests of FDE1Y.
    (ii) Gross income and deductions (other than for foreign income 
taxes). In Year 1, CFC1X generates [euro]100x of gross income from 
services to unrelated parties that would be gross tested income without 
regard to paragraph (c)(7) of this section and that is properly 
reflected on the books and records of FDE1Y. The [euro]100x of services 
income is general category income under Sec. 1.904-4(d). In Year 1, 
FDE1Y accrues and pays [euro]20x of interest to CFC1X that is deductible 
for Country Y tax purposes but is disregarded for federal income tax 
purposes. The [euro]20x of disregarded interest income received by CFC1X 
from FDE1Y is properly reflected on CFC1X's books and records, and the 
[euro]20x of disregarded interest expense paid from FDE1Y to CFC1X is 
properly reflected on FDE1Y's books and records.
    (iii) Foreign income taxes. Country X imposes no tax on net income, 
and Country Y imposes a 25% tax on net income. For Country Y tax 
purposes, FDE1Y (which is not disregarded under Country Y tax law) has 
[euro]80x of taxable income ([euro]100x of services income from the 
unrelated parties, less a [euro]20x deduction for the interest paid to 
CFC1X). Accordingly, FDE1Y incurs a Country Y income tax liability with 
respect to Year 1 of [euro]20x ([euro]80x x 25%), the U.S. dollar amount 
of which is $20x.
    (2) Analysis--(i) Tentative gross tested income items. Under 
paragraph (c)(7)(ii)(A) of this section, the tentative gross tested 
income item with respect to each of the CFC1X tested unit and the FDE1Y 
tested unit is the aggregate of the gross income of CFC1X that is 
attributable to the tested unit, that would be gross tested income 
(without regard to this paragraph (c)(7)), and that would be in a single 
tested income group. Under paragraphs (c)(7)(ii)(B)(1) and (2) of this 
section, items of gross income of CFC1X are attributable to the CFC1X 
tested unit, or the FDE1Y tested unit, to the extent properly reflected 
on its separate set of books and records, as determined under federal 
income tax principles and adjusted to take into account disregarded 
payments. Without regard to the [euro]20x disregarded interest payment 
from FDE1Y to CFC1X, gross income attributable to the CFC1X tested unit 
would be [euro]0 (that is, the [euro]20x of interest income reflected on 
the books and records of CFC1X would be reduced by [euro]20x, the amount 
attributable to the payment that is disregarded for federal income tax 
purposes). Similarly, without regard to the [euro]20x disregarded 
interest payment from FDE1Y to CFC1X, gross income attributable to the 
FDE1Y tested unit would be [euro]100x (that is, [euro]100x of services 
income reflected on the books and records of FDE1Y, unreduced by the 
[euro]20x disregarded interest payment from FDE1Y to CFC1X). However, 
under paragraph (c)(7)(ii)(B)(2) of this section, the gross income 
attributable to each of the CFC1X tested unit and the FDE1Y tested unit 
is adjusted by [euro]20x, the amount of the disregarded interest payment 
from FDE1Y to CFC1X that is deductible for Country Y tax purposes. 
Accordingly, the tentative gross tested income item attributable to the 
CFC1X tested unit (the ``CFC1X tentative gross tested income item'') is 
[euro]20x ([euro]0 + [euro]20x), and the tentative gross tested income 
item attributable to the FDE1Y tested unit (the ``FDE1Y tentative gross 
tested income item'') is [euro]80x ([euro]100x - [euro]20x).

[[Page 196]]

    (ii) Foreign income tax deduction. Under paragraph (c)(7)(iii)(A) of 
this section, CFC1X's tentative tested income items are computed by 
treating the CFC1X tentative gross tested income item and the FDE1Y 
tentative gross tested income item each as income in a separate tested 
income group (the ``CFC1X income group'' and the ``FDE1Y income group'') 
and by allocating and apportioning CFC1X's deductions for current year 
taxes under the principles of Sec. 1.960-1(d)(3)(ii) (CFC1X has no 
other deductions to allocate and apportion). Under paragraph 
(c)(7)(iii)(A) of this section, the [euro]20x deduction for Country Y 
income taxes is allocated and apportioned solely to the FDE1Y income 
group (the ``FDE1Y group tax''). None of the Country Y taxes are 
allocated and apportioned to the CFC1X income group under paragraph 
(c)(7)(iii)(B) of this section and the principles of Sec. 1.904-
6(a)(2)(ii)(A), because none of the Country Y tax is imposed solely by 
reason of the disregarded interest payment.
    (iii) Tentative tested income items. Under paragraph (c)(7)(iii) of 
this section, the tentative tested income item with respect to the CFC1X 
income group (the ``CFC1X tentative tested item''), is [euro]20x. The 
tentative tested income item with respect to the FDE1Y income group (the 
``CFC1X tentative tested item'') is [euro]60x (the FDE1Y tentative gross 
tested income item of [euro]80x, less the [euro]20x deduction for the 
FDE1Y group tax).
    (iv) Foreign income tax paid or accrued with respect to a tentative 
tested income item. Under paragraph (c)(7)(vii) of this section, the 
foreign income taxes paid or accrued with respect to a tentative tested 
income item is the U.S. dollar amount of the current year taxes that are 
allocated and apportioned to the related tentative gross tested income 
item under the rules of paragraph (c)(7)(iii) of this section. 
Therefore, the foreign income taxes paid or accrued with respect to the 
FDE1Y tentative tested income item is $20x, the U.S. dollar amount of 
the FDE1Y group tax. The foreign income tax paid or accrued with respect 
to the CFC1X tentative tested income item is $0, the U.S. dollar amount 
of the foreign tax allocated and apportioned to the CFC1X tentative 
gross tested income item under paragraph (c)(7)(iii) of this section.
    (v) Effective foreign tax rate. The effective foreign tax rate is 
determined under paragraph (c)(7)(vi) of this section by dividing the 
U.S. dollar amount of foreign income taxes paid or accrued with respect 
to each respective tentative tested income item by the U.S. dollar 
amount of the tentative tested income item increased by the U.S. dollar 
amount of the relevant foreign income taxes. Therefore, the effective 
foreign tax rate with respect to the FDE1Y tentative tested income item 
is 25%, computed by dividing $20x (the U.S. dollar amount of the foreign 
income taxes paid or accrued with respect to the FDE1Y tentative tested 
income item under paragraph (c)(7)(vii) of this section) by $80x (the 
sum of $60x, the U.S. dollar amount of the FDE1Y tentative tested income 
item, and $20x, the U.S. dollar amount of the foreign income taxes paid 
or accrued with respect to the FDE1Y tentative tested income item). The 
CFC1X tentative tested income item is not subject to any foreign income 
tax, so is subject to an effective foreign tax rate of 0%, calculated as 
$0 (the U.S. dollar amount of the foreign income taxes paid or accrued 
with respect to the CFC1X tentative tested income item) divided by $20x 
(the U.S. dollar amount of the CFC1X tentative tested income item).
    (vi) Gross income items excluded under sections 954(b)(4) and 
951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item is subject 
to an effective foreign tax rate (25%) that is greater than 18.9% (90% 
of the maximum rate of tax specified in section 11). Therefore, the 
requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and 
the FDE1Y tentative gross tested income item qualifies under paragraph 
(c)(7)(i) of this section for the high-tax exception of section 
954(b)(4) and is excluded from tested income under sections 
951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this 
section. The CFC1X tentative tested income item is subject to an 
effective foreign tax rate of 0%. Therefore, the CFC1X tentative tested 
income item does not satisfy the requirement of paragraph (c)(7)(i)(B) 
of this section, and the CFC1X tentative

[[Page 197]]

gross tested income item does not qualify under paragraph (c)(7)(i) of 
this section for the high-tax exception of section 954(b)(4) and is not 
excluded from tested income under sections 951A(c)(2)(A)(i)(III) and 
954(b)(4) and paragraph (c)(1)(iii) of this section.
    (B) Example 2: Disregarded payment for services--(1) Facts--(i) 
Ownership. USP owns all of the stock of CFC1X. CFC1X owns all of the 
interests of FDE1Y. FDE1Y is a tax resident of Country Y, but is treated 
as fiscally transparent for Country X tax purposes, so that FDE1Y is 
subject to tax in Country Y and CFC1X is subject to tax in Country X 
with respect to FDE1Y's activities.
    (ii) Gross income, deductions (other than for foreign income taxes), 
and disregarded payments. In Year 1, CFC1X generates [euro]1,000x of 
gross income from services to unrelated parties that would be gross 
tested income without regard to paragraph (c)(7) of this section and 
that is properly reflected on the books and records of CFC1X. In Year 1, 
CFC1X accrues and pays [euro]480x of deductible expenses to unrelated 
parties, [euro]280x of which is properly reflected on CFC1X's books and 
records and is definitely related solely to CFC1X's gross income 
reflected on its books and records, and [euro]200x of which is properly 
reflected on FDE1Y's books and records and is definitely related solely 
to FDE1Y's gross income reflected on its books and records. Country X 
law does not provide rules for the allocation or apportionment of these 
deductions to particular items of gross income. In Year 1, CFC1X also 
accrues and pays [euro]325x to FDE1Y for support services performed by 
FDE1Y in Country Y; the payment is disregarded for federal income tax 
purposes. The [euro]325x of disregarded support services income received 
by FDE1Y from CFC1X is properly reflected on FDE1Y's books and records, 
and the [euro]325x of disregarded support services expense paid from 
CFC1X to FDE1Y is properly reflected on CFC1X's books and records.
    (iii) Foreign income taxes. Country X imposes a 10% tax on net 
income, and Country Y imposes a 16% tax on net income. Country X allows 
a deduction, but not a credit, for foreign income taxes paid or accrued 
to another country (such as Country Y). For Country Y tax purposes, 
FDE1Y (which is not disregarded under Country Y tax law) has [euro]125x 
of taxable income ([euro]325x of support services income received from 
CFC1X, less a [euro]200x deduction for expenses paid to unrelated 
parties). Accordingly, FDE1Y incurs a Country Y income tax liability 
with respect to Year 1 of [euro]20x ([euro]125x x 16%), the U.S. dollar 
amount of which is $20x. For Country X tax purposes, CFC1X has 
[euro]500x of taxable income ([euro]1,000x of gross income for services, 
less a [euro]480x deduction for expenses paid to unrelated parties by 
CFC1X and FDE1Y and a [euro]20x deduction for Country Y taxes; Country X 
does not allow CFC1X a deduction for the [euro]325x paid to FDE1Y for 
support services because the [euro]325x payment is disregarded for 
Country X tax purposes). Accordingly, CFC1X incurs a Country X income 
tax liability with respect to Year 1 of [euro]50x ([euro]500x x 10%), 
the U.S. dollar amount of which is $50x.
    (2) Analysis--(i) Tentative gross tested income item. Under 
paragraph (c)(7)(ii) of this section, CFC1X has two tentative gross 
tested income items, one item with respect to CFC1X (the ``CFC1X 
tentative gross tested income item'') and one item with respect to 
CFC1X's interest in FDE1Y (the ``FDE1Y tentative gross tested income 
item''). The gross income attributable to each tested unit comprises the 
gross income properly reflected on the books and records of each tested 
unit under paragraph (c)(7)(ii)(B)(1) of this section, as adjusted under 
paragraph (c)(7)(ii)(B)(2) of this section. Without regard to the 
[euro]325x payment for support services from CFC1X to FDE1Y, the gross 
income attributable to the FDE1Y tested unit would be [euro]0 (that is, 
the [euro]325x of services income properly reflected on the books and 
records of FDE1Y, reduced by the [euro]325x payment from CFC1X to FDE1Y 
that is disregarded for federal income tax purposes). Similarly, without 
regard to the [euro]325x payment for support services from CFC1X to 
FDE1Y, the gross income attributable to the CFC1X tested unit would be 
[euro]1,000x (that is, [euro]1,000x of services income reflected on the 
books and records of CFC1X, unreduced by the [euro]325x disregarded 
payment). However, under paragraph (c)(7)(ii)(B)(2) of

[[Page 198]]

this section, the gross income attributable to each of the CFC1X tested 
unit and the FDE1Y tested unit is adjusted by [euro]325x, the amount of 
the disregarded services payment from CFC1X to FDE1Y. Accordingly, the 
FDE1Y tentative gross tested income item is [euro]325x ([euro]0 + 
[euro]325x), and the CFC1X tentative gross tested income item is 
[euro]675x ([euro]1,000x - [euro]325x).
    (ii) Deductions (other than for foreign income taxes). Under 
paragraph (c)(7)(iii) of this section, CFC1X's tentative tested income 
items are computed by applying the principles of Sec. 1.960-1(d)(3), 
treating the CFC1X tentative gross tested income item and the FDE1Y 
tentative gross tested income item each as income in a separate tested 
income group (the ``CFC1X income group'' and the ``FDE1Y income group'') 
and by allocating and apportioning CFC1X's deductions among the income 
groups under federal income tax principles. For Year 1, CFC1X has 
deductible expense (other than foreign income tax) of [euro]480x. This 
amount includes [euro]280x of deductible expense that is definitely 
related solely the services activity of the CFC1X tested unit, and 
another [euro]200x of deductible expense (other than foreign income tax) 
that is definitely related solely to the services provided by the FDE1Y 
tested unit. Therefore, [euro]280x of deductible expense (other than 
foreign income tax) is allocated and apportioned to the CFC1X income 
group, and [euro]200x of deductible expense (other than foreign income 
tax) is allocated and apportioned to the FDE1Y income group.
    (iii) Foreign income tax deduction. CFC1X accrues foreign income tax 
in Year 1 of [euro]70x ([euro]50x imposed by Country X and [euro]20x 
imposed by Country Y). Under paragraph (c)(7)(iii) of this section, the 
deductions for foreign income taxes are allocated and apportioned under 
the principles of Sec. 1.960-1(d)(3)(ii) to the FDE1Y income group and 
the CFC1X income group. Under paragraph (c)(7)(iii)(A) of this section 
and Sec. 1.960-1(d)(3)(ii), the principles of Sec. 1.904-6(a)(1) 
generally apply to determine the amount of the foreign income tax paid 
or accrued with respect to each income group. However, under paragraph 
(c)(7)(iii)(B) of this section, foreign income taxes imposed by reason 
of the receipt of a disregarded payment are allocated and apportioned 
under the principles of Sec. 1.904-6(a)(2). The Country Y tax of 
[euro]20x is imposed solely by reason of FDE1Y's receipt of a [euro]325x 
disregarded payment. As a result, the entire [euro]20x of Country Y tax 
is allocated and apportioned to the FDE1Y income group under the 
principles of Sec. 1.904-6(a)(2)(ii)(A). If Country X had allowed a 
deduction for the disregarded payment from CFC1X to FDE1Y and not 
otherwise imposed tax on CFC1X with respect to income of FDE1Y, the 
foreign tax imposed by Country X would relate only to the CFC1X tested 
income group, and no portion of it would be allocated and apportioned to 
the FDE1Y income group because the FDE1Y income would not be included in 
the Country X tax base. However, because gross income subject to tax in 
Country X includes gross income that for federal income tax purposes is 
attributable to both the FDE1Y tested unit and the CFC1X tested unit, 
the [euro]50x of foreign income tax imposed by Country X is related to 
both the FDE1Y income group and to the CFC1X income group and must be 
allocated and apportioned under the principles of Sec. 1.904-
6(a)(1)(i). Because Country X does not provide specific rules for the 
allocation or apportionment of the [euro]500x of deductible expenses, 
Sec. 1.904-6(a)(1)(ii) applies the principles of Sec. Sec. 1.861-8 
through 1.861-14T to determine the foreign law net income subject to 
Country X tax for purposes of apportioning the [euro]50x of Country X 
tax between the income groups. CFC1X has [euro]1,000x of gross income 
and [euro]500x of deductible expenses under the tax laws of Country X, 
resulting in [euro]500x of net foreign law income. Of the [euro]1,000x 
of foreign law gross income, [euro]325x corresponds to the gross income 
in the FDE1Y income group, and [euro]675x corresponds to the gross 
income in the CFC1X income group. Applying federal income tax principles 
to allocate and apportion the foreign law deductions to foreign law 
gross income, [euro]220x of the [euro]500x foreign law deductions is 
allocated and apportioned to the FDE1Y income group and [euro]280x is 
allocated and apportioned to the CFC1X income group. Of the total 
[euro]500x of net foreign law income, [euro]105x ([euro]325x Country X 
gross income corresponding to the

[[Page 199]]

FDE1Y income group, less [euro]220x allocable Country X expenses) 
corresponds to the FDE1Y income group and [euro]395x ([euro]675x Country 
X gross income corresponding to the CFC1X income group, less [euro]280x 
allocable Country X expenses) corresponds to the CFC1X income group. 
Therefore, [euro]10.5x ([euro]50x x [euro]105x/[euro]500x) of Country X 
tax is allocated and apportioned to the FDE1Y income group, and 
[euro]39.5x ([euro]50x x [euro]395x/[euro]500x) is allocated and 
apportioned to the CFC1X income group. In total, [euro]30.5x of foreign 
tax ([euro]10.5x of Country X tax and [euro]20x of Country Y tax) is 
allocated and apportioned to the FDE1Y income group (the ``FDE1Y group 
tax''), and [euro]39.5x of foreign tax (all of which is Country X tax) 
is allocated and apportioned to the CFC1X tested income group (the 
``CFC1X group tax'').
    (iv) Tentative tested income items. Under paragraph (c)(7)(iii) of 
this section, the tentative tested income item attributable to FDE1Y 
(the ``FDE1Y tentative tested income item'') is [euro]94.5x (the FDE1Y 
gross tested income item of [euro]325x, less the allocated and 
apportioned deductions of [euro]230.5x (the sum of deductions (other 
than for foreign income tax) of [euro]200x, Country Y tax of [euro]20x, 
and Country X tax of [euro]10.5x)). The tentative tested income item 
attributable to CFC1X (the ``CFC1X tentative tested income item'') is 
[euro]355.5x (the CFC1X gross tentative tested income item of 
[euro]675x, less the allocated and apportioned deductions of 
[euro]319.5x (the sum of deductions (other than for foreign income tax) 
of [euro]280x and Country X tax of [euro]39.5x)).
    (v) Foreign income taxes paid or accrued with respect to a tentative 
tested income item. Under paragraph (c)(7)(vii) of this section, the 
foreign income taxes paid or accrued with respect to a tentative tested 
income item is the U.S. dollar amount of the current year taxes that are 
allocated and apportioned to the related tentative gross tested income 
item under the rules of paragraph (c)(7)(iii) of this section. 
Therefore, the foreign income taxes paid or accrued with respect to the 
FDE1Y tentative tested income item is $30.5x, the U.S. dollar amount of 
the FDE1Y group tax, and the foreign income taxes paid or accrued with 
respect to the CFC1X tentative tested income item is $39.5x, the U.S. 
dollar amount of the CFC1X group tax.
    (vi) Effective foreign tax rate. The effective foreign tax rate is 
determined under paragraph (c)(7)(vi) of this section by dividing the 
U.S. dollar amount of foreign income taxes paid or accrued with respect 
to each respective tentative tested income item by the U.S. dollar 
amount of the tentative tested income item increased by the U.S. dollar 
amount of the relevant foreign income taxes. Therefore, the effective 
foreign tax rate for the FDE1Y tentative tested income item is 24.4%, 
computed by dividing $30.5x (the U.S. dollar amount of the foreign 
income taxes paid or accrued with respect to the FDE1Y tentative tested 
income item), by $125x (the sum of $94.5x, the U.S. dollar amount of the 
FDE1Y tentative tested income item, and $30.5x, the U.S. dollar amount 
of the foreign income taxes paid or accrued with respect to the FDE1Y 
tentative tested income item). Similarly, the effective foreign tax rate 
for the CFC1X tentative tested income item is 10%, computed by dividing 
$39.5x (the U.S. dollar amount of the foreign income taxes paid or 
accrued with respect to the CFC1X tentative tested income item) by $395x 
(the sum of $355.5x, the U.S. dollar amount of the CFC1X tentative 
tested income item, and $39.5x, the U.S. dollar amount of the foreign 
taxes paid or accrued with respect to the CFC1X tentative tested income 
item).
    (vii) Gross income items excluded under sections 954(b)(4) and 
951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item has an 
effective foreign tax rate (24.4%) that is greater than 18.9% (90% of 
the maximum rate of tax specified in section 11). Therefore, the 
requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and 
the FDE1Y tentative gross tested income item qualifies under paragraph 
(c)(7)(i) of this section for the high-tax exception of section 
954(b)(4) and is excluded from tested income under sections 
951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this 
section. The CFC1X tentative tested income item has an effective foreign 
tax rate (10%) that is not greater than 90% of the maximum rate of tax 
specified in section 11. Therefore, the CFC1X tentative gross tested 
income item

[[Page 200]]

does not qualify under paragraph (c)(7)(i) of this section for the high-
tax exception of section 954(b)(4) and is not excluded from tested 
income under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph 
(c)(1)(iii) of this section.
    (C) Example 3: Interest expense allocated and apportioned with 
respect to the income of a lower-tier CFC--(1) Facts--(i) Ownership. USP 
owns all of the stock of CFC1X. CFC1X directly owns all the interests of 
FDE1Y. FDE1Y owns all of the stock of CFC3Z. Pursuant to Sec. 1.861-
9(j) and Sec. 1.861-9T(j), CFC1X uses the modified gross income method 
to allocate and apportion its interest expense.
    (ii) Gross income and deductions (including for foreign income 
taxes). During Year 1, CFC1X generates [euro]4,000x of gross income from 
services that would be gross tested income without regard to paragraph 
(c)(7) of this section, [euro]3,000x of which is properly reflected on 
the books and records of the CFC1X tested unit and [euro]1,000x of which 
is properly reflected on the books and records of the FDE1Y tested unit. 
CFC1X also accrues [euro]1,000x of interest expense to an unrelated 
person. Country X imposes [euro]200x of income taxes with respect to the 
[euro]3,000x of gross income properly reflected on the books and records 
of the CFC1X tested unit, and Country Y imposes [euro]200x of income 
taxes with respect to the [euro]1,000x of gross income properly 
reflected on the books and records of the FDE1Y tested unit. CFC3Z 
generates [euro]1,000x of gross income from services that would be gross 
tested income without regard to paragraph (c)(7) of this section, and 
such gross income is properly reflected on the books and records of the 
CFC3Z tested unit. CFC3Z accrues no expenses, and Country Z imposes 
[euro]100x of income taxes with respect to the [euro]1,000x of gross 
income generated by CFC3Z.
    (2) Analysis--(i) Tentative gross tested income items. Under 
paragraph (c)(7)(ii) of this section, the [euro]3,000x of gross income 
that is reflected on the books and records of the CFC1X tested unit, and 
the [euro]1,000x of gross income that is reflected on the books and 
records of the FDE1Y tested unit, are attributable to the CFC1X tested 
unit and the FDE1Y tested unit, respectively. Under paragraph (c)(7)(ii) 
of this section, each of these amounts is a separate tentative gross 
tested income item of CFC1X (the ``CFC1X tentative gross tested income 
item'' and the ``FDE1Y tentative gross tested income item,'' 
respectively). Under paragraph (c)(7)(ii) of this section, the 
[euro]1,000x item of tentative gross tested income that is properly 
reflected on the books and records of the CFC3Z tested unit is 
attributable to the CFC3Z tested unit. Under paragraph (c)(7)(ii) of 
this section, the amount attributable to the CFC3Z tested unit is a 
tentative gross tested income item of CFC3Z (the ``CFC3Z tentative gross 
tested income item'').
    (ii) Allocation and apportionment of interest expense. To compute 
CFC1X's tentative tested income items, the principles of Sec. 1.960-
1(d)(3) apply by treating each of CFC1X's tentative gross tested income 
items as income in a separate tested income group (the ``CFC1X income 
group'' and the ``FDE1Y income group'') and allocate and apportion its 
deductions among those income groups under federal income tax 
principles. Because CFC1X uses the modified gross income method under 
Sec. 1.861-9(j) and Sec. 1.861-9T(j) to allocate and apportion 
interest expense, it must allocate and apportion its interest expense 
between the CFC1X income group and the FDE1Y income group based on a 
combined gross income amount that includes both the gross income of 
CFC1X (including the gross income attributable to both the CFC1X tested 
unit and the FDE1Y tested unit) and the gross income of CFC3Z, adjusted 
as provided under Sec. 1.861-9(j) and Sec. 1.861-9T(j). Under Sec. 
1.861-9(j) and Sec. 1.861-9T(j), the adjusted combined gross income of 
CFC1X comprises the CFC1X tentative gross tested income item 
([euro]3,000x), or 60% of the combined adjusted gross income amount, the 
FDE1Y tentative gross tested income item ([euro]1,000x), or 20% of the 
combined adjusted gross income amount, and the CFC3Z gross tentative 
tested income item ([euro]1,000x), or 20% of the combined adjusted gross 
income amount. Under paragraph (c)(7)(iii) of this section, interest 
expense of CFC1X that is allocated and apportioned to the gross income 
of CFC3Z under Sec. 1.861-9(j) and Sec. 1.861-9T(j) is not allocated 
and apportioned to either the CFC1X income group or the

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FDE1Y income group. Therefore, [euro]600x of interest expense (60% of 
the [euro]1,000x of interest expense) is allocated and apportioned to 
the CFC1X income group, and [euro]200x of interest expense (20% of the 
[euro]1,000x of interest expense) is allocated and apportioned to the 
FDE1Y income group. The [euro]200x of interest expense that is allocated 
and apportioned to the [euro]1,000x of gross tentative tested income of 
CFC3Z is allocated and apportioned to the residual income group for 
purposes of paragraph (c)(7) of this section, but can still be allocated 
and apportioned to a statutory grouping of tested income of CFC1X for 
purposes of paragraph (c)(3) of this section. See paragraph (c)(7)(iii) 
of this section.
    (iii) Foreign income tax deduction. Under paragraph (c)(7)(iii) of 
this section, deductions for foreign income taxes paid or accrued by 
CFC1X are allocated and apportioned under the principles of Sec. Sec. 
1.960-1(d)(3)(ii) and Sec. 1.904-6(a)(1) to the CFC1X income group and 
the FDE1Y income group. Similarly, foreign income taxes paid or accrued 
by CFC3Z are allocated and apportioned under the principles of 
Sec. Sec. 1.960-1(d)(3)(ii) and 1.904-6(a)(1) to the tentative gross 
tested income item of CFC3Z (the ``CFC3Z income group''). Under these 
principles, the [euro]200x of Country X income taxes are allocated and 
apportioned to the CFC1X income group (the ``CFC1X group tax''), the 
[euro]200x of Country Y income taxes are allocated and apportioned to 
the FDE1Y income group (the ``FDE1Y group tax''), and the [euro]100x of 
Country Z income taxes are allocated and apportioned to the CFC3Z income 
group (the ``CFC3Z group tax'').
    (iv) Tentative tested income items. After the allocation and 
apportionment of deductions to reduce the tentative gross tested income 
in each income group, under paragraph (c)(7)(iii) of this section, CFC1X 
has a tentative tested income item with respect to the CFC1X tested unit 
of [euro]2,200x ([euro]3,000x, less [euro]600x of interest expense and 
[euro]200x of foreign income tax expense, the ``CFC1X tentative tested 
income item'') and a tentative tested income item with respect to the 
FDE1Y tested unit of [euro]600x ([euro]1,000x, less [euro]200x of 
interest expense and [euro]200x of foreign income tax expense, the 
``FDE1Y tentative tested income item''). CFC3Z has a tentative tested 
income item of [euro]900x ([euro]1,000x, less [euro]100x of foreign 
income tax expense, the ``CFC3Z tentative tested income item'').
    (v) Foreign income taxes paid or accrued with respect to a tentative 
tested income item. Under paragraph (c)(7)(vii) of this section, the 
foreign income taxes paid or accrued with respect to a tentative tested 
income item is the U.S. dollar amount of the current year taxes that are 
allocated and apportioned to the related tentative gross tested income 
item under the rules of paragraph (c)(7)(iii) of this section. 
Therefore, the foreign income tax paid or accrued with respect to the 
CFC1X tentative tested income item is $200x, the U.S. dollar amount of 
the CFC1X group tax. Similarly, the foreign income tax paid or accrued 
with respect to the FDE1Y tentative tested income item is $200x, the 
U.S. dollar amount of the FDE1Y group tax, and the foreign income tax 
paid or accrued with respect to the CFC3Z tentative tested income item 
is $100x, the U.S. dollar amount of the CFC3Z group tax.
    (vi) Effective foreign tax rate. The effective foreign tax rate is 
determined under paragraph (c)(7)(vi) of this section by dividing the 
U.S. dollar amount of foreign income taxes paid or accrued with respect 
to each respective tentative tested income item by the U.S. dollar 
amount of the tentative tested income item increased by the U.S. dollar 
amount of the relevant foreign income taxes. Therefore, the effective 
foreign tax rate for the CFC1X tentative tested income item is 8.3%, 
computed by dividing $200x (the U.S. dollar amount of the foreign income 
taxes paid or accrued with respect to the CFC1X tentative tested income 
item), by $2,400x (the sum of $2,200x, the U.S. dollar amount of the 
CFC1X tentative tested income item and $200x, the U.S. dollar amount of 
the foreign taxes paid or accrued with respect to the CFC1X tentative 
tested income item). The effective foreign tax rate for the FDE1Y 
tentative tested income item is 25%, computed by dividing $200x (the 
U.S. dollar amount of the foreign taxes paid or accrued with respect to 
the FDE1Y tentative tested income item) by $800x (the sum of $600x, the 
U.S. dollar

[[Page 202]]

amount of the FDE1Y tentative tested income item, and $200x, the U.S. 
dollar amount of the foreign taxes paid or accrued with respect to the 
FDE1Y tentative tested income item). The effective foreign tax rate for 
the CFC3Z tentative tested income item is 10%, computed by dividing 
$100x (the U.S. dollar amount of the foreign taxes paid or accrued with 
respect to the CFC3Z tentative tested income item) by $1,000x (the sum 
of $900x, the U.S. dollar amount of the CFC3Z tentative tested income 
item, and $100x, the U.S. dollar amount of the foreign taxes paid or 
accrued with respect to the CFC3Z tentative tested income item).
    (vii) Gross income items excluded under sections 954(b)(4) and 
951A(c)(2)(A)(i)(III). The FDE1Y tentative tested income item is subject 
to tax at an effective foreign tax rate (25%) that is greater than 18.9% 
(90% of the maximum rate of tax specified in section 11). Therefore, the 
requirement of paragraph (c)(7)(i)(B) of this section is satisfied, and 
the FDE1Y tentative gross tested income item qualifies under paragraph 
(c)(7)(i) of this section for the high-tax exception of section 
954(b)(4) and is excluded from tested income under sections 
951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph (c)(1)(iii) of this 
section. In computing the tested income of CFC1X under paragraph (c)(3) 
of this section, the deductions of CFC1X that were allocated and 
apportioned to the FDE1Y tentative gross tested income item (that is, 
the [euro]200x of interest expense and the [euro]200x of FDE1Y group 
taxes) are allocated and apportioned to this item of tentative gross 
tested income. As a result, the [euro]1,000x of tentative gross tested 
income excluded from tested income under section 954(b)(4), as well as 
the [euro]200x of interest expense and [euro]200x of foreign tax expense 
allocable to that gross income, are allocated and apportioned to the 
residual category under paragraph (c)(3) of this section for purposes of 
determining the tested income of CFC1X. Under Sec. 1.960-1(d)(3), the 
$200x of foreign income taxes allocated and apportioned to the excluded 
gross income would also be assigned to the residual income group for 
purposes of determining CFC1X's tested taxes for purposes of section 
960(d). The CFC1X tentative tested income item and CFC3Z tentative 
tested income item each have effective foreign tax rates (8.3% and 10%, 
respectively) that are not greater than 90% of the maximum rate of tax 
specified in section 11. Therefore, the CFC1X tentative gross tested 
income item and the CFC3Z tentative gross tested income item do not 
qualify under paragraph (c)(7)(i) of this section for the high-tax 
exception of section 954(b)(4), and are not excluded from tested income 
under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph 
(c)(1)(i) of this section. Under paragraph (c)(3) of this section, the 
corresponding deductions are allocated and apportioned to that gross 
tested income in a manner that achieves a result that is consistent the 
result of the allocation and apportionment of those deductions under 
paragraph (c)(7) of this section. Accordingly, because CFC3Z's tentative 
gross tested income is not excluded from gross tested income under 
sections 951A(c)(2)(A)(i)(IIII) and 954(b)(4) and paragraph (c)(1)(i) of 
this section, under paragraph (c)(3) of this section the [euro]200x of 
CFC1X's interest expense that was apportioned to tentative gross tested 
income of CFC3Z under the modified gross income method in Sec. 1.861-9 
is allocated and apportioned to gross tested income of CFC1X and 
therefore reduces CFC1X's tested income. In contrast, if the CFC3Z 
tentative gross tested item had been excluded from gross tested income 
under sections 951A(c)(2)(A)(i)(III) and 954(b)(4) and paragraph 
(c)(1)(i) of this section, then the [euro]200x of CFC1X's interest 
expense that was allocated and apportioned to that income would be 
assigned to the residual category.
    (D) Example 4: Application of tested unit rules--(1) Facts--(i) 
Ownership. USP owns all of the stock of CFC1X. CFC1X directly owns all 
the interests of FDEX and FDE1Y. In addition, CFC1X directly carries on 
activities in Country Y that constitute a branch (as described in Sec. 
1.267A-5(a)(2)) and that give rise to a taxable presence under Country Y 
tax law and Country X tax law (such branch, ``FBY'').
    (ii) Items reflected on books and records. For the CFC inclusion 
year, CFC1X had a [euro]20x item of gross income (Item A),

[[Page 203]]

which is properly reflected on the books and records of FBY, and a 
[euro]30x item of gross income (Item B), which is properly reflected on 
the books and records of FDEX.
    (2) Analysis--(i) Identifying the tested units of CFC1X. Without 
regard to the combination rule of paragraph (c)(7)(iv)(C) of this 
section, CFC1X, CFC1X's interest in FDEX, CFC1X's interest in FDE1Y, and 
FBY would each be a tested unit of CFC1X. See paragraph (c)(7)(iv)(A) of 
this section. Pursuant to the combination rule, however, the FDE1Y 
tested unit is combined with the FBY tested unit and treated as a single 
tested unit because FDE1Y is a tax resident of Country Y, the same 
country in which FBY is located (the ``Country Y tested unit''). See 
paragraph (c)(7)(iv)(C)(1) of this section. The CFC1X tested unit 
(without regard to any items attributable to the FDEX, FDE1Y, or FBY 
tested units) is also combined with the FDEX tested unit and treated as 
a single tested unit because CFC1X and FDEX are both tax residents of 
County X (the ``Country X tested unit''). See paragraph (c)(7)(iv)(C)(1) 
of this section.
    (ii) Computing the items of CFC1X. Under paragraph (c)(7)(ii)(A) of 
this section, a tentative gross tested income item is determined with 
respect to each of the Country Y tested unit and the Country X tested 
unit. To determine the tentative gross tested income item of each tested 
unit, the item of gross income that is attributable to the tested unit 
is determined under paragraph (c)(7)(ii)(B) of this section. Under 
paragraph (c)(7)(ii)(B) of this section, only Item A is attributable to 
the Country Y tested unit. Item A is not attributable to the Country X 
tested unit because it is not reflected on the separate set of books and 
records of the CFC1X tested unit or the FDEX tested unit, and an item of 
gross income is only attributable to one tested unit. See paragraph 
(c)(7)(ii)(B)(1) of this section. Under paragraph (c)(7)(ii)(B) of this 
section, only Item B is attributable to the Country X tested unit.
    (3) Alternative facts--branch does not give rise to a taxable 
presence in country where located--(i) Facts. The facts are the same as 
in paragraph (c)(8)(iii)(D)(1) of this section (the original facts in 
this Example 4), except that FBY does not give rise to a taxable 
presence under Country Y tax law; moreover, Country X tax law does not 
provide an exclusion, exemption, or other similar relief with respect to 
income attributable to FBY.
    (ii) Analysis. FBY is not a tested unit but is a transparent 
interest. See paragraphs (c)(7)(iv)(A)(3) and (c)(7)(ix)(C) of this 
section. CFC1X has a tested unit in Country X that includes the CFC1X 
tested unit (without regard to any items related to the interest in FDEX 
or FDE1Y, but that includes FBY since it is a transparent interest and 
not a tested unit) and the interest in FDEX. See paragraph (c)(7)(iv)(C) 
of this section. CFC1X has another tested unit in Country Y, the 
interest in FDE1Y.
    (4) Alternative facts--branch is a tested unit but is not combined--
(i) Facts. The facts are the same as in paragraph (c)(8)(iii)(D)(1) of 
this section (the original facts in this Example 4), except that FBY 
does not give rise to a taxable presence under Country Y tax law but 
Country X tax law provides an exclusion, exemption, or other similar 
relief (such as a preferential rate) with respect to income attributable 
to FBY.
    (ii) Analysis. FBY is a tested unit. See paragraph (c)(7)(iv)(A)(3) 
of this section. CFC1X has two tested units in Country Y, the interest 
in FDE1Y and FBY. The interest in FDE1Y and FBY tested units are not 
combined because FBY does not give rise to a taxable presence under the 
tax law of Country Y. See paragraph (c)(7)(iv)(C)(2) of this section. 
CFC1X also has a tested unit in Country X that includes the activities 
of CFC1X (without regard to any items related to the interest in FDEX, 
the interest in FDE1Y, or FBY) and the interest in FDEX.
    (5) Alternative facts--split ownership of tested unit--(i) Facts. 
The facts are the same as in paragraph (c)(8)(iii)(D)(1) of this section 
(the original facts in this Example 4), except that USP also owns CFC2X, 
CFC1X does not own FDE1Y, and CFC1X and CFC2X own 60% and 40%, 
respectively, of the interests of FPSY.
    (ii) Analysis for CFC1X. Under paragraph (c)(7)(iv)(C)(1) of this 
section, FBY and CFC1X's 60% interest in

[[Page 204]]

FPSY are combined and treated as a single tested unit of CFC1X 
(``CFC1X's Country Y tested unit''), and CFC1X's interest in FDEX and 
CFC1X's other activities are combined and treated as a single tested 
unit of CFC1X (``CFC1X's Country X tested unit''). CFC1X's Country Y 
tested unit is attributed any item of CFC1X that is derived through its 
interest in FPSY to the extent the item is properly reflected on the 
books and records of FPSY. See paragraph (c)(7)(ii)(B)(1) of this 
section.
    (iii) Analysis for CFC2X. Under paragraphs (c)(7)(iv)(A)(1) and 
(c)(7)(iv)(A)(2)(i) of this section, CFC2X and CFC2X's 40% interest in 
FPSY are tested units of CFC2X. CFC2X's interest in FPSY is attributed 
any item of CFC2X that is derived through FPSY to the extent that it is 
properly reflected on the books and records of FPSY. See paragraph 
(c)(7)(ii)(B)(1) of this section.
    (iv) Analysis for not combining CFC1X and CFC2X tested units. None 
of the tested units of CFC1X are combined with the tested units of CFC2X 
under paragraph (c)(7)(iv)(C)(1) of this section because they are tested 
units of different controlled foreign corporations, and the combination 
rule only combines tested units of the same controlled foreign 
corporation.
    (6) Alternative facts--split ownership of transparent interest--(i) 
Facts. The facts are the same as in paragraph (c)(8)(iii)(D)(1) of this 
section (the original facts in this Example 4), except that USP also 
owns CFC2X, CFC1X does not own FDE1Y, and CFC1X and CFC2X own 60% and 
40%, respectively, of the interests in FPSY, but FPSY is not a tax 
resident of any foreign country and is fiscally transparent for Country 
X tax law purposes.
    (ii) Analysis for CFC1X. CFC1X's interest in FPSY is not a tested 
unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)(2) and 
(c)(7)(ix)(C) of this section. Under paragraph (c)(7)(v)(C) of this 
section, any item of CFC1X that is derived through its interest in FPSY 
and is properly reflected on the books and records of FPSY is treated as 
properly reflected on the books and records of CFC1X.
    (iii) Analysis for CFC2X. CFC2X's interest in FPSY is not a tested 
unit but is a transparent interest. See paragraphs (c)(7)(iv)(A)(2) and 
(c)(7)(ix)(C) of this section. Under paragraph (c)(7)(v)(C) of this 
section, any item of CFC2X that is derived through its interest in FPSY 
and is properly reflected on the books and records of FPSY is treated as 
properly reflected on the books and records of CFC2X.
    (E) Example 5: CFC group--Controlled foreign corporations with 
different taxable years--(1) Facts. USP owns all the stock of CFC1X and 
CFC2X. CFC2X has a taxable year ending November 30. On December 15, Year 
1, USP sells all the stock of CFC2X to an unrelated party for cash.
    (2) Analysis. The determination of whether CFC1X and CFC2X are in a 
CFC group is made as of the close of their CFC inclusion years that end 
with or within the taxable year ending December 31, Year 1, the taxable 
year of USP, the controlling domestic shareholder. See paragraph 
(c)(7)(viii)(E)(2)(ii) of this section. Under paragraph 
(c)(7)(viii)(E)(2)(i) of this section, USP directly owns more than 50% 
of the stock of CFC1X as of December 31, Year 1, the end of CFC1X's CFC 
inclusion year. USP also directly owns more than 50% of the stock of 
CFC2X as of November 30, Year 1, the end of CFC2X's CFC inclusion year. 
Therefore, CFC1X and CFC2X are members of a CFC group, and USP must 
consistently make high-tax elections, or revocations, under paragraph 
(c)(7)(viii) of this section with respect to CFC1X's taxable year ending 
December 31, Year 1, and CFC2X's taxable year ending November 30, Year 
1. This is the case notwithstanding that USP does not directly own more 
than 50% of the stock of CFC2X as of December 31, Year 1, the end of 
CFC1X's CFC inclusion year. See paragraph (c)(7)(viii)(E)(2)(ii) of this 
section.

[T.D. 9866, 84 FR 29341, June 21, 2019; 84 FR 44694, Aug. 27, 2019, as 
amended by T.D. 9882, 84 FR 69107, Dec. 17, 2019; T.D. 9902, 85 FR 
44638, July 23, 2020; T.D. 9902, 85 FR 64040, Oct. 9, 2020; T.D. 9922, 
85 FR 72069, Nov. 12, 2020; T.D. 9934, 85 FR 76975, Dec. 1, 2020; T.D. 
9902, 85 FR 79853, Dec. 11, 2020; ]

[[Page 205]]



Sec. 1.951A-3  Qualified business asset investment.

    (a) Scope. This section provides rules for determining the qualified 
business asset investment of a controlled foreign corporation for 
purposes of determining a United States shareholder's deemed tangible 
income return under Sec. 1.951A-1(c)(3)(ii). Paragraph (b) of this 
section defines qualified business asset investment. Paragraph (c) of 
this section defines tangible property and specified tangible property. 
Paragraph (d) of this section provides rules for determining the portion 
of tangible property that is specified tangible property when the 
property is used in the production of both gross tested income and gross 
income that is not gross tested income. Paragraph (e) of this section 
provides rules for determining the adjusted basis in specified tangible 
property. Paragraph (f) of this section provides rules for determining 
qualified business asset investment of a tested income CFC with a short 
taxable year. Paragraph (g) of this section provides rules for 
increasing the qualified business asset investment of a tested income 
CFC by reason of property owned by a partnership. Paragraph (h) of this 
section provides anti-avoidance rules that disregard the basis in 
property transferred in certain transactions when determining the 
qualified business asset investment of a tested income CFC.
    (b) Qualified business asset investment. The term qualified business 
asset investment means the average of a tested income CFC's aggregate 
adjusted bases as of the close of each quarter of a CFC inclusion year 
in specified tangible property that is used in a trade or business of 
the tested income CFC and is of a type with respect to which a deduction 
is allowable under section 167. In the case of partially depreciable 
property, only the depreciable portion of the property is of a type with 
respect to which a deduction is allowable under section 167. A tested 
loss CFC has no qualified business asset investment.
    (c) Specified tangible property--(1) In general. The term specified 
tangible property means, with respect to a tested income CFC and a CFC 
inclusion year, tangible property of the tested income CFC used in the 
production of gross tested income for the CFC inclusion year. For 
purposes of the preceding sentence, tangible property of a tested income 
CFC is used in the production of gross tested income for a CFC inclusion 
year if some or all of the depreciation or cost recovery allowance with 
respect to the tangible property is either allocated and apportioned to 
the gross tested income of the tested income CFC for the CFC inclusion 
year under Sec. 1.951A-2(c)(3) or capitalized to inventory or other 
property held for sale, some or all of the gross income or loss from the 
sale of which is taken into account in determining tested income of the 
tested income CFC for the CFC inclusion year. None of the tangible 
property of a tested loss CFC is specified tangible property.
    (2) Tangible property. The term tangible property means property for 
which the depreciation deduction provided by section 167(a) is eligible 
to be determined under section 168 without regard to section 168(f)(1), 
(2), or (5), section 168(k)(2)(A)(i)(II), (IV), or (V), and the date 
placed in service.
    (d) Dual use property--(1) In general. The amount of the adjusted 
basis in dual use property of a tested income CFC for a CFC inclusion 
year that is treated as adjusted basis in specified tangible property 
for the CFC inclusion year is the average of the tested income CFC's 
adjusted basis in the property multiplied by the dual use ratio with 
respect to the property for the CFC inclusion year.
    (2) Definition of dual use property. The term dual use property 
means, with respect to a tested income CFC and a CFC inclusion year, 
specified tangible property of the tested income CFC that is used in 
both the production of gross tested income and the production of gross 
income that is not gross tested income for the CFC inclusion year. For 
purposes of the preceding sentence, specified tangible property of a 
tested income CFC is used in the production of gross tested income and 
the production of gross income that is not gross tested income for a CFC 
inclusion year if less than all of the depreciation or cost recovery 
allowance with respect to the property is either allocated and 
apportioned to the gross tested income of

[[Page 206]]

the tested income CFC for the CFC inclusion year under Sec. 1.951A-
2(c)(3) or capitalized to inventory or other property held for sale, the 
gross income or loss from the sale of which is taken into account in 
determining the tested income of the tested income CFC for the CFC 
inclusion year.
    (3) Dual use ratio. The term dual use ratio means, with respect to 
dual use property, a tested income CFC, and a CFC inclusion year, a 
ratio (expressed as a percentage) calculated as--
    (i) The sum of--
    (A) The depreciation deduction or cost recovery allowance with 
respect to the property that is allocated and apportioned to the gross 
tested income of the tested income CFC for the CFC inclusion year under 
Sec. 1.951A-2(c)(3), and
    (B) The depreciation or cost recovery allowance with respect to the 
property that is capitalized to inventory or other property held for 
sale, the gross income or loss from the sale of which is taken into 
account in determining the tested income of the tested income CFC for 
the CFC inclusion year, divided by
    (ii) The sum of--
    (A) The total amount of the tested income CFC's depreciation 
deduction or cost recovery allowance with respect to the property for 
the CFC inclusion year, and
    (B) The total amount of the tested income CFC's depreciation or cost 
recovery allowance with respect to the property capitalized to inventory 
or other property held for sale, the gross income or loss from the sale 
of which is taken into account in determining the income or loss of the 
tested income CFC for the CFC inclusion year.
    (4) Example. The following example illustrates the application of 
this paragraph (d).
    (i) Facts. FS is a tested income CFC and a wholesale distributor of 
Product A. FS owns a warehouse and trucks that store and deliver Product 
A, respectively. The warehouse has an average adjusted basis for Year 1 
of $20,000x. The depreciation with respect to the warehouse for Year 1 
is $2,000x, which is capitalized to inventory of Product A. Of the 
$2,000x depreciation capitalized to inventory of Product A, $500x is 
capitalized to FS's ending inventory of Product A, $1,200x is 
capitalized to inventory of Product A, the gross income or loss from the 
sale of which is taken into account in determining FS's tested income 
for Year 1, and $300x is capitalized to inventory of Product A, the 
gross income or loss from the sale of which is taken into account in 
determining FS's foreign base company sales income for Year 1. The 
trucks have an average adjusted basis for Year 1 of $4,000x. FS does not 
capitalize depreciation with respect to the trucks to inventory or other 
property held for sale. FS's depreciation deduction with respect to the 
trucks is $20x for Year 1, $15x of which is allocated and apportioned to 
FS's gross tested income under Sec. 1.951A-2(c)(3).
    (ii) Analysis--(A) Dual use property. The warehouse and trucks are 
property for which the depreciation deduction provided by section 167(a) 
is eligible to be determined under section 168 (without regard to 
section 168(f)(1), (2), or (5), section 168(k)(2)(A)(i)(II), (IV), or 
(V), and the date placed in service). Therefore, under paragraph (c)(2) 
of this section, the warehouse and trucks are tangible property. 
Furthermore, because the warehouse and trucks are used in the production 
of gross tested income in Year 1 within the meaning of paragraph (c)(1) 
of this section, the warehouse and trucks are specified tangible 
property. Finally, because the warehouse and trucks are used in both the 
production of gross tested income and the production of gross income 
that is not gross tested income in Year 1 within the meaning of 
paragraph (d)(2) of this section, the warehouse and trucks are dual use 
property. Therefore, under paragraph (d)(1) of this section, the amount 
of FS's adjusted basis in the warehouse and trucks that is treated as 
adjusted basis in specified tangible property for Year 1 is determined 
by multiplying FS's adjusted basis in the warehouse and trucks by FS's 
dual use ratio with respect to the warehouse and trucks determined under 
paragraph (d)(3) of this section.
    (B) Depreciation not capitalized to inventory. Because none of the 
depreciation with respect to the trucks is capitalized to inventory or 
other property held for sale, FS's dual use ratio with

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respect to the trucks is determined entirely by reference the 
depreciation deduction with respect to the trucks. Therefore, under 
paragraph (d)(3) of this section, FS's dual use ratio with respect to 
the trucks for Year 1 is 75%, which is FS's depreciation deduction with 
respect to the trucks that is allocated and apportioned to gross tested 
income under Sec. 1.951A-2(c)(3) for Year 1 ($15x), divided by the 
total amount of FS's depreciation deduction with respect to the trucks 
for Year 1 ($20x). Accordingly, under paragraph (d)(1) of this section, 
$3,000x ($4,000x x 0.75) of FS's average adjusted bases in the trucks is 
taken into account under paragraph (b) of this section in determining 
FS's qualified business asset investment for Year 1.
    (C) Depreciation capitalized to inventory. Because all of the 
depreciation with respect to the warehouse is capitalized to inventory, 
FS's dual use ratio with respect to the warehouse is determined entirely 
by reference to the depreciation with respect to the warehouse that is 
capitalized to inventory and included in cost of goods sold. Therefore, 
under paragraph (d)(3) of this section, FS's dual use ratio with respect 
to the warehouse for Year 1 is 80%, which is FS's depreciation with 
respect to the warehouse that is capitalized to inventory of Product A, 
the gross income or loss from the sale of which is taken into account in 
determining in FS's tested income for Year 1 ($1,200x), divided by FS's 
depreciation with respect to the warehouse that is capitalized to 
inventory of Product A, the gross income or loss from the sale of which 
is taken into account in determining FS's income for Year 1 ($1,500x). 
Accordingly, under paragraph (d)(1) of this section, $16,000x ($20,000x 
x 0.8) of FS's average adjusted basis in the warehouse is taken into 
account under paragraph (b) of this section in determining FS's 
qualified business asset investment for Year 1.
    (e) Determination of adjusted basis in specified tangible property--
(1) In general. Except as provided in paragraph (e)(3)(ii) of this 
section, the adjusted basis in specified tangible property for purposes 
of this section is determined by using the cost capitalization methods 
of accounting used by the controlled foreign corporation for purposes of 
determining the gross income and allowable deductions of the controlled 
foreign corporation under Sec. 1.951A-2(c)(2) and the alternative 
depreciation system under section 168(g), and by allocating the 
depreciation deduction with respect to such property for a CFC inclusion 
year ratably to each day during the period in the CFC inclusion year to 
which such depreciation relates. For purposes of the preceding sentence, 
the period in the CFC inclusion year to which such depreciation relates 
is determined without regard to the applicable convention under section 
168(d).
    (2) Effect of change in law. The adjusted basis in specified 
tangible property is determined without regard to any provision of law 
enacted after December 22, 2017, unless such later enacted law 
specifically and directly amends the definition of qualified business 
asset investment under section 951A.
    (3) Specified tangible property placed in service before enactment 
of section 951A--(i) In general. Except as provided in paragraph 
(e)(3)(ii) of this section, the adjusted basis in specified tangible 
property placed in service before December 22, 2017, is determined using 
the alternative depreciation system under section 168(g), as if this 
system had applied from the date that the property was placed in 
service.
    (ii) Election to use income and earnings and profits depreciation 
method for property placed in service before the first taxable year 
beginning after December 22, 2017--(A) In general. If a controlled 
foreign corporation is not required to use, and does not in fact use, 
the alternative depreciation system under section 168(g) for purposes of 
determining income under Sec. 1.952-2 and earnings and profits under 
Sec. 1.964-1 with respect to property placed in service before the 
first taxable year beginning after December 22, 2017, and the 
controlling domestic shareholders (as defined in Sec. 1.964-1(c)(5)) of 
the controlled foreign corporation make an election described in this 
paragraph (e)(3)(ii), the adjusted basis in specified tangible property 
of the controlled foreign corporation that was placed in service before 
the first taxable year of the controlled foreign

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corporation beginning after December 22, 2017, and the partner adjusted 
basis in partnership specified tangible property of any partnership of 
which the controlled foreign corporation is a partner that was placed in 
service before the first taxable year of the partnership beginning after 
December 22, 2017, is determined for purposes of this section based on 
the method of accounting for depreciation used by the controlled foreign 
corporation for purposes of determining income under Sec. 1.952-2, 
subject to the modification described in this paragraph (e)(3)(ii)(A). 
If the controlled foreign corporation's method of accounting for 
depreciation takes into account salvage value of the property, the 
salvage value is reduced to zero by allocating the salvage value ratably 
to each day of the taxable year immediately after the last taxable year 
in which the method of accounting determined an amount of depreciation 
deduction for the property.
    (B) Manner of making the election. The controlling domestic 
shareholders making the election described in this paragraph (e)(3) must 
file a statement that meets the requirements of Sec. 1.964-1(c)(3)(ii) 
with their income tax returns for the taxable year that includes the 
last day of the controlled foreign corporation's applicable taxable year 
and follow the notice requirements of Sec. 1.964-1(c)(3)(iii). The 
controlled foreign corporation's applicable taxable year is the first 
CFC inclusion year that begins after December 31, 2017, and ends within 
the controlling domestic shareholder's taxable year. For purposes of 
Sec. 301.9100-3 of this chapter (addressing requests for extensions of 
time for filing certain regulatory elections), a controlling domestic 
shareholder is qualified to make the election described in this 
paragraph (e)(3) only if the shareholder determined the adjusted basis 
in specified tangible property placed in service before the first 
taxable year beginning after December 22, 2017, by applying the method 
described in paragraph (e)(3)(ii)(A) of this section with respect to the 
first taxable year of the controlled foreign corporation beginning after 
December 22, 2017, and each subsequent taxable year. The election 
statement must be filed in accordance with the rules provided in forms 
or instructions.
    (f) Special rules for short taxable years--(1) In general. In the 
case of a tested income CFC that has a CFC inclusion year that is less 
than twelve months (a short taxable year), the rules for determining the 
qualified business asset investment of the tested income CFC under this 
section are modified as provided in paragraphs (f)(2) and (3) of this 
section with respect to the CFC inclusion year.
    (2) Determination of quarter closes. For purposes of determining 
quarter closes, in determining the qualified business asset investment 
of a tested income CFC for a short taxable year, the quarters of the 
tested income CFC for purposes of this section are the full quarters 
beginning and ending within the short taxable year (if any), determining 
quarter length as if the tested income CFC did not have a short taxable 
year, plus one or more short quarters (if any).
    (3) Reduction of qualified business asset investment. The qualified 
business asset investment of a tested income CFC for a short taxable 
year is the sum of--
    (i) The sum of the tested income CFC's aggregate adjusted bases in 
specified tangible property as of the close of each full quarter (if 
any) in the CFC inclusion year divided by four, plus
    (ii) The tested income CFC's aggregate adjusted bases in specified 
tangible property as of the close of each short quarter (if any) in the 
CFC inclusion year multiplied by the sum of the number of days in each 
short quarter divided by 365.
    (4) Example. The following example illustrates the application of 
this paragraph (f).
    (i) Facts. USP1, a domestic corporation, owns all of the stock of 
FS, a controlled foreign corporation. USP1 owns FS from the beginning of 
Year 1. On July 15, Year 1, USP1 sells FS to USP2, an unrelated person. 
USP2 makes a section 338(g) election with respect to the purchase of FS, 
as a result of which FS's taxable year is treated as ending on July 15. 
USP1, USP2, and FS all use the calendar year as their taxable year. FS's 
aggregate adjusted bases in specified tangible property is $250x as of 
March 31, $300x as of June 30, $275x as

[[Page 209]]

of July 15, $500x as of September 30, and $450x as of December 31.
    (ii) Analysis--(A) Determination of short taxable years and 
quarters. FS has two short taxable years in Year 1. The first short 
taxable year is from January 1 to July 15, with two full quarters 
(January 1 through March 31 and April 1 through June 30) and one short 
quarter (July 1 through July 15). The second taxable year is from July 
16 to December 31, with one short quarter (July 16 through September 30) 
and one full quarter (October 1 through December 31).
    (B) Calculation of qualified business asset investment for the first 
short taxable year. Under paragraph (f)(2) of this section, for the 
first short taxable year in Year 1, FS has three quarter closes (March 
31, June 30, and July 15). Under paragraph (f)(3) of this section, the 
qualified business asset investment of FS for the first short taxable 
year is $148.80x, the sum of $137.50x (($250x + $300x)/4) attributable 
to the two full quarters and $11.30x ($275x x 15/365) attributable to 
the short quarter.
    (C) Calculation of qualified business asset investment for the 
second short taxable year. Under paragraph (f)(2) of this section, for 
the second short taxable year in Year 1, FS has two quarter closes 
(September 30 and December 31). Under paragraph (f)(3) of this section, 
the qualified business asset investment of FS for the second short 
taxable year is $217.98x, the sum of $112.50x ($450x/4) attributable to 
the one full quarter and $105.48x ($500x x 77/365) attributable to the 
short quarter.
    (g) Partnership property--(1) In general. If a tested income CFC 
holds an interest in one or more partnerships during a CFC inclusion 
year (including indirectly through one or more partnerships that are 
partners in a lower-tier partnership), the qualified business asset 
investment of the tested income CFC for the CFC inclusion year 
(determined without regard to this paragraph (g)(1)) is increased by the 
sum of the tested income CFC's partnership QBAI with respect to each 
partnership for the CFC inclusion year. A tested loss CFC has no 
partnership QBAI for a CFC inclusion year.
    (2) Determination of partnership QBAI. For purposes of paragraph 
(g)(1) of this section, the term partnership QBAI means, with respect to 
a partnership, a tested income CFC, and a CFC inclusion year, the sum of 
the tested income CFC's partner adjusted basis in each partnership 
specified tangible property of the partnership for each partnership 
taxable year that ends with or within the CFC inclusion year. If a 
partnership taxable year is less than twelve months, the principles of 
paragraph (f) of this section apply in determining a tested income CFC's 
partnership QBAI with respect to the partnership.
    (3) Determination of partner adjusted basis--(i) In general. For 
purposes of paragraph (g)(2) of this section, the term partner adjusted 
basis means the amount described in paragraph (g)(3)(ii) of this section 
with respect to sole use partnership property or paragraph (g)(3)(iii) 
of this section with respect to dual use partnership property. The 
principles of section 706(d) apply to this determination.
    (ii) Sole use partnership property--(A) In general. The amount 
described in this paragraph (g)(3)(ii), with respect to sole use 
partnership property, a partnership taxable year, and a tested income 
CFC, is the sum of the tested income CFC's proportionate share of the 
partnership adjusted basis in the sole use partnership property for the 
partnership taxable year and the tested income CFC's partner-specific 
QBAI basis in the sole use partnership property for the partnership 
taxable year.
    (B) Definition of sole use partnership property. The term sole use 
partnership property means, with respect to a partnership, a partnership 
taxable year, and a tested income CFC, partnership specified tangible 
property of the partnership that is used in the production of only gross 
tested income of the tested income CFC for the CFC inclusion year in 
which or with which the partnership taxable year ends. For purposes of 
the preceding sentence, partnership specified tangible property of a 
partnership is used in the production of only gross tested income for a 
CFC inclusion year if all the tested income CFC's distributive share of 
the partnership's depreciation deduction or cost recovery allowance with 
respect to the property (if any) for the partnership taxable year that 
ends with or within

[[Page 210]]

the CFC inclusion year is allocated and apportioned to the tested income 
CFC's gross tested income for the CFC inclusion year under Sec. 1.951A-
2(c)(3) and, if any of the partnership's depreciation or cost recovery 
allowance with respect to the property is capitalized to inventory or 
other property held for sale, all the tested income CFC's distributive 
share of the partnership's gross income or loss from the sale of such 
inventory or other property for the partnership taxable year that ends 
with or within the CFC inclusion year is taken into account in 
determining the tested income of the tested income CFC for the CFC 
inclusion year.
    (iii) Dual use partnership property--(A) In general. The amount 
described in this paragraph (g)(3)(iii), with respect to dual use 
partnership property, a partnership taxable year, and a tested income 
CFC, is the sum of the tested income CFC's proportionate share of the 
partnership adjusted basis in the property for the partnership taxable 
year and the tested income CFC's partner-specific QBAI basis in the 
property for the partnership taxable year, multiplied by the tested 
income CFC's dual use ratio with respect to the property for the 
partnership taxable year determined under the principles of paragraph 
(d)(3) of this section, except that the ratio described in paragraph 
(d)(3) of this section is determined by reference to the tested income 
CFC's distributive share of the amounts described in paragraph (d)(3) of 
this section.
    (B) Definition of dual use partnership property. The term dual use 
partnership property means partnership specified tangible property other 
than sole use partnership property.
    (4) Determination of proportionate share of the partnership's 
adjusted basis in partnership specified tangible property--(i) In 
general. For purposes of paragraph (g)(3) of this section, the tested 
income CFC's proportionate share of the partnership adjusted basis in 
partnership specified tangible property for a partnership taxable year 
is the partnership adjusted basis in the property multiplied by the 
tested income CFC's proportionate share ratio with respect to the 
property for the partnership taxable year. Solely for purposes of 
determining the proportionate share ratio under paragraph (g)(4)(ii) of 
this section, the partnership's calculation of, and a partner's 
distributive share of, any income, loss, depreciation, or cost recovery 
allowance is determined under section 704(b).
    (ii) Proportionate share ratio. The term proportionate share ratio 
means, with respect to a partnership, a partnership taxable year, and a 
tested income CFC, the ratio (expressed as a percentage) calculated as--
    (A) The sum of--
    (1) The tested income CFC's distributive share of the partnership's 
depreciation deduction or cost recovery allowance with respect to the 
property for the partnership taxable year, and
    (2) The amount of the partnership's depreciation or cost recovery 
allowance with respect to the property that is capitalized to inventory 
or other property held for sale, the gross income or loss from the sale 
of which is taken into account in determining the tested income CFC's 
distributive share of the partnership's income or loss for the 
partnership taxable year, divided by
    (B) The sum of--
    (1) The total amount of the partnership's depreciation deduction or 
cost recovery allowance with respect to the property for the partnership 
taxable year, and
    (2) The total amount of the partnership's depreciation or cost 
recovery allowance with respect to the property capitalized to inventory 
or other property held for sale, the gross income or loss from the sale 
of which is taken into account in determining the partnership's income 
or loss for the partnership taxable year.
    (5) Definition of partnership specified tangible property. The term 
partnership specified tangible property means, with respect to a tested 
income CFC, tangible property (as defined in paragraph (c)(2) of this 
section) of a partnership that is--
    (i) Used in the trade or business of the partnership,
    (ii) Of a type with respect to which a deduction is allowable under 
section 167, and
    (iii) Used in the production of gross income included in the tested 
income CFC's gross tested income.

[[Page 211]]

    (6) Determination of partnership adjusted basis. For purposes of 
this paragraph (g), the term partnership adjusted basis means, with 
respect to a partnership, partnership specified tangible property, and a 
partnership taxable year, the amount equal to the average of the 
partnership's adjusted basis in the partnership specified tangible 
property as of the close of each quarter in the partnership taxable year 
determined without regard to any adjustments under section 734(b) except 
for adjustments under section 734(b)(1)(B) or section 734(b)(2)(B) that 
are attributable to distributions of tangible property (as defined in 
paragraph (c)(2) of this section) and for adjustments under section 
734(b)(1)(A) or 734(b)(2)(A). The principles of paragraphs (e) and (h) 
of this section apply for purposes of determining a partnership's 
adjusted basis in partnership specified tangible property and the 
proportionate share of the partnership's adjusted basis in partnership 
specified tangible property.
    (7) Determination of partner-specific QBAI basis. For purposes of 
this paragraph (g), the term partner-specific QBAI basis means, with 
respect to a tested income CFC, a partnership, and partnership specified 
tangible property, the amount that is equal to the average of the basis 
adjustment under section 743(b) that is allocated to the partnership 
specified tangible property of the partnership with respect to the 
tested income CFC as of the close of each quarter in the partnership 
taxable year. For this purpose, a negative basis adjustment under 
section 743(b) is expressed as a negative number. The principles of 
paragraphs (e) and (h) of this section apply for purposes of determining 
the partner-specific QBAI basis with respect to partnership specified 
tangible property.
    (8) Examples. The following examples illustrate the rules of this 
paragraph (g).
    (i) Facts. Except as otherwise stated, the following facts are 
assumed for purposes of the examples:
    (A) FC, FC1, FC2, and FC3 are tested income CFCs.
    (B) PRS is a partnership and its allocations satisfy the 
requirements of section 704.
    (C) All properties are partnership specified tangible property.
    (D) All persons use the calendar year as their taxable year.
    (E) There is neither disqualified basis nor partner-specific QBAI 
basis with respect to any property.
    (ii) Example 1: Sole use partnership property--(A) Facts. FC is a 
partner in PRS. PRS owns two properties, Asset A and Asset B. The 
average of PRS's adjusted basis as of the close of each quarter of PRS's 
taxable year in Asset A is $100x and in Asset B is $500x. In Year 1, 
PRS's section 704(b) depreciation deduction is $10x with respect to 
Asset A and $5x with respect to Asset B, and FC's section 704(b) 
distributive share of the depreciation deduction is $8x with respect to 
Asset A and $1x with respect to Asset B. None of the depreciation with 
respect to Asset A or Asset B is capitalized to inventory or other 
property held for sale. FC's entire distributive share of the 
depreciation deduction with respect to Asset A and Asset B is allocated 
and apportioned to FC's gross tested income for Year 1 under Sec. 
1.951A-2(c)(3).
    (B) Analysis--(1) Sole use partnership property. Because all of FC's 
distributive share of the depreciation deduction with respect to Asset A 
and B is allocated and apportioned to gross tested income for Year 1, 
Asset A and Asset B are sole use partnership property within the meaning 
of paragraph (g)(3)(ii)(B) of this section. Therefore, under paragraph 
(g)(3)(ii)(A) of this section, FC's partner adjusted basis in Asset A 
and Asset B is equal to the sum of FC's proportionate share of PRS's 
partnership adjusted basis in Asset A and Asset B for Year 1 and FC's 
partner-specific QBAI basis in Asset A and Asset B for Year 1, 
respectively.
    (2) Proportionate share. Under paragraph (g)(4)(i) of this section, 
FC's proportionate share of PRS's partnership adjusted basis in Asset A 
and Asset B is PRS's partnership adjusted basis in Asset A and Asset B 
for Year 1, multiplied by FC's proportionate share ratio with respect to 
Asset A and Asset B for Year 1, respectively. Because none of the 
depreciation with respect to Asset A or Asset B is capitalized to 
inventory or other property held for sale, FC's

[[Page 212]]

proportionate share ratio with respect to Asset A and Asset B is 
determined entirely by reference to the depreciation deduction with 
respect to Asset A and Asset B. Therefore, FC's proportionate share 
ratio with respect to Asset A for Year 1 is 80%, which is the ratio of 
FC's section 704(b) distributive share of PRS's section 704(b) 
depreciation deduction with respect to Asset A for Year 1 ($8x), divided 
by the total amount of PRS's section 704(b) depreciation deduction with 
respect to Asset A for Year 1 ($10x). FC's proportionate share ratio 
with respect to Asset B for Year 1 is 20%, which is the ratio of FC's 
section 704(b) distributive share of PRS's section 704(b) depreciation 
deduction with respect to Asset B for Year 1 ($1x), divided by the total 
amount of PRS's section 704(b) depreciation deduction with respect to 
Asset B for Year 1 ($5x). Accordingly, under paragraph (g)(4)(i) of this 
section, FC's proportionate share of PRS's partnership adjusted basis in 
Asset A is $80x ($100x x 0.8), and FC's proportionate share of PRS's 
partnership adjusted basis in Asset B is $100x ($500x x 0.2).
    (3) Partner adjusted basis. Because FC has no partner-specific QBAI 
basis with respect to Asset A and Asset B, FC's partner adjusted basis 
in Asset A and Asset B is determined entirely by reference to its 
proportionate share of PRS's partnership adjusted basis in Asset A and 
Asset B. Therefore, under paragraph (g)(3)(ii)(A) of this section, FC's 
partner adjusted basis in Asset A is $80x, FC's proportionate share of 
PRS's partnership adjusted basis in Asset A, and FC's partner adjusted 
basis in Asset B is $100x, FC's proportionate share of PRS's partnership 
adjusted basis in Asset A.
    (4) Partnership QBAI. Under paragraph (g)(2) of this section, FC's 
partnership QBAI with respect to PRS is $180x, the sum of FC's partner 
adjusted basis in Asset A ($80x) and FC's partner adjusted basis in 
Asset B ($100x). Accordingly, under paragraph (g)(1) of this section, FC 
increases its qualified business asset investment for Year 1 by $180x.
    (iii) Example 2: Dual use partnership property--(A) Facts. FC owns a 
50% interest in PRS. All section 704(b) and tax items are identical and 
are allocated equally between FC and its other partner. PRS owns three 
properties, Asset C, Asset D, and Asset E. PRS sells two products, 
Product A and Product B. All of FC's distributive share of the gross 
income or loss from the sale of Product A is taken into account in 
determining FC's tested income, and none of FC's distributive share of 
the gross income or loss from the sale of Product B is taken into 
account in determining FC's tested income.
    (1) Asset C. The average of PRS's adjusted basis as of the close of 
each quarter of PRS's taxable year in Asset C is $100x. In Year 1, PRS's 
depreciation is $10x with respect to Asset C, none of which is 
capitalized to inventory or other property held for sale. FC's 
distributive share of the depreciation deduction with respect to Asset C 
is $5x ($10x x 0.5), $3x of which is allocated and apportioned to FC's 
gross tested income under Sec. 1.951A-2(c)(3).
    (2) Asset D. The average of PRS's adjusted basis as of the close of 
each quarter of PRS's taxable year in Asset D is $500x. In Year 1, PRS's 
depreciation is $50x with respect to Asset D, $10x of which is 
capitalized to inventory of Product A and $40x is capitalized to 
inventory of Product B. None of the $10x depreciation with respect to 
Asset D capitalized to inventory of Product A is capitalized to ending 
inventory. However, of the $40x capitalized to inventory of Product B, 
$10x is capitalized to ending inventory. Therefore, the amount of 
depreciation with respect to Asset D capitalized to inventory of Product 
A that is taken into account in determining FC's distributive share of 
the income or loss of PRS for Year 1 is $5x ($10x x 0.5), and the amount 
of depreciation with respect to Asset D capitalized to inventory of 
Product B that is taken into account in determining FC's distributive 
share of the income or loss of PRS for Year 1 is $15x ($30x x 0.5).
    (3) Asset E. The average of PRS's adjusted basis as of the close of 
each quarter of PRS's taxable year in Asset E is $600x. In Year 1, PRS's 
depreciation is $60x with respect to Asset E. Of the $60x depreciation 
with respect to Asset E, $20x is allowed as a deduction,

[[Page 213]]

$24x is capitalized to inventory of Product A, and $16x is capitalized 
to inventory of Product B. FC's distributive share of the depreciation 
deduction with respect to Asset E is $10x ($20x x 0.5), $8x of which is 
allocated and apportioned to FC's gross tested income under Sec. 
1.951A-2(c)(3). None of the $24x depreciation with respect to Asset E 
capitalized to inventory of Product A is capitalized to ending 
inventory. However, of the $16x depreciation with respect to Asset E 
capitalized to inventory of Product B, $10x is capitalized to ending 
inventory. Therefore, the amount of depreciation with respect to Asset E 
capitalized to inventory of Product A that is taken into account in 
determining FC's distributive share of the income or loss of PRS for 
Year 1 is $12x ($24x x 0.5), and the amount of depreciation with respect 
to Asset E capitalized to inventory of Product B that is taken into 
account in determining FC's distributive share of the income or loss of 
PRS for Year 1 is $3x ($6x x 0.5).
    (B) Analysis. Because Asset C, Asset D, and Asset E are not used in 
the production of only gross tested income in Year 1 within the meaning 
of paragraph (g)(3)(ii)(B) of this section, Asset C, Asset D, and Asset 
E are partnership dual use property within the meaning of paragraph 
(g)(3)(iii)(B) of this section. Therefore, under paragraph 
(g)(3)(iii)(A) of this section, FC's partner adjusted basis in Asset C, 
Asset D, and Asset E is the sum of FC's proportionate share of PRS's 
partnership adjusted basis in Asset C, Asset D, and Asset E, 
respectively, for Year 1, and FC's partner-specific QBAI basis in Asset 
C, Asset D, and Asset E, respectively, for Year 1, multiplied by FC's 
dual use ratio with respect to Asset C, Asset D, and Asset E, 
respectively, for Year 1, determined under the principles of paragraph 
(d)(3) of this section, except that the ratio described in paragraph 
(d)(3) of this section is determined by reference to FC's distributive 
share of the amounts described in paragraph (d)(3) of this section.
    (1) Asset C--(i) Proportionate share. Under paragraph (g)(4)(i) of 
this section, FC's proportionate share of PRS's partnership adjusted 
basis in Asset C is PRS's partnership adjusted basis in Asset C for Year 
1, multiplied by FC's proportionate share ratio with respect to Asset C 
for Year 1. Because none of the depreciation with respect to Asset C is 
capitalized to inventory or other property held for sale, FC's 
proportionate share ratio with respect to Asset C is determined entirely 
by reference to the depreciation deduction with respect to Asset C. 
Therefore, FC's proportionate share ratio with respect to Asset C is 
50%, which is the ratio calculated as the amount of FC's section 704(b) 
distributive share of PRS's section 704(b) depreciation deduction with 
respect to Asset C for Year 1 ($5x), divided by the total amount of 
PRS's section 704(b) depreciation deduction with respect to Asset C for 
Year 1 ($10x). Accordingly, under paragraph (g)(4)(i) of this section, 
FC's proportionate share of PRS's partnership adjusted basis in Asset C 
is $50x ($100x x 0.5).
    (ii) Dual use ratio. Because none of the depreciation with respect 
to Asset C is capitalized to inventory or other property held for sale, 
FC's dual use ratio with respect to Asset C is determined entirely by 
reference to the depreciation deduction with respect to Asset C. 
Therefore, FC's dual use ratio with respect to Asset C is 60%, which is 
the ratio calculated as the amount of FC's distributive share of PRS's 
depreciation deduction with respect to Asset C that is allocated and 
apportioned to FC's gross tested income under Sec. 1.951A-2(c)(3) for 
Year 1 ($3x), divided by the total amount of FC's distributive share of 
PRS's depreciation deduction with respect to Asset C for Year 1 ($5x).
    (iii) Partner adjusted basis. Because FC has no partner-specific 
QBAI basis with respect to Asset C, FC's partner adjusted basis in Asset 
C is determined entirely by reference to FC's proportionate share of 
PRS's partnership adjusted basis in Asset C, multiplied by FC's dual use 
ratio with respect to Asset C. Under paragraph (g)(3)(iii)(A) of this 
section, FC's partner adjusted basis in Asset C is $30x, FC's 
proportionate share of PRS's partnership adjusted basis in Asset C for 
Year 1 ($50x), multiplied by FC's dual use ratio with respect to Asset C 
for Year 1 (60%).

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    (3) Asset D--(i) Proportionate share. Under paragraph (g)(4)(i) of 
this section, FC's proportionate share of PRS's partnership adjusted 
basis in Asset D is PRS's partnership adjusted basis in Asset D for Year 
1, multiplied by FC's proportionate share ratio with respect to Asset D 
for Year 1. Because all of the depreciation with respect to Asset D is 
capitalized to inventory, FC's proportionate share ratio with respect to 
Asset D is determined entirely by reference to the depreciation with 
respect to Asset D that is capitalized to inventory and included in cost 
of goods sold. Therefore, FC's proportionate share ratio with respect to 
Asset D is 50%, which is the ratio calculated as the amount of PRS's 
section 704(b) depreciation with respect to Asset D capitalized to 
Product A and Product B that is taken into account in determining FC's 
section 704(b) distributive share of PRS's income or loss for Year 1 
($20x), divided by the total amount of PRS's section 704(b) depreciation 
with respect to Asset D capitalized to Product A and Product B that is 
taken into account in determining PRS's section 704(b) income or loss 
for Year 1 ($40x). Accordingly, under paragraph (g)(4)(i) of this 
section, FC's proportionate share of PRS's partnership adjusted basis in 
Asset D is $250x ($500x x 0.5).
    (ii) Dual use ratio. Because all of the depreciation with respect to 
Asset D is capitalized to inventory, FC's dual use ratio with respect to 
Asset D is determined entirely by reference to the depreciation with 
respect to Asset D that is capitalized to inventory and included in cost 
of goods sold. Therefore, FC's dual use ratio with respect to Asset D is 
25%, which is the ratio calculated as the amount of depreciation with 
respect to Asset D capitalized to inventory of Product A and Product B 
that is taken into account in determining FC's tested income for Year 1 
($5x), divided by the total amount of depreciation with respect to Asset 
D capitalized to inventory of Product A and Product B that is taken into 
account in determining FC's income or loss for Year 1 ($20x).
    (iii) Partner adjusted basis. Because FC has no partner-specific 
QBAI basis with respect to Asset D, FC's partner adjusted basis in Asset 
D is determined entirely by reference to FC's proportionate share of 
PRS's partnership adjusted basis in Asset D, multiplied by FC's dual use 
ratio with respect to Asset D. Under paragraph (g)(3)(iii)(A) of this 
section, FC's partner adjusted basis in Asset D is $62.50x, FC's 
proportionate share of PRS's partnership adjusted basis in Asset D for 
Year 1 ($250x), multiplied by FC's dual use ratio with respect to Asset 
D for Year 1 (25%).
    (4) Asset E--(i) Proportionate share. Under paragraph (g)(4)(i) of 
this section, FC's proportionate share of PRS's partnership adjusted 
basis in Asset E is PRS's partnership adjusted basis in Asset E for Year 
1, multiplied by FC's proportionate share ratio with respect to Asset E 
for Year 1. Because the depreciation with respect to Asset E is partly 
deducted and partly capitalized to inventory, FC's proportionate share 
ratio with respect to Asset E is determined by reference to both the 
depreciation that is deducted and the depreciation that is capitalized 
to inventory and included in cost of goods sold. Therefore, FC's 
proportionate share ratio with respect to Asset E is 50%, which is the 
ratio calculated as the sum ($25x) of the amount of FC's section 704(b) 
distributive share of PRS's section 704(b) depreciation deduction with 
respect to Asset E for Year 1 ($10x) and the amount of PRS's section 
704(b) depreciation with respect to Asset E capitalized to inventory of 
Product A and Product B that is taken into account in determining FC's 
section 704(b) distributive share of PRS's income or loss for Year 1 
($15x), divided by the sum ($50x) of the total amount of PRS's section 
704(b) depreciation deduction with respect to Asset E for Year 1 ($20x) 
and the total amount of PRS's section 704(b) depreciation with respect 
to Asset E capitalized to inventory of Product A and Product B that is 
taken into account in determining PRS's section 704(b) income or loss 
for Year 1 ($30x). Accordingly, under paragraph (g)(4)(i) of this 
section, FC's proportionate share of PRS's partnership adjusted basis in 
Asset E is $300x ($600x x 0.5).
    (ii) Dual use ratio. Because the depreciation with respect to Asset 
E is partly deducted and partly capitalized to

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inventory, FC's dual use ratio with respect to Asset E is determined by 
reference to the depreciation that is deducted and the depreciation that 
is capitalized to inventory and included in cost of goods sold. 
Therefore, FC's dual use ratio with respect to Asset E is 80%, which is 
the ratio calculated as the sum ($20x) of the amount of FC's 
distributive share of PRS's depreciation deduction with respect to Asset 
E that is allocated and apportioned to FC's gross tested income under 
Sec. 1.951A-2(c)(3) for Year 1 ($8x) and the amount of depreciation 
with respect to Asset E capitalized to inventory of Product A and 
Product B that is taken into account in determining FC's tested income 
for Year 1 ($12x), divided by the sum ($25x) of the total amount of FC's 
distributive share of PRS's depreciation deduction with respect to Asset 
E for Year 1 ($10x) and the total amount of depreciation with respect to 
Asset E capitalized to inventory of Product A and Product B that is 
taken into account in determining FC's income or loss for Year 1 ($15x).
    (iii) Partner adjusted basis. Because FC has no partner-specific 
QBAI basis with respect to Asset E, FC's partner adjusted basis in Asset 
E is determined entirely by reference to FC's proportionate share of 
PRS's partnership adjusted basis in Asset E, multiplied by FC's dual use 
ratio with respect to Asset E. Under paragraph (g)(3)(iii)(A) of this 
section, FC's partner adjusted basis in Asset E is $240x, FC's 
proportionate share of PRS's partnership adjusted basis in Asset E for 
Year 1 ($300x), multiplied by FC's dual use ratio with respect to Asset 
E for Year 1 (80%).
    (5) Partnership QBAI. Under paragraph (g)(2) of this section, FC's 
partnership QBAI with respect to PRS is $332.50x, the sum of FC's 
partner adjusted basis in Asset C ($30x), FC's partner adjusted basis in 
Asset D ($62.50x), and FC's partner adjusted basis in Asset E ($240x). 
Accordingly, under paragraph (g)(1) of this section, FC increases its 
qualified business asset investment for Year 1 by $332.50x.
    (iv) Example 3: Sole use partnership specified tangible property; 
section 743(b) adjustments--(A) Facts. The facts are the same as in 
paragraph (g)(8)(ii)(A) of this section (the facts in Example 1), except 
that there is an average of $40x positive adjustment to the adjusted 
basis in Asset A as of the close of each quarter of PRS's taxable year 
with respect to FC under section 743(b) and an average of $20x negative 
adjustment to the adjusted basis in Asset B as of the close of each 
quarter of PRS's taxable year with respect to FC under section 743(b).
    (B) Analysis. Under paragraph (g)(3)(ii)(A) of this section, FC's 
partner adjusted basis in Asset A is $120x, which is the sum of $80x 
(FC's proportionate share of PRS's partnership adjusted basis in Asset A 
as illustrated in paragraph (g)(8)(ii)(B)(2) of this section (paragraph 
(B)(2) of the analysis in Example 1)) and $40x (FC's partner-specific 
QBAI basis in Asset A). Under paragraph (g)(3)(ii)(A) of this section, 
FC's partner adjusted basis in Asset B is $80x, the sum of $100x (FC's 
proportionate share of the partnership adjusted basis in the property as 
illustrated in paragraph (g)(8)(ii)(B)(2) of this section (paragraph 
(B)(2) of the analysis in Example 1)) and (-$20x) (FC's partner-specific 
QBAI basis in Asset B). Therefore, under paragraph (g)(2) of this 
section, FC's partnership QBAI with respect to PRS is $200x ($120x + 
$80x). Accordingly, under paragraph (g)(1) of this section, FC increases 
its qualified business asset investment for Year 1 by $200x.
    (v) Example 4: Tested income CFC with distributive share of loss 
from a partnership--(A) Facts. FC owns a 50% interest in PRS. All 
section 704(b) and tax items are identical and are allocated equally 
between FC and its other partner. PRS owns Asset F. None of the 
depreciation with respect to Asset F is capitalized to inventory or 
other property held for sale. The average of PRS's adjusted basis as of 
the close of each quarter of PRS's taxable year in Asset F is $220x. PRS 
has $20x of gross income, a $22x depreciation deduction with respect to 
Asset F, and no other income or expense in Year 1. FC's distributive 
share of the gross income is $10x, all of which is includible in FC's 
gross tested income in Year 1, and FC's distributive share of PRS's 
depreciation deduction with respect to Asset F is $11x in Year

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1, all of which is allocated and apportioned to FC's gross tested income 
under Sec. 1.951A-2(c)(3). FC's distributive share of loss from PRS is 
$1x. FC also has $8x of gross tested income from other sources in Year 1 
and no other deductions. Therefore, FC has tested income of $7x for Year 
1.
    (B) Analysis. FC's partner adjusted basis in Asset F is $110x, which 
is the sum of FC's proportionate share of the partnership adjusted basis 
in the property ($220x x 0.5) and FC's partnership-specific QBAI basis 
in Asset F ($0). Therefore, FC's partnership QBAI with respect to PRS is 
$110x. Accordingly, under paragraph (g)(1) of this section, FC increases 
its qualified business asset investment by $110x, notwithstanding that 
FC would not be a tested income CFC but for its $8x of gross tested 
income from other sources.
    (vi) Example 5: Tested income CFC sale of partnership interest 
before CFC inclusion date--(A) Facts. FC1 owns a 50% interest in PRS on 
January 1 of Year 1. On July 1 of Year 1, FC1 sells its entire interest 
in PRS to FC2. PRS owns Asset G. The average of PRS's adjusted basis as 
of the close of each quarter of PRS's taxable year in Asset G is $100x. 
FC1's section 704(b) distributive share of the depreciation deduction 
with respect to Asset G is 25% with respect to PRS's entire year. FC2's 
section 704(b) distributive share of the depreciation deduction with 
respect to Asset G is also 25% with respect to PRS's entire year. Both 
FC1's and FC2's entire distributive shares of the depreciation deduction 
with respect to Asset G are allocated and apportioned under Sec. 
1.951A-2(c)(3) to FC1's and FC2's gross tested income, respectively, for 
Year 1. PRS's allocations satisfy section 706(d).
    (B) Analysis--(1) FC1. Because FC1 owns an interest in PRS during 
FC1's CFC inclusion year and receives a distributive share of 
partnership items of the partnership under section 706(d), FC1 has 
partnership QBAI with respect to PRS in the amount determined under 
paragraph (g)(2) of this section. Under paragraph (g)(3)(i) of this 
section, FC1's partner adjusted basis in Asset G is $25x, the product of 
$100x (the partnership's adjusted basis in the property) and 25% (FC1's 
section 704(b) distributive share of depreciation deduction with respect 
to Asset G). Therefore, FC1's partnership QBAI with respect to PRS is 
$25x. Accordingly, under paragraph (g)(1) of this section, FC1 increases 
its qualified business asset investment by $25x for Year 1.
    (2) FC2. FC2's partner adjusted basis in Asset G is also $25x, the 
product of $100x (the partnership's adjusted basis in the property) and 
25% (FC2's section 704(b) distributive share of depreciation deduction 
with respect to Asset G). Therefore, FC2's partnership QBAI with respect 
to PRS is $25x. Accordingly, under paragraph (g)(1) of this section, FC2 
increases its qualified business asset investment by $25x for Year 1.
    (vii) Example 6: Partnership adjusted basis; distribution of 
property in liquidation of partnership interest--(A) Facts. FC1, FC2, 
and FC3 are equal partners in PRS, a partnership. FC1 and FC2 each has 
an adjusted basis of $100x in its partnership interest. FC3 has an 
adjusted basis of $50x in its partnership interest. PRS has a section 
754 election in effect. PRS owns Asset H with a fair market value of 
$50x and an adjusted basis of $0, Asset I with a fair market value of 
$100x and an adjusted basis of $100x, and Asset J with a fair market 
value of $150x and an adjusted basis of $150x. Asset H and Asset J are 
tangible property, but Asset I is not tangible property. PRS distributes 
Asset I to FC3 in liquidation of FC3's interest in PRS. None of FC1, 
FC2, FC3, or PRS recognizes gain on the distribution. Under section 
732(b), FC3's adjusted basis in Asset I is $50x. PRS's adjusted basis in 
Asset H is increased by $50x to $50x under section 734(b)(1)(B), which 
is the amount by which PRS's adjusted basis in Asset I immediately 
before the distribution exceeds FC3's adjusted basis in Asset I.
    (B) Analysis. Under paragraph (g)(6) of this section, PRS's adjusted 
basis in Asset H is determined without regard to any adjustments under 
section 734(b) except for adjustments under section 734(b)(1)(B) or 
section 734(b)(2)(B) that are attributable to distributions of tangible 
property and for adjustments under section 734(b)(1)(A) or 734(b)(2)(A). 
The adjustment to the adjusted basis in Asset H is under section

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734(b)(1)(B) and is attributable to the distribution of Asset I, which 
is not tangible property. Accordingly, for purposes of applying 
paragraph (g)(1) of this section, PRS's adjusted basis in Asset H is $0.
    (h) Anti-avoidance rules related to certain transfers of property--
(1) Disregard of adjusted basis in specified tangible property held 
temporarily--(i) In general. For purposes of determining a controlled 
foreign corporation's aggregate adjusted bases in specified tangible 
property as of the close of a quarter (tested quarter close), the 
adjusted basis in specified tangible property is disregarded as of the 
tested quarter close if the controlled foreign corporation (acquiring 
CFC) acquires the property temporarily before the tested quarter close 
with a principal purpose of increasing the deemed tangible income return 
of a U.S. shareholder (applicable U.S. shareholder) for a U.S. 
shareholder year, and the holding of the property by the acquiring CFC 
as of the tested quarter close would, without regard to this paragraph 
(h)(1)(i), increase the deemed tangible income return of the applicable 
U.S. shareholder for the U.S. shareholder inclusion year.
    (ii) Disregard of first quarter close. The adjusted basis in 
specified tangible property may be disregarded under paragraph (h)(1)(i) 
of this section for purposes of multiple tested quarter closes that 
follow an acquisition and on which the acquiring CFC holds the property. 
However, if the holding of specified tangible property would, without 
regard to paragraph (h)(1)(i) of this section, increase the deemed 
tangible income return of an applicable U.S. shareholder because the 
adjusted basis in such property is taken into account for only one 
additional quarter close of a tested income CFC of the applicable U.S. 
shareholder in determining the deemed tangible income return of the 
applicable U.S. shareholder of the U.S. shareholder inclusion year, the 
adjusted basis in the property is disregarded for purposes of 
determining the acquiring CFC's aggregate adjusted bases in specified 
tangible property only as of the first tested quarter close that follows 
the acquisition.
    (iii) Safe harbor for certain transfers involving CFCs. The holding 
of specified tangible property as of a tested quarter close does not 
increase the deemed tangible income return of an applicable U.S. 
shareholder within the meaning of paragraph (h)(1)(i) of this section if 
each of the following conditions is satisfied with respect to the 
acquisition and subsequent transfer of property by the acquiring CFC--
    (A) A controlled foreign corporation (predecessor CFC) holds the 
property on a quarter close of the predecessor CFC (preceding quarter 
close) that occurs on the same date as the last quarter close of the 
acquiring CFC preceding the acquisition.
    (B) A controlled foreign corporation (successor CFC) holds the 
property on a quarter close of the successor CFC (succeeding quarter 
close) that occurs on the same date as the first quarter close of the 
acquiring CFC following the subsequent transfer.
    (C) The proportion of the stock that the applicable U.S. shareholder 
owns (within the meaning of section 958(a)) of the acquiring CFC on the 
tested quarter close does not exceed the proportion of the stock that 
the applicable U.S. shareholder owns of either the predecessor CFC on 
the preceding quarter close or the successor CFC on the succeeding 
quarter close; and
    (D) Each of the predecessor CFC and the successor CFC is a tested 
income CFC for its CFC inclusion year that includes the date of the 
tested quarter close.
    (iv) Determination of principal purpose and transitory holding--(A) 
Presumption for ownership less than 12 months. For purposes of paragraph 
(h)(1)(i) of this section, specified tangible property is presumed to be 
acquired temporarily with a principal purpose of increasing the deemed 
tangible income return of an applicable U.S. shareholder for a U.S. 
shareholder inclusion year if the property is held by the acquiring CFC 
for less than 12 months and the holding of the property by the acquiring 
CFC as of the tested quarter close would have the effect of increasing 
the deemed tangible income return of the applicable U.S. shareholder for 
a U.S. shareholder inclusion year. The presumption described in the 
preceding sentence may be rebutted only if the

[[Page 218]]

facts and circumstances clearly establish that the subsequent transfer 
of the property by the acquiring CFC was not contemplated when the 
property was acquired by the acquiring CFC and that a principal purpose 
of the acquisition of the property was not to increase the deemed 
tangible income return of the applicable U.S. shareholder for a U.S. 
shareholder inclusion year. In order to rebut the presumption, a 
statement must be attached to the Form 5471 filed by the taxpayer for 
the taxable year of the CFC in which the subsequent transfer occurs and 
include any information required by applicable administrative 
announcements, forms or instructions. The statement must explain the 
facts and circumstances supporting the rebuttal and be in accordance 
with any rules provided in forms and instructions.
    (B) Presumption for ownership greater than 36 months. For purposes 
of paragraph (h)(1)(i) of this section, specified tangible property is 
presumed not to be acquired temporarily with a principal purpose of 
increasing the deemed tangible income return of an applicable U.S. 
shareholder for a U.S. shareholder inclusion year if the property is 
held by the acquiring CFC for more than 36 months. The presumption 
described in the preceding sentence may be rebutted only if the facts 
and circumstances clearly establish that the subsequent transfer of the 
property by the acquiring CFC was contemplated when the property was 
acquired by the acquiring CFC and that a principal purpose of the 
acquisition of the property was to increase the deemed tangible income 
return of the applicable U.S. shareholder for a U.S. shareholder 
inclusion year.
    (v) Determination of holding period. For purposes of this paragraph 
(h)(1), the period during which an acquiring CFC holds specified 
tangible property is determined without regard to section 1223.
    (vi) Treatment as single applicable U.S. shareholder. For purposes 
of this paragraph (h)(1), all U.S. persons that are related persons are 
treated as a single applicable U.S. shareholder. For purposes of the 
preceding sentence, U.S. persons are related if they bear a relationship 
described in section 267(b) or 707(b) immediately before or immediately 
after a transaction.
    (vii) Examples. The following examples illustrate the application of 
this paragraph (h)(1).
    (A) Facts. Except as otherwise stated, the following facts are 
assumed for purposes of the examples:
    (1) USP is a domestic corporation.
    (2) CFC1, CFC2 and CFC3 are tested income CFCs.
    (3) R is unrelated to USP.
    (4) All persons use the calendar year as their taxable year.
    (5) Asset A is specified tangible property.
    (6) Both Year 1 and Year 2 begin on or after January 1, 2018, and 
have 365 days.
    (7) USP has no specified interest expense (as defined in Sec. 
1.951A-1(c)(3)(iii)).
    (B) Example 1: Qualification for safe harbor--(1) Facts. USP owns 
all of the stock of CFC1, which owns all of the stock of CFC2, which 
owns all the stock of CFC3. As of January 1, Year 1, CFC1 owns Asset A, 
which is specified tangible property. On December 30, Year 1, CFC1 
transfers Asset A to CFC2. On April 10, Year 2, CFC2 transfers Asset A 
to CFC3. CFC3 holds Asset A for the rest of Year 2.
    (2) Analysis. Under the safe harbor of paragraph (h)(1)(iii) of this 
section, CFC2's holding of Asset A as of each of the December 31, Year 1 
tested quarter close and the March 31, Year 2 tested quarter close does 
not increase the deemed tangible income return of USP, the applicable 
United States shareholder, for Year 1 or Year 2 because each of the 
requirements in paragraphs (h)(1)(iii)(A) through (D) of this section is 
satisfied. The requirement in paragraph (h)(1)(iii)(A) of this section 
is satisfied because CFC1, a predecessor CFC, held Asset A on September 
30, Year 1, a quarter close of CFC1 that occurs on the same date as the 
last quarter close of CFC2, the acquiring CFC, preceding the December 
30, Year 1 acquisition of Asset A. The requirement in paragraph 
(h)(1)(iii)(B) of this section is satisfied because CFC3, a successor 
CFC, holds Asset A on June 30, Year 2, a quarter close of CFC3 that 
occurs on the same date as the first quarter close of CFC2 following 
April 10, Year 2, the date of the subsequent

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transfer of Asset A. The requirement in paragraph (h)(1)(iii)(C) of this 
section is satisfied because the proportion of stock that USP, the 
applicable U.S. shareholder, owns (within the meaning of section 958(a)) 
of CFC2, the acquiring CFC, on each of the December 31, Year 1 tested 
quarter close and the March 31, Year 2 tested quarter close (100%), does 
not exceed the proportion of the stock that USP owns of either CFC1 
(100%) on the preceding quarter close (September 30, Year 1) or of CFC3 
(100%) on the succeeding quarter close (June 30, Year 2). Finally, the 
requirement in paragraph (h)(1)(iii)(D) of this section is satisfied 
because each of CFC1 and CFC3 is a tested income CFC for Year 1 and Year 
2, the CFC inclusion years that include the December 31, Year 1 tested 
quarter close and the March 31, Year 2 tested quarter close. 
Accordingly, paragraph (h)(1)(i) of this section does not apply to 
disregard the adjusted basis in Asset A in determining CFC2's aggregate 
adjusted basis in specified tangible property as of December 31, Year 1, 
or March 30, Year 2.
    (C) Example 2: Transfers between CFCs with different taxable year 
ends--(1) Facts. The facts are the same as in paragraph 
(h)(1)(vii)(B)(1) of this section (the facts in Example 1), except that 
CFC1 has a taxable year ending November 30, and the facts and 
circumstances do not clearly establish that the April 10, Year 2 
transfer of Asset A by CFC2 was not contemplated when Asset A was 
acquired by CFC2 and that a principal purpose of the acquisition of the 
property was not to increase the deemed tangible income return of USP, 
the applicable U.S. shareholder.
    (2) Analysis. CFC2's holding of Asset A as of each of the December 
31, Year 1 tested quarter close and the March 31, Year 2 tested quarter 
close does not satisfy the safe harbor under paragraph (h)(1)(iii) of 
this section because CFC1, the predecessor CFC, does not hold Asset A on 
a quarter close of CFC1 that occurs on the same date as the September 
30, Year 1, quarter close of CFC2, the acquiring CFC, which is the last 
quarter close of CFC2 preceding the December 30, Year 1 acquisition of 
Asset A. In addition, because CFC2 held Asset A for less than 12 months 
(from December 31, Year 1, until April 10, Year 2), the presumption in 
paragraph (h)(1)(iv)(A) of this section applies such that CFC2 is 
presumed to have acquired Asset A temporarily with a principal purpose 
of increasing the deemed tangible income return of USP for the 
shareholder inclusion year, and the facts and circumstances do not 
clearly establish that CFC2 did not acquire Asset A with such a 
principal purpose. Because CFC2 holds Asset A as of December 31, Year 1, 
the tested quarter close, the adjusted basis in Asset A would be, 
without regard to paragraph (h)(1)(i) of this section, taken into 
account for purposes of determining USP's deemed tangible income return 
for its Year 1 taxable year as of five quarter closes (CFC1's quarter 
closes on February 28, May 31, August 31, and November 30, and CFC2's 
quarter close on December 31). If instead CFC1 had retained Asset A 
during the period CFC2 temporarily held the asset and had transferred 
Asset A directly to CFC3 on January 10, Year 2, the adjusted basis in 
Asset A would have been taken into account for purposes of determining 
USP's deemed tangible income return for its Year 1 taxable year as of 
only four quarter closes (CFC1's quarter closes on February 28, May 30, 
August 30, and November 30). Under paragraph (h)(1)(ii) of this section, 
because the adjusted basis in Asset A would (without regard to paragraph 
(h)(1)(i) of this section) be taken into account for only one additional 
quarter close of a tested income CFC of USP in determining USP's deemed 
tangible income return for Year 1 and Year 2, the adjusted basis in 
Asset A is disregarded for purposes of determining CFC's aggregate 
adjusted bases in specified tangible property only as of December 31, 
Year 1, the first tested quarter close that follows the acquisition. 
Accordingly, under paragraph (h)(1)(i) of this section, the adjusted 
basis in Asset A is disregarded in determining CFC2's aggregate adjusted 
basis in specified tangible property as of December 31, Year 1.
    (D) Example 3: Acquisition from unrelated person--(1) Facts. USP 
owns all of the stock of CFC1 and CFC2. CFC1 has a taxable year ending 
November 30. On October 30, Year 1, CFC1 acquires Asset

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B from R. On December 30, Year 1, CFC1 transfers Asset B to CFC2. The 
facts and circumstances do not clearly establish that the December 31, 
Year 1, transfer of Asset B by CFC1 was not contemplated when Asset B 
was acquired by CFC1 and that a principal purpose of the acquisition of 
the property was not to increase the deemed tangible income return of 
USP, the applicable U.S. shareholder.
    (2) Analysis. CFC1's holding of Asset B as of the November 30, Year 
1 tested quarter close does not satisfy the safe harbor under paragraph 
(h)(1)(iii) of this section because the requirements in paragraphs 
(h)(1)(iii)(A) through (D) of this section are not satisfied. Because 
CFC1 held Asset B for less than 12 months (from October 30, Year 1, 
until December 30, Year 1), the presumption in paragraph (h)(1)(iv)(A) 
of this section applies such that CFC1 is presumed to have held Asset B 
temporarily with a principal purpose of increasing the deemed tangible 
income return of USP for the taxable year, and the facts and 
circumstances do not clearly establish that CFC1 did not acquire Asset B 
with a principal purpose of increasing the deemed tangible income return 
of USP. Because CFC1 holds Asset B as of November 30, Year 1, the 
adjusted basis in Asset B would be, without regard to paragraph 
(h)(1)(i) of this section, taken into account for purposes of 
determining USP's deemed tangible income return for its Year 1 taxable 
year as of two quarter closes (CFC1's quarter close on November 30, Year 
1, and CFC2's quarter close on December 31, Year 1). If instead CFC2 had 
acquired Asset B directly from R, the adjusted basis in Asset B would 
have been taken into account for purposes of determining USP's deemed 
tangible income return for its Year 1 taxable year as of only one 
quarter close (CFC2's quarter close on December 31, Year 1). 
Accordingly, under paragraph (h)(1)(i) of this section, the adjusted 
basis in Asset B is disregarded in determining CFC1's aggregate adjusted 
basis in specified tangible property as of November 30, Year 1.
    (E) Example 4: Acquisitions from tested loss CFCs--(1) Facts. USP 
owns all of the stock of CFC1 and CFC2. As of January 1, Year 1, CFC1 
owns Asset C. On March 30, Year 1, CFC1 transfers Asset C to CFC2. For 
Year 1, CFC1 is a tested loss CFC and CFC2 is a tested income CFC. On 
March 30, Year 2, CFC2 transfers Asset C back to CFC1. For Year 2, both 
CFC1 and CFC2 are tested income CFCs. A principal purpose of CFC2 
holding Asset C as of March 31, Year 1, June 30, Year 1, September 30, 
Year 1, and December 31, Year 1, was to increase USP's deemed tangible 
income return.
    (2) Analysis. CFC2's holding of Asset C as of March 31, Year 1, June 
30, Year 1, September 30, Year 1, and December 31, Year 1 does not 
satisfy the safe harbor under paragraph (h)(1)(iii) of this section 
because CFC1 is not a tested income CFC for Year 1 and thus the 
requirement in paragraph (h)(1)(iii)(D) of this section is not 
satisfied. Because CFC2 acquired Asset C before, and temporarily held as 
of, March 31, Year 1, June 30, Year 1, September 30, Year 1, December 
31, Year 1 and the holding of the property by CFC2 as of each such 
tested quarter close would increase the deemed tangible income return of 
USP, under paragraph (h)(1)(i) of this section, the adjusted basis in 
Asset C is disregarded in determining CFC2's aggregate adjusted basis in 
specified tangible property as of each of March 31, Year 1, June 30, 
Year 1, September 30, Year 1, and December 31, Year 1.
    (2) Disregard of adjusted basis in property transferred during the 
disqualified period--(i) Operative rules--(A) In general. For purposes 
of determining the qualified business asset investment of a tested 
income CFC for any CFC inclusion year, disqualified basis in property is 
disregarded.
    (B) Application to dual use property. In the case of dual use 
property (as defined in paragraph (d)(2) of this section), paragraph 
(h)(2)(i)(A) of this section applies by reducing the amount of the 
adjusted basis in the property treated as adjusted basis in specified 
tangible property for the CFC inclusion year under paragraph (d)(1) of 
this section by the amount of the disqualified basis in the property. 
For purposes of determining the amount described in

[[Page 221]]

paragraph (d)(1) of this section, including for purposes of determining 
whether tangible property is dual use property within the meaning of 
paragraph (d)(2) of this section and for purposes of determining the 
dual use ratio with respect to dual use property under paragraph (d)(3) 
of this section, the rules of Sec. 1.951A-2(c)(5) are not taken into 
account.
    (C) Application to partnership specified tangible property. In the 
case of partnership specified tangible property (as defined in paragraph 
(g)(5) of this section), paragraph (h)(2)(i)(A) of this section applies 
by reducing a tested income CFC's partner adjusted basis with respect to 
partnership specified tangible property under paragraph (g)(3)(i) of 
this section by the tested income CFC's share of the disqualified basis 
in the partnership specified tangible property. A tested income CFC's 
share of disqualified basis in partnership specified tangible property 
is the sum of the tested income CFC's proportionate share of the 
disqualified basis in the partnership specified tangible property 
determined under the principles of paragraph (g)(4) of this section and 
the tested income CFC's partner-specific QBAI basis in the property 
determined under the principles of paragraph (g)(7) of this section that 
is disqualified basis. For purposes of determining the amount described 
in paragraph (g)(3)(i) of this section, including for purposes of 
determining whether partnership specified tangible property is sole use 
partnership property within the meaning of paragraph (g)(3)(ii)(B) of 
this section or dual use partnership property within the meaning of 
paragraph (g)(3)(iii)(B) of this section and for purposes of determining 
the dual use ratio with respect to dual use partnership property under 
the principles of paragraph (d)(3) of this section, the rules of Sec. 
1.951A-2(c)(5) are not taken into account.
    (ii) Determination of disqualified basis--(A) In general. Subject to 
the adjustments described in paragraph (h)(2)(ii)(B) of this section, 
the term disqualified basis means, with respect to property (other than 
property described in section 1221(a)(1)), the excess (if any) of the 
property's adjusted basis immediately after a disqualified transfer, 
over the sum of the property's adjusted basis immediately before the 
disqualified transfer and the qualified gain amount with respect to the 
disqualified transfer. For this purpose, the adjusted basis in property 
immediately after a disqualified transfer includes a positive adjustment 
to the adjusted basis in partnership property with respect to a partner 
under section 734(b)(1)(A) or 743(b).
    (B) Adjustments to disqualified basis--(1) Reduction or elimination 
of disqualified basis--(i) In general. Except to the extent provided in 
this paragraph (h)(2)(ii)(B)(1), disqualified basis in property is 
reduced or eliminated to the extent that such basis reduces taxable 
income through, for example, depreciation, amortization, and taxable 
sales or exchanges, or is otherwise reduced or eliminated, for example, 
through the application of section 362(e) or 732(a) or (b). In such 
circumstances, in the case of property with disqualified basis and 
adjusted basis other than disqualified basis, disqualified basis in the 
property is reduced or eliminated in the same proportion that the 
disqualified basis bears to the total adjusted basis in the property. 
However, in the case of a loss from a taxable sale or exchange, 
disqualified basis in the property is reduced or eliminated to the 
extent the loss is treated as attributable to disqualified basis under 
Sec. 1.951A-2(c)(5)(ii).
    (ii) Exception for related party transfers. Disqualified basis in 
property is not reduced or eliminated by reason of any transfer of the 
property to a related person, except to the extent any loss recognized 
on the transfer of such property is treated as attributable to the 
disqualified basis under Sec. 1.951A-2(c)(5)(ii), or the basis is 
reduced or eliminated in a nonrecognition transaction within the meaning 
of section 7701(a)(45), for example, through the application of section 
362(e) or 732(a) or (b).
    (2) Increase to disqualified basis for nonrecognition transactions--
(i) Increase corresponding to adjustments in other property. If the 
adjusted basis in property is increased by reason of a nonrecognition 
transaction (as defined in section 7701(a)(45)), for example, through 
the application of section

[[Page 222]]

732(b) or section 734(b)(1)(B), the disqualified basis in the property 
is increased by a proportionate share of the aggregate reduction to the 
disqualified basis (if any) in one or more other properties by reason of 
such nonrecognition transaction under paragraph (h)(2)(ii)(B)(1) of this 
section.
    (ii) Exchanged basis property. Disqualified basis in exchanged basis 
property (as defined in section 7701(a)(44)) includes the amount of the 
disqualified basis in any property by reference to which the adjusted 
basis in the exchanged basis property was determined, in whole or in 
part, provided that the nonrecognition transaction giving rise to such 
exchanged basis did not also increase the disqualified basis in the 
exchanged basis property under paragraph (h)(2)(ii)(B)(2)(i) of this 
section.
    (iii) Increase by reason of section 732(d). Disqualified basis in 
property is increased by the amount of a positive adjustment to the 
adjusted basis in property under section 732(d) to the extent that, if 
an election provided in section 754 were in effect at the time of the 
acquisition described in section 732(d), the adjusted basis in the 
property immediately after the acquisition would have been disqualified 
basis under paragraph (h)(2)(ii)(A) of this section.
    (3) Election to eliminate disqualified basis--(i) In general. If an 
election made under this paragraph (h)(2)(ii)(B)(3) with respect to a 
controlled foreign corporation or a partnership is effective, the 
adjusted basis in each property with disqualified basis held by the 
controlled foreign corporation or the partnership is reduced by the 
amount of the disqualified basis and the disqualified basis in each 
property is eliminated. The reduction of the adjusted basis and the 
elimination of the disqualified basis described in the preceding 
sentence is treated as occurring immediately after the disqualified 
transfer of each property.
    (ii) Manner of making the election with respect to a controlled 
foreign corporation. The election described in this paragraph 
(h)(2)(ii)(B)(3) with respect to a controlled foreign corporation is 
made by each controlling domestic shareholder (as defined in Sec. 
1.964-1(c)(5)) of the controlled foreign corporation by filing a 
statement as described in Sec. 1.964-1(c)(3)(ii) with its income tax 
return for its taxable year that includes the last day of the taxable 
year of the controlled foreign corporation that includes the 
disqualified transfer and follow the notice requirements of Sec. 1.964-
1(c)(3)(iii). If the return for the taxable year has been filed before 
July 22, 2019, the statement must be included with an amended return 
filed within 180 days June 21, 2019. The election statement must be 
filed in accordance with the rules provided in forms or instructions.
    (iii) Manner of making the election with respect to a partnership. 
The election described in this paragraph (h)(2)(ii)(B)(3) with respect 
to a partnership is made by the partnership by filing a statement as 
described in Sec. 1.754-1(b)(1) for the taxable year that includes the 
date of the disqualified transfer. If a return for the taxable year has 
been filed before July 22, 2019, the statement must be included with an 
amended return filed within 180 days of June 21, 2019. The election 
statement must be filed in accordance with the rules provided in forms 
or instructions.
    (iv) Conditions of making an election. An election under this 
paragraph (h)(2)(ii)(B)(3) with respect to a controlled foreign 
corporation or a partnership is not effective unless the election is 
made with respect to each controlled foreign corporation or partnership 
that holds property with disqualified basis and that is related (within 
the meaning of section 267(b) and 707(b)) to the controlled foreign 
corporation or partnership and unless any return that has been filed 
that is inconsistent with the elimination of the adjusted basis and 
disqualified basis immediately after the disqualified transfer by reason 
of this paragraph (h)(2)(ii)(B)(3) is amended to take into account the 
elimination of the adjusted basis and disqualified basis immediately 
after the disqualified transfer by reason of this paragraph 
(h)(2)(ii)(B)(3).
    (C) Definitions related to disqualified basis. The following 
definitions apply for purposes of this paragraph (h)(2).
    (1) Disqualified period. The term disqualified period means, with 
respect to a transferor CFC, the period beginning

[[Page 223]]

on January 1, 2018, and ending as of the close of the transferor CFC's 
last taxable year that is not a CFC inclusion year. A transferor CFC 
that has a CFC inclusion year beginning January 1, 2018, has no 
disqualified period.
    (2) Disqualified transfer. The term disqualified transfer means a 
transfer of property during a transferor CFC's disqualified period by 
the transferor CFC to a related person in which gain was recognized, in 
whole or in part, by the transferor CFC.
    (3) Qualified gain amount. The term qualified gain amount means, 
with respect to a disqualified transfer by a transferor CFC, the sum of 
the following amounts:
    (i) The amount of gain recognized by the transferor CFC on the 
disqualified transfer of property that is subject to Federal income tax 
under section 882 (except to the extent the gain is exempt from tax 
pursuant to an applicable treaty obligation of the United States); and
    (ii) Any United States shareholder's pro rata share of the gain 
recognized by the transferor CFC on the disqualified transfer of 
property (determined without regard to properly allocable deductions) 
taken into account in determining the United States shareholder's 
inclusion under section 951(a)(1)(A), excluding any amount that is 
described in paragraph (h)(2)(ii)(C)(3)(i) of this section.
    (4) Related person. The term related person means, with respect to a 
person that transfers property, any person that bears a relationship to 
such person described in section 267(b) or 707(b) immediately before or 
immediately after the transfer.
    (5) Transfer. The term transfer includes any disposition of 
property, including any sale, exchange, contribution, or distribution of 
property, and includes an indirect transfer. For example, a transfer of 
an interest in a partnership is treated as an indirect transfer of the 
property of the partnership and a transfer by or to a partnership is 
treated as an indirect transfer by or to its partners. In addition, a 
distribution of property to a partner with respect to which gain is 
recognized to the distributee partner under section 731(a)(1) is treated 
as an indirect transfer of the property of the partnership.
    (6) Transferor CFC. The term transferor CFC means any controlled 
foreign corporation that transfers property during the disqualified 
period of the controlled foreign corporation.
    (iii) Examples. The following examples illustrate the application of 
this paragraph (h)(2).
    (A) Example 1: Sale of asset; disqualified period--(1) Facts. USP, a 
domestic corporation, owns all of the stock of CFC1 and CFC2, each a 
controlled foreign corporation. Both USP and CFC2 use the calendar year 
as their taxable year. CFC1 uses a taxable year ending November 30. On 
November 1, 2018, before the start of its first CFC inclusion year, CFC1 
sells Asset A, which has an adjusted basis of $10x in the hands of CFC1, 
to CFC2 in exchange for $100x of cash. CFC1 recognizes $90x of gain as a 
result of the sale ($100x - $10x), $30x of which is foreign base company 
income. USP includes in gross income under section 951(a)(1)(A) its pro 
rata share of the subpart F income of $30x. CFC1's gain is not otherwise 
subject to U.S. tax or taken into account in determining USP's inclusion 
under section 951(a)(1)(A).
    (2) Analysis. The transfer of Asset A is a disqualified transfer of 
Asset A because it is a transfer of property (other than property 
described in section 1221(a)(1)) by CFC1; CFC1 and CFC2 are related 
persons; and the transfer occurs during the disqualified period, the 
period that begins on January 1, 2018, and ends the last day before the 
first CFC inclusion year of CFC1 (November 30, 2018). Accordingly, under 
paragraph (h)(2)(ii)(A) of this section, the disqualified basis in Asset 
A immediately after the disqualified transfer is $60x, the excess of 
CFC2's adjusted basis in Asset A immediately after the disqualified 
transfer ($100x), over the sum of CFC1's adjusted basis in Asset A 
immediately before the transfer ($10x) and USP's pro rata share of the 
gain recognized by CFC1 on the transfer of the property taken into 
account by USP under section 951(a)(1)(A) ($30x).
    (B) Example 2: Sale of asset; no disqualified period--(1) Facts. The 
facts are the same as in paragraph (h)(2)(iii)(A)(1) of this section 
(the facts

[[Page 224]]

in Example 1), except that CFC1 uses the calendar year as its taxable 
year.
    (2) Analysis. Because CFC1 has a taxable year beginning January 1, 
2018, CFC1 has no disqualified period. Accordingly, the property was not 
transferred during a disqualified period of CFC1, and there is no 
disqualified basis with respect to the property.
    (C) Example 3: Sale of partnership interest--(1) Facts. USP, a 
domestic corporation, owns all of the stock of CFC1, CFC2, and CFC3, 
each a controlled foreign corporation. CFC1 and CFC2 are equal partners 
in PRS, a partnership. PRS owns Asset B with an adjusted basis of $20x 
and a fair market value of $100x. PRS has a section 754 election in 
effect. USP, CFC2, and CFC3 all use the calendar year as their taxable 
year. CFC1 uses a taxable year ending November 30. On November 1, 2018, 
before the start of its first CFC inclusion year, CFC1 sells its 
interest in the partnership to CFC3 for $50x of cash. CFC1 has an 
adjusted basis of $10x in its partnership interest, and thus CFC1 
recognizes $40x of gain as a result of the sale ($50x - $10x), none of 
which is foreign base company income or otherwise subject to U.S. tax. 
As a result of the sale, there is a $40x adjustment to the adjusted 
basis in Asset B with respect to CFC3 under section 743(b).
    (2) Analysis. The transfer of the PRS partnership interest is a 
disqualified transfer of Asset B because it is an indirect transfer of 
property (other than property described in section 1221(a)(1)) by CFC1; 
CFC1 and CFC3 are related persons; and the transfer occurs during the 
disqualified period, the period that begins on January 1, 2018, and ends 
the last day before the first CFC inclusion year of CFC1 (November 30, 
2018). Accordingly, under paragraph (h)(2)(ii)(A) of this section, the 
disqualified basis in Asset B immediately after the disqualified 
transfer is $40x, the excess of CFC3's share of adjusted basis in Asset 
B immediately after the disqualified transfer ($50x), taking into 
account the basis adjustment with respect to CFC3 under section 743(b), 
over CFC1's share of adjusted basis in the property immediately before 
the transfer ($10x).
    (D) Example 4: Distribution of property in liquidation of 
partnership interest--(1) Facts. FC1, FC2, and FC3 are controlled 
foreign corporations that are equal partners in PRS, a partnership. 
FC1's adjusted basis in its partnership interest in PRS is $0, FC2's 
basis is $50x, and FC3's basis is $50x. PRS has a section 754 election 
in effect. PRS owns Asset C with a fair market value of $50x and an 
adjusted basis of $0, Asset D with a fair market value of $50x and an 
adjusted basis of $50x, and Asset E with a fair market value of $50x and 
an adjusted basis of $50x, and all the adjusted basis in Asset D and 
Asset E is disqualified basis. PRS distributes Asset C to FC3 in 
liquidation of FC3's interest in PRS. None of FC1, FC2, FC3, or PRS 
recognizes gain on the distribution. Under section 732(b), FC3's 
adjusted basis in Asset C is $50x. PRS's adjusted bases in Asset D and 
Asset E are decreased, in the aggregate, by $50x under section 
734(b)(2)(B), which is the amount by which FC3's adjusted basis in Asset 
C exceeds PRS's adjusted basis in Asset C immediately before the 
distribution.
    (2) Analysis. The distribution of Asset C is a nonrecognition 
transaction under section 7701(a)(45). Under paragraph 
(h)(2)(ii)(B)(1)(i) of this section, the disqualified bases in Asset D 
and Asset E are reduced, in the aggregate, by $50x. Further, under 
paragraph (h)(2)(ii)(B)(2)(i) of this section, the disqualified basis in 
Asset C is increased by $50x, the aggregate reduction to the 
disqualified basis in Asset D and Asset E.
    (E) Example 5: Distribution of property to a partner in basis 
reduction transaction--(1) Facts. The facts are the same as in paragraph 
(h)(2)(iii)(D)(1) of this section (the facts in Example 4), except PRS 
distributes Asset D to FC1. Under section 732(a), FC1's adjusted basis 
in Asset D is $0. PRS's adjusted basis in Asset C is increased by $50x 
under section 734(b)(1)(B), which is the amount by which PRS's adjusted 
basis in Asset D immediately before the distribution exceeds FC1's 
adjusted basis in Asset D under section 732(a).
    (2) Analysis. The distribution of Asset D is a nonrecognition 
transaction under section 7701(a)(45). Under paragraph 
(h)(2)(ii)(B)(1)(i) of this section, the disqualified basis in Asset D 
is reduced by $50x. Further, under paragraph (h)(2)(ii)(B)(2)(i) of this 
section,

[[Page 225]]

the disqualified basis in Asset C is increased by $50x, the reduction to 
the disqualified basis in Asset D.
    (F) Example 6: Dual use property with disqualified basis--(1) Facts. 
FS is a tested income CFC and a wholesale distributor of Product A. FS 
owns trucks that deliver Product A. The trucks are specified tangible 
property. In Year 1, FS earns $250x in total gross income from inventory 
sales of Product A, $200x of which is included in gross tested income. 
The trucks have an average adjusted basis for Year 1 of $4,000x, of 
which $2,500x is disqualified basis. FS does not capitalize depreciation 
with respect to the trucks to inventory or other property held for sale. 
The depreciation deduction with respect to the trucks is $20x, $15x of 
which would be allocated and apportioned to gross tested income under 
Sec. 1.951A-2(c)(3) without regard to Sec. 1.951A-2(c)(5).
    (2) Analysis. Because the trucks are used in both the production of 
gross tested income and the production of gross income that is not gross 
tested income in Year 1, the trucks are dual use property within the 
meaning of paragraph (d)(2) of this section. Under paragraph 
(h)(2)(i)(A) of this section, the disqualified basis in the trucks is 
disregarded for purposes of determining FS's qualified business asset 
investment for Year 1. Under paragraph (h)(2)(i)(B) of this section, 
paragraph (h)(2)(i)(A) of this section applies by reducing the amount of 
FS's adjusted basis in the trucks treated as adjusted basis in specified 
tangible property for Year 1 under paragraph (d)(1) of this section 
(determined without regard to Sec. 1.951A-2(c)(5)) by the amount of the 
disqualified basis in the trucks. Without regard to Sec. 1.951A-
2(c)(5), FS's adjusted basis in the trucks treated as adjusted basis in 
specified tangible property for Year 1 under paragraph (d)(1) of this 
section is FS's adjusted basis in the trucks multiplied by FS's dual use 
ratio with respect to the trucks for Year 1. Because none of the 
depreciation with respect to the trucks is capitalized into inventory or 
other property held for sale, FS's dual use ratio with respect to the 
trucks is determined entirely by reference to the depreciation deduction 
with respect to the trucks. Therefore, under paragraph (d)(3) of this 
section, without regard to Sec. 1.951A-2(c)(5), FS's dual use ratio 
with respect to the trucks for Year 1 is 75%, which is FS's depreciation 
deduction with respect to the trucks that is allocated and apportioned 
to gross tested income under Sec. 1.951A-2(c)(3) for Year 1 ($15x), 
divided by FS's depreciation deduction with respect to the trucks for 
Year 1 ($20x). Accordingly, paragraph (d)(1) of this section, without 
regard to paragraph (h)(2)(i)(A) of this section, FS's adjusted basis in 
the trucks treated as adjusted basis in specified tangible property is 
$3,000x ($4,000x x 0.75). Under paragraph (h)(2)(i)(A) and (B) of this 
section, the amount of the adjusted basis in the trucks treated as 
adjusted basis in specified tangible property is reduced by the $2,500x 
of disqualified basis in the trucks. Accordingly, $500x ($3,000x - 
$2,500x) of FS's average adjusted basis in the trucks is taken into 
account under paragraph (b) of this section in determining FS's 
qualified business asset investment for Year 1.

[T.D. 9866, 84 FR 29341, June 21, 2019]



Sec. 1.951A-4  Tested interest expense and tested interest income.

    (a) Scope. This section provides rules for determining the tested 
interest expense and tested interest income of a controlled foreign 
corporation for purposes of determining a United States shareholder's 
specified interest expense under Sec. 1.951A-1(c)(3)(iii). Paragraph 
(b) of this section provides definitions related to tested interest 
expense and tested interest income. Paragraph (c) of this section 
provides examples illustrating these definitions and the application of 
Sec. 1.951A-1(c)(3)(iii). The amount of specified interest expense 
determined under Sec. 1.951A-1(c)(3)(iii) and this section is the 
amount of interest expense described in section 951A(b)(2)(B).
    (b) Definitions related to specified interest expense--(1) Tested 
interest expense--(i) In general. The term tested interest expense 
means, with respect to a controlled foreign corporation for a CFC 
inclusion year, interest expense paid or accrued by the controlled 
foreign corporation that is allocated and apportioned to gross tested 
income of the controlled foreign corporation for the

[[Page 226]]

CFC inclusion year under Sec. 1.951A-2(c)(3), reduced (but not below 
zero) by the sum of the qualified interest expense of the controlled 
foreign corporation for the CFC inclusion year and the tested loss QBAI 
amount of the controlled foreign corporation for the CFC inclusion year.
    (ii) Interest expense. The term interest expense means any expense 
or loss that is treated as interest expense under section 163(j).
    (iii) Qualified interest expense--(A) In general. The term qualified 
interest expense means, with respect to a controlled foreign corporation 
for a CFC inclusion year, to the extent established by the controlled 
foreign corporation, the interest expense paid or accrued by the 
controlled foreign corporation that is allocated and apportioned to 
gross tested income of the controlled foreign corporation for the CFC 
inclusion year under Sec. 1.951A-2(c)(3), multiplied by a fraction, the 
numerator of which is the average of the aggregate adjusted bases as of 
the close of each quarter of the CFC inclusion year of qualified assets 
held by the controlled foreign corporation, and the denominator of which 
is the average of the aggregate adjusted bases as of the close of each 
quarter of the CFC inclusion year of all assets held by the controlled 
foreign corporation.
    (B) Qualified asset--(1) In general. Except as provided in paragraph 
(b)(1)(iii)(B)(2) of this section, the term qualified asset means, with 
respect to a controlled foreign corporation for a CFC inclusion year, 
any obligation or financial instrument held by the controlled foreign 
corporation that gives rise to income included in the gross tested 
income of the controlled foreign corporation for the CFC inclusion year 
that is excluded from foreign personal holding company income (as 
defined in section 954(c)(1)) by reason of section 954(c)(2)(C)(ii) or 
section 954(h) or (i).
    (2) Exclusion for related party receivables. A qualified asset does 
not include an asset that gives rise to interest income that is also 
excludible from foreign personal holding company income by reason of 
section 954(c)(3) or (6).
    (3) Look-through rule for subsidiary stock. For purposes of 
paragraph (b)(1)(iii)(A) of this section, the adjusted basis in the 
stock of another controlled foreign corporation held by a controlled 
foreign corporation is treated as adjusted basis in a qualified asset in 
an amount equal to the adjusted basis in the stock multiplied by the 
fraction described in paragraph (b)(1)(iii)(A) of this section 
determined with respect to the assets of such other controlled foreign 
corporation.
    (4) Look-through rule for certain partnership interests. For 
purposes of paragraph (b)(1)(iii)(A) of this section, if a controlled 
foreign corporation owns 25 percent or more of the capital or profits 
interest in a partnership the controlled foreign corporation is treated 
as holding its attributable share of any property held by the 
partnership, as determined under the principles of Sec. 1.956-4(b), and 
the controlled foreign corporation's basis in the partnership interest 
is not taken into account.
    (iv) Tested loss QBAI amount. The term tested loss QBAI amount 
means, with respect to a tested loss CFC for a CFC inclusion year, 10 
percent of the amount that would be the qualified business asset 
investment of the tested loss CFC for the CFC inclusion year under 
section 951A(d) and Sec. 1.951A-3 if the tested loss CFC were a tested 
income CFC for the CFC inclusion year.
    (2) Tested interest income--(i) In general. The term tested interest 
income means, with respect to a controlled foreign corporation for a CFC 
inclusion year, interest income included in gross tested income of the 
controlled foreign corporation for the CFC inclusion year, reduced by 
qualified interest income of the controlled foreign corporation for the 
CFC inclusion year.
    (ii) Interest income. The term interest income means any income or 
gain that is treated as interest income under section 163(j).
    (iii) Qualified interest income--(A) In general. Except as provided 
in paragraph (b)(2)(iii)(B) of this section, the term qualified interest 
income means, with respect to a controlled foreign corporation for a CFC 
inclusion year, interest income of the controlled foreign corporation 
for the CFC inclusion year included in the gross tested income of the 
controlled foreign corporation for the CFC inclusion year that is 
excluded from foreign personal holding

[[Page 227]]

company income (as defined in section 954(c)(1)) by reason of section 
954(c)(2)(C)(ii) or section 954(h) or (i).
    (B) Exclusion for related party interest. Qualified interest income 
does not include interest income that is also excludable from foreign 
personal holding company income by reason of section 954(c)(3) or (6).
    (c) Examples. The following examples illustrate the application of 
this section.
    (1) Example 1: Wholly-owned CFCs--(i) Facts. A Corp, a domestic 
corporation, owns 100% of the single class of stock of each of FS1 and 
FS2, each a controlled foreign corporation. A Corp, FS1, and FS2 all use 
the calendar year as their taxable year. For Year 1, FS1 and FS2 are 
both tested income CFCs. In Year 1, FS1 pays $100x of interest to FS2. 
The interest expense of FS1 is allocated and apportioned to its gross 
tested income under Sec. 1.951A-2(c)(3). The interest income of FS2 is 
excluded from its foreign personal holding company income under section 
954(c)(6). Also, in Year 1, FS2 pays $100x of interest to a bank that is 
not related to FS2, which interest expense is allocated and apportioned 
to FS2's gross tested income under Sec. 1.951A-2(c)(3). Neither FS1 nor 
FS2 holds qualified assets or owns stock of another controlled foreign 
corporation.
    (ii) Analysis--(A) CFC-level determination; tested interest expense 
and tested interest income--(1) Tested interest expense and tested 
interest income of FS1. FS1 has $100x of interest expense that is 
allocated and apportioned to its gross tested income under Sec. 1.951A-
2(c)(3). FS1 has no interest income. Accordingly, FS1 has $100x of 
tested interest expense and no tested interest income for Year 1.
    (2) Tested interest expense and tested interest income of FS2. FS2 
has $100x of interest expense that is allocated and apportioned to its 
gross tested income under Sec. 1.951A-2(c)(3) and $100x of interest 
income that is included in its gross tested income. Accordingly, FS2 has 
$100x of tested interest expense and $100x of tested interest income for 
Year 1.
    (B) United States shareholder-level determination; pro rata share 
and specified interest expense. Under Sec. 1.951A-1(d)(5) and (6), A 
Corp's pro rata share of FS1's tested interest expense is $100x, its pro 
rata share of FS2's tested interest expense is $100x, and its pro rata 
share of FS2's tested interest income is $100x. For Year 1, A Corp's 
aggregate pro rata share of tested interest expense is $200x and its 
aggregate pro rata share of tested interest income is $100x. 
Accordingly, under Sec. 1.951A-1(c)(3)(iii), A Corp's specified 
interest expense is $100x ($200x-$100x) for Year 1.
    (2) Example 2: Less than wholly-owned CFCs--(i) Facts. The facts are 
the same as in paragraph (c)(1)(i) of this section (the facts in Example 
1), except that A Corp owns 50% of the single class of stock of FS1 and 
80% of the single class of stock of FS2.
    (ii) Analysis--(A) CFC-level determination; tested interest expense 
and tested interest income. The analysis is the same as in paragraph 
(c)(1)(ii)(A) of this section (paragraph (A) of the analysis in Example 
1).
    (B) United States shareholder-level determination; pro rata share 
and specified interest expense. Under Sec. 1.951A-1(d)(5) and (6), A 
Corp's pro rata share of FS1's tested interest expense is $50x ($100x x 
0.50), its pro rata share of FS2's tested interest expense is $80x 
($100x x 0.80), and its pro rata share of FS2's tested interest income 
is $80x ($100x x 0.80). For Year 1, A Corp's aggregate pro rata share of 
the tested interest expense is $130x ($50x + $80x) and its aggregate pro 
rata share of the tested interest income is $80x ($0 + $80x). 
Accordingly, under Sec. 1.951A-1(c)(3)(iii), A Corp's specified 
interest expense is $50x ($130x-$80x) for Year 1.
    (3) Example 3: Operating company; qualified interest expense--(i) 
Facts. B Corp, a domestic corporation, owns 100% of the single class of 
stock of each of FS1 and FS2, each a controlled foreign corporation. For 
Year 1, FS1 and FS2 are both tested income CFCs. B Corp, FS1, and FS2 
all use the calendar year as their taxable year. FS2 is an eligible 
controlled foreign corporation within the meaning of section 954(h)(2). 
In Year 1, FS1 pays $100x of interest to FS2. The interest expense of 
FS1 is allocated and apportioned to its gross tested income under Sec. 
1.951A-2(c)(3). The interest income of FS2 is excluded

[[Page 228]]

from its foreign personal holding company income by reason of section 
954(c)(6). In addition, in Year 1, FS2 receives $300x of interest from 
customers that are not related to FS2, which interest income is excluded 
from FS2's foreign personal holding company income by reason of section 
954(h), and FS2 pays $300x of interest to a bank, which interest expense 
is allocated and apportioned to FS2's gross tested income under Sec. 
1.951A-2(c)(3). Neither FS1 nor FS2 owns stock of another controlled 
foreign corporation. FS1 does not hold qualified assets. FS2's average 
adjusted bases in qualified assets is $8,000x, and FS2's average 
adjusted bases in all its assets is $12,000x.
    (ii) Analysis--(A) CFC-level determination; tested interest expense 
and tested interest income--(1) Tested interest expense and tested 
interest income of FS1. FS1 has $100x of interest expense that is 
allocated and apportioned to its gross tested income under Sec. 1.951A-
2(c)(3). FS1 has no interest income. Accordingly, FS1 has $100x of 
tested interest expense and no tested interest income for Year 1.
    (2) Tested interest expense and tested interest income of FS2. FS2 
has $300x of interest expense that is allocated and apportioned to its 
gross tested income under Sec. 1.951A-2(c)(3) and $400x of interest 
income that is included in gross tested income. However, a portion of 
FS2's interest income is excluded from foreign personal holding company 
income by reason of section 954(h), and a portion of FS2's assets are 
qualified assets. As a result, in determining the tested interest income 
and tested interest expense of FS2, the qualified interest income and 
qualified interest expense of FS2 are excluded. FS2 has qualified 
interest income of $300x, the amount of FS2's interest income that is 
excluded from foreign personal holding company income by reason of 
section 954(h). In addition, FS2 has qualified interest expense of 
$200x, the amount of FS2's interest expense that is allocated and 
apportioned to its gross tested income under Sec. 1.951A-2(c)(3) 
($300x), multiplied by a fraction, the numerator of which is FS2's 
average adjusted bases in qualified assets ($8,000x), and the 
denominator of which is FS2's average adjusted bases in all its assets 
($12,000x). Accordingly, FS2 has tested interest income of $100x ($400x-
$300x) and tested interest expense of $100x ($300x-$200x) for Year 1.
    (B) United States shareholder-level determination; pro rata share 
and specified interest expense. Under Sec. 1.951A-1(d)(5) and (6), B 
Corp's pro rata share of FS1's tested interest expense is $100x, its pro 
rata share of FS2's tested interest expense is $100x, and its pro rata 
share of FS2's tested interest income is $100x. For Year 1, B Corp's 
aggregate pro rata share of tested interest expense is $200x ($100x + 
$100x) and its aggregate pro rata share of tested interest income is 
$100x ($0 + $100x). Accordingly, under Sec. 1.951A-1(c)(3)(iii), B 
Corp's specified interest expense is $100x ($200x-$100x) for Year 1.
    (4) Example 4: Holding company; qualified interest expense--(i) 
Facts. C Corp, a domestic corporation, owns 100% of the single class of 
stock of each of FS1 and FS2, each a controlled foreign corporation. FS2 
owns 100% of the single class of stock of FS3, a qualifying insurance 
company within the meaning of section 953(e)(3). For Year 1, FS1, FS2, 
and FS3 are all tested income CFCs. C Corp, FS1, FS2, and FS3 all use 
the calendar year as their taxable year. In Year 1, FS1 pays $100x of 
interest to FS3. The interest expense of FS1 is allocated and 
apportioned to its gross tested income under Sec. 1.951A-2(c)(3). The 
interest income of FS3 is excluded from its foreign personal holding 
company income by reason of section 954(c)(6). In addition, FS3 receives 
$300x of interest from persons that are not related to FS3, which 
interest income is excluded from FS's foreign personal holding company 
income by reason of section 954(i). Also in Year 1, FS2 pays $300x of 
interest to a bank, which interest expense is allocated and apportioned 
to FS2's gross tested income under Sec. 1.951A-2(c)(3). None of FS1, 
FS2, or FS3 owns stock of another controlled foreign corporation, except 
for the stock of FS3 owned by FS2. FS2 has no assets other than the 
stock of FS3. Neither FS1 nor FS2 hold qualified assets directly. FS2's 
average adjusted bases in the FS3 stock is $6,000x. FS3's average 
adjusted bases in qualified assets is $8,000x, and FS3's average 
adjusted bases in all its assets is $12,000x.

[[Page 229]]

    (ii) Analysis--(A) CFC-level determination; tested interest expense 
and tested interest income--(1) Tested interest expense and tested 
interest income of FS1. In Year 1, FS1 has $100x of interest expense 
allocated and apportioned to its gross tested income under Sec. 1.951A-
2(c)(3). FS1 has no interest income. Accordingly, FS1 has $100x of 
tested interest expense and no tested interest income for Year 1.
    (2) Tested interest expense and tested interest income of FS2. FS2 
has $300x of interest expense that is allocated and apportioned to its 
gross tested income under Sec. 1.951A-2(c)(3). FS2 has no interest 
income. While FS2 holds no qualified assets directly, $4,000x of FS3's 
average adjusted basis in FS3 stock is treated as adjusted basis in a 
qualified asset, which is equal to FS3's average adjusted basis in FS3 
stock ($6,000x) multiplied by a fraction, the numerator of which is 
FS3's average adjusted bases in qualified assets ($8,000x), and the 
denominator of which is FS3's average adjusted bases in all its assets 
($12,000x). Accordingly, FS2 has qualified interest expense of $200x, 
the amount of FS2's interest expense allocated and apportioned to FS2's 
gross tested income under Sec. 1.951A-2(c)(3) ($300x), multiplied by a 
fraction, the numerator of which is FS2's average adjusted bases in 
qualified assets ($4,000x), and the denominator of which is FS2's 
average adjusted bases in all its assets ($6,000x). Therefore, FS2 has 
tested interest expense of $100x ($300x-$200x) and no tested interest 
income for Year 1.
    (3) Tested interest expense and tested interest income of FS3. In 
Year 1, FS3 has no interest expense, but FS3 has $400x of interest 
income that is included in gross tested income. However, a portion of 
FS3's interest income is excluded from foreign personal holding company 
income by reason of section 954(i). As a result, in determining the 
tested interest income of FS3, the qualified interest income of FS3 is 
excluded. FS3 has qualified interest income of $300x, the amount of 
FS3's interest income that is excluded from foreign personal holding 
company income by reason of section 954(i). Therefore, FS2 has tested 
interest income of $100x ($400x-$300x) and no tested interest expense 
for Year 1.
    (B) United States shareholder-level determination; pro rata share 
and specified interest expense. Under Sec. 1.951A-1(d)(5) and (6), C 
Corp's pro rata share of FS1's tested interest expense is $100x, its pro 
rata share of FS2's tested interest expense is $100x, and its pro rata 
share of FS3's tested interest income is $100x. For Year 1, C Corp's 
aggregate pro rata share of tested interest expense is $200x ($100x + 
$100x + $0) and its aggregate pro rata share of tested interest income 
is $100x ($0 + $0 + $100x). Accordingly, under Sec. 1.951A-
1(c)(3)(iii), C Corp's specified interest expense is $100x ($200x-$100x) 
for Year 1.
    (5) Example 5: Specified interest expense and tested loss QBAI 
amount--(i) Facts. D Corp, a domestic corporation, owns 100% of a single 
class of stock of each of FS1 and FS2, each a controlled foreign 
corporation. For Year 1, FS1 is a tested income CFC and FS2 is a tested 
loss CFC. D Corp, FS1, and FS2 all use the calendar year as their 
taxable year. In Year 1, FS1 pays $100x of interest to FS2. The interest 
expense of FS1 is allocated and apportioned to its gross tested income 
under Sec. 1.951A-2(c)(3). The interest income of FS2 is excluded from 
its foreign personal holding company income by reason of section 
954(c)(6). Also, in Year 1, FS2 pays $100x of interest to a bank that is 
not related to FS2, which interest expense is allocated and apportioned 
to FS2's gross tested income under Sec. 1.951A-2(c)(3). Neither FS1 nor 
FS2 holds qualified assets or owns stock of another controlled foreign 
corporation. Because FS2 is a tested loss CFC, FS2 has no QBAI. See 
Sec. 1.951A-3(b). However, if FS2 were a tested income CFC, FS2 would 
have QBAI of $1,000x.
    (ii) Analysis--(A) CFC-level determination; tested interest expense 
and tested interest income--(1) Tested interest expense and tested 
interest income of FS1. In Year 1, FS1 has $100x of interest expense 
that is allocated and apportioned to its gross tested income under Sec. 
1.951A-2(c)(3). FS1 has no interest income. Accordingly, FS1 has $100x 
of tested interest expense and no tested interest income for Year 1.
    (2) Tested interest expense and tested interest income of FS2. FS2 
has $100x of

[[Page 230]]

interest income that is included in gross tested income. Accordingly, 
FS2 has $100x of tested interest income. FS2 also has 100x of interest 
expense that is allocated and apportioned to its gross tested income. 
However, because FS2 is a tested loss CFC, FS2's tested interest expense 
is reduced by its tested loss QBAI amount. FS2's tested loss QBAI amount 
is $100x (10% of $1,000x, the amount that would be QBAI if FS2 were a 
tested income CFC). Accordingly, FS2's tested interest expense is $0 
($100x interest expense-$100x tested loss QBAI amount) for Year 1.
    (B) United States shareholder-level determination; pro rata share 
and specified interest expense. Under Sec. 1.951A-1(d)(5) and (6), D 
Corp's pro rata share of FS1's tested interest expense is $100x, its pro 
rata share of FS2's tested interest expense is $0, and its pro rata 
share of FS2's tested interest income is $100x. For Year 1, D Corp's 
aggregate pro rata share of tested interest expense is $100x, and its 
aggregate pro rata share of tested interest income is $100x. 
Accordingly, under Sec. 1.951A-1(c)(3)(iii), D Corp's specified 
interest expense is $0 ($100x-$100x) for Year 1.

[T.D. 9866, 84 FR 29341, June 21, 2019]



Sec. 1.951A-5  Treatment of GILTI inclusion amounts.

    (a) Scope. This section provides rules relating to the treatment of 
GILTI inclusion amounts and adjustments to earnings and profits to 
account for tested losses. Paragraph (b) of this section provides that a 
GILTI inclusion amount is treated in the same manner as an amount 
included under section 951(a)(1)(A) for purposes of applying certain 
Code sections. Paragraph (c) of this section provides rules for the 
treatment of amounts taken into account in determining the net CFC 
tested income of a United States shareholder when applying sections 
163(e)(3)(B)(i) and 267(a)(3)(B). Paragraph (d) of this section provides 
a rule for the treatment of a GILTI inclusion amount for purposes of 
determining the personal holding company income of a United States 
shareholder that is a domestic corporation under section 543.
    (b) Treatment as subpart F income for certain purposes--(1) In 
general. A GILTI inclusion amount is treated in the same manner as an 
amount included under section 951(a)(1)(A) for purposes of applying 
sections 168(h)(2)(B), 535(b)(10), 851(b), 904(h)(1), 959, 961, 962, 
993(a)(1)(E), 996(f)(1), 1248(b)(1), 1248(d)(1), 1411, 6501(e)(1)(C), 
6654(d)(2)(D), and 6655(e)(4).
    (2) Allocation of GILTI inclusion amount to tested income CFCs--(i) 
In general. For purposes of the sections referred to in paragraph (b)(1) 
of this section, the portion of the GILTI inclusion amount of a United 
States shareholder for a U.S. shareholder inclusion year treated as 
being with respect to each controlled foreign corporation of the United 
States shareholder for the U.S. shareholder inclusion year is--
    (A) In the case of a tested loss CFC, zero, and
    (B) In the case of a tested income CFC, the portion of the GILTI 
inclusion amount of the United States shareholder which bears the same 
ratio to such amount as the United States shareholder's pro rata share 
of the tested income of the tested income CFC for the U.S. shareholder 
inclusion year bears to the aggregate amount of the United States 
shareholder's pro rata share of the tested income of each tested income 
CFC for the U.S. shareholder inclusion year.
    (ii) Example. The following example illustrates the application of 
paragraph (b)(2)(i) of this section.
    (A) Facts. USP, a domestic corporation, owns all of the stock of 
three controlled foreign corporations, CFC1, CFC2, and CFC3. USP, CFC1, 
CFC2, and CFC3 all use the calendar year as their taxable year. In Year 
1, CFC1 has tested income of $100x, CFC2 has tested income of $300x, and 
CFC3 has tested loss of $50x. USP has no net deemed tangible income 
return for Year 1.
    (B) Analysis. In Year 1, USP has net CFC tested income (as defined 
in Sec. 1.951A-1(c)(2)) of $350x ($100x + $300x-$50x) and, because USP 
has no net deemed tangible income return, a GILTI inclusion amount (as 
defined in Sec. 1.951A-1(c)(1)) of $350x ($350x-$0). The aggregate 
amount of USP's pro rata share of tested income is $400x ($100x from 
CFC1 + $300x from CFC2). Therefore, under paragraph (b)(2)(i) of this 
section, the portion of USP's GILTI inclusion amount treated as being 
with

[[Page 231]]

respect to CFC1 is $87.50x ($350x x $100x/$400x). The portion of USP's 
GILTI inclusion amount treated as being with respect to CFC2 is $262.50x 
($350x x $300x/$400x). The portion of USP's GILTI inclusion amount 
treated as being with respect to CFC3 is $0 because CFC3 is a tested 
loss CFC.
    (3) Translation of portion of GILTI inclusion amount allocated to 
tested income CFC. The portion of the GILTI inclusion amount of a United 
States shareholder allocated to a tested income CFC under section 
951A(f)(2) and paragraph (b)(2)(i) of this section is translated into 
the functional currency of the tested income CFC using the average 
exchange rate for the CFC inclusion year of the tested income CFC.
    (c) Treatment as an amount includible in the gross income of a 
United States person. For purposes of sections 163(e)(3)(B)(i) and 
267(a)(3)(B), an item (including original issue discount) is treated as 
includible in the gross income of a United States person to the extent 
that the item increases a United States shareholder's pro rata share of 
tested income of a controlled foreign corporation for a U.S. shareholder 
inclusion year, reduces the shareholder's pro rata share of tested loss 
of a controlled foreign corporation for the U.S. shareholder inclusion 
year, or both.
    (d) Treatment for purposes of personal holding company rules. For 
purposes of determining whether a United States shareholder that is a 
domestic corporation is a personal holding company under section 542, no 
portion of the adjusted ordinary gross income of such domestic 
corporation that consists of its GILTI inclusion amount for the U.S. 
shareholder inclusion year is personal holding company income (as 
defined in section 543(a)).

[T.D. 9866, 84 FR 29341, June 21, 2019]



Sec. 1.951A-6  Adjustments related to tested losses.

    (a) Scope. This section provides rules relating to adjustments 
related to tested losses. Paragraph (b) of this section provides rules 
that increase the earnings and profits of a tested loss CFC for purposes 
of section 952(c)(1)(A). Paragraph (c) of this section is reserved for a 
rule for tested loss adjustments.
    (b) Increase of earnings and profits of tested loss CFC for purposes 
of section 952(c)(1)(A). For purposes of section 952(c)(1)(A) with 
respect to a CFC inclusion year, the earnings and profits of a tested 
loss CFC are increased by an amount equal to the tested loss of the 
tested loss CFC for the CFC inclusion year.
    (c) [Reserved]

[T.D. 9866, 84 FR 29341, June 21, 2019]



Sec. 1.951A-7  Applicability dates.

    (a) In general. Except as otherwise provided in this section, 
sections 1.951A-1 through 1.951A-6 apply to taxable years of foreign 
corporations beginning after December 31, 2017, and to taxable years of 
United States shareholders in which or with which such taxable years of 
foreign corporations end.
    (b) High-tax exception. Section 1.951A-2(c)(1)(iii), (c)(3)(ii), and 
(c)(7) and (8) apply to taxable years of foreign corporations beginning 
on or after July 23, 2020, and to taxable years of United States 
shareholders in which or with which such taxable years of foreign 
corporations end. In addition, taxpayers may choose to apply the rules 
in Sec. 1.951A-2(c)(1)(iii), (c)(3)(ii), and (c)(7) and (8) to taxable 
years of foreign corporations that begin after December 31, 2017, and 
before July 23, 2020, and to taxable years of U.S. shareholders in which 
or with which such taxable years of the foreign corporations end, 
provided that they consistently apply those rules and the rules in Sec. 
1.954-1(c)(1)(iii)(A)(3), Sec. 1.954-1(c)(1)(iv), and the first 
sentence of Sec. 1.954-1(d)(3)(i) to such taxable years.
    (c) [Reserved]
    (d) Deduction for disqualified payments. Section 1.951A-2(c)(6) 
applies to taxable years of foreign corporations ending on or after 
April 7, 2020, and to taxable years of United States shareholders in 
which or with which such taxable years end.

[T.D. 9866, 84 FR 29341, June 21, 2019, as amended by T.D. 9902, 85 FR 
44648, July 23, 2020; T.D. 9922, 85 FR 72070, Nov. 12, 2020]

[[Page 232]]



Sec. 1.952-1  Subpart F income defined.

    (a) In general. For purposes of sections 951 through 964, a 
controlled foreign corporation's subpart F income for any taxable year 
shall, except as provided in paragraph (b) of this section and subject 
to the limitations of paragraphs (c) and (d) of this section, consist of 
the sum of--
    (1) The income derived by such corporation for such year from the 
insurance of United States risks (determined in accordance with the 
provisions of section 953 and Sec. Sec. 1.953-1 through 1.953-6),
    (2) The income derived by such corporation for such year which 
constitutes foreign base company income (determined in accordance with 
the provisions of section 954 and Sec. Sec. 1.954-1 through 1.954-8),
    (3)(i) An amount equal to the product of--
    (A) The income of such corporation other than income which--
    (1) Is attributable to earnings and profits of the foreign 
corporation included in the gross income of a United States person under 
section 951 (other than by reason of this paragraph) (determined in 
accordance with the provisions of section 951 and Sec. 1.951-1), or
    (2) Is described in section 952(b),


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


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


Thus, for example, dividends received from sources within the United 
States by a foreign corporation engaged in business in the United States 
during the taxable year, which are not effectively connected for that 
year with the conduct of a trade or business in the United States by 
that corporation, shall not be excluded from subpart F income under 
section 952(b) and this

[[Page 233]]

subparagraph even though such dividends are subject to the tax of 30 
percent imposed by section 881 (a). Also, for example, if, by reason of 
an income tax convention to which the United States is a party, an 
amount of interest from sources within the United States which is 
effectively connected for the taxable year with the conduct of a 
business in the United States by a foreign corporation is subject to tax 
under chapter 1 at a flat rate of 15 percent, as provided in Sec. 
1.871-12, such interest is not excluded from subpart F income under 
section 952(b) and this subparagraph. The deductions attributable to 
items of income which are excluded from subpart F income under this 
subparagraph shall not be taken into account for purposes of section 
952.
    (3) Rule applicable under section 956 (b)(2). For purposes only of 
paragraph (b)(1))(viii) of Sec. 1.956-2, an item of income derived by a 
controlled foreign corporation from sources within the United States 
with respect to which for the taxable year a tax is imposed in 
accordance with section 882(a) shall be considered described in section 
952(b) whether or not such item of income would have constituted subpart 
F income for such year.
    (c) Limitation on a controlled foreign corporation's subpart F 
income--(1) In general. A United States shareholder's pro rata share 
(determined in accordance with the rules of paragraph (e) of Sec. 
1.951-1) of a controlled foreign corporation's subpart F income for any 
taxable year shall not exceed his pro rata share of the earnings and 
profits (as defined in section 964(a) and Sec. 1.964-1) of such 
corporation for such taxable year, computed as of the close of such 
taxable year without diminution by reason of any distributions made 
during such taxable year, minus the sum of--
    (i) The amount, if any, by which such shareholder's pro rata share 
of--
    (a) The sum of such corporation's deficits in earnings and profits 
for prior taxable years beginning after December 31, 1962, plus
    (b) The sum of such corporation's deficits in earnings and profits 
for taxable years beginning after December 31, 1959, and before January 
1, 1963 (reduced by the sum of the earnings and profits (as so defined) 
of such corporation for any of such taxable years) exceeds
    (c) The sum of such corporation's earnings and profits for prior 
taxable years beginning after December 31, 1962, which, with respect to 
such shareholder, are allocated to other earnings and profits under 
section 959(c)(3) and Sec. 1.959-3; and
    (ii) Such shareholder's pro rata share of any deficits in earnings 
and profits of other foreign corporations for a taxable year beginning 
after December 31, 1962, which are attributable to stock of such other 
foreign corporations owned by such shareholder within the meaning of 
section 958(a) and which, in accordance with section 952(d) and 
paragraph (d) of this section, are taken into account as a reduction in 
the controlled foreign corporation's earnings and profits for such 
taxable year.


For purposes of applying this subparagraph, the reduction (if any) 
provided by subdivision (i) of this subparagraph in a United States 
shareholder's pro rata share of the earnings and profits of a controlled 
foreign corporation shall be taken into account before the reduction 
provided by subdivision (ii) of this subparagraph. See section 952(c).
    (2) Special rules. For purposes only of determining the limitation 
under subparagraph (1) of this paragraph on a United States 
shareholder's pro rata share of a controlled foreign corporation's 
subpart F income for any taxable year--
    (i) Status of foreign corporation. The earnings and profits, or 
deficit in earnings and profits, of a foreign corporation for any 
taxable year shall be taken into account whether or not such foreign 
corporation is a controlled foreign corporation at the time such 
earnings and profits are derived or such deficit in earnings and profits 
is incurred.
    (ii) Deficits in earnings and profits taken into account only once. 
A controlled foreign corporation's deficit in earnings and profits for 
any taxable year preceding the taxable year shall be taken into account 
for the taxable year only to the extent such deficit has not been taken 
into account under this

[[Page 234]]

paragraph, paragraph (d) of this section, or paragraph (d)(2)(ii) of 
Sec. 1.963-2 (applied as if section 963 had not been repealed by the 
Tax Reduction Act of 1975) in computing a minimum distribution, for any 
taxable year preceding the taxable year, to reduce earnings and profits 
of such preceding year of such controlled foreign corporation or of any 
other controlled foreign corporation. To the extent a controlled foreign 
corporation's (the ``first corporation'') excess foreign base company 
shipping deductions for any taxable year (determined under Sec. 1.955A-
3(c)(2)(i)) reduce the foreign base company shipping income of another 
member of a related group (as defined in Sec. 1.955A-2(b)), such 
deductions shall not be taken into account in determining the earnings 
and profits or deficits in earnings and profits of such first 
corporation for such taxable year for purposes of this paragraph (c) and 
paragraph (d) of this section. The rule of the preceding sentence shall 
not apply to the extent the excess foreign base company shipping 
deductions of the first corporation reduce the foreign base company 
shipping income of another member of a related group below zero.
    (iii) Determination of pro rata share. A United States shareholder's 
pro rata share of a controlled foreign corporation's earnings and 
profits, or deficit in earnings and profits, for any taxable year shall 
be determined in accordance with the principles of paragraph (e) of 
Sec. 1.951-1 and paragraph (d)(2)(ii) of Sec. 1.963-2.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

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

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


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

    (d) Treatment of deficits in earnings and profits attributable to 
stock of other foreign corporation indirectly owned by a

[[Page 235]]

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


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

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

[[Page 236]]

in earnings and profits (determined under section 964(a) and Sec. 
1.964-1), of each of the foreign corporations for 1963 are as follows, 
the deficits being set forth in parentheses:

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

    (c) The chains of foreign corporations (within the meaning of 
subparagraph (2)(ii) of this paragraph) for 1963 are the ``A'' chain, 
consisting of corporations, A, B, C, D, E, G, and H, but only to the 
extent of M Corporation's stock interest in such corporations under 
section 958(a) by reason of its ownership of stock in A Corporation; the 
``B'' chain, consisting of corporations B, D, G, and H, but only to the 
extent of M Corporation's stock interest in such corporations under 
section 958(a) by reason of its ownership of stock in B Corporation; and 
the ``F'' chain, consisting of corporations F, C, and E, but only to the 
extent of M Corporation's stock interest in such corporations under 
section 958(a) by reason of its ownership of stock in F Corporation.
    (d) Corporation M's stock interest under section 958(a) in each of 
the chains of foreign corporations is as follows for 1963:

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

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

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

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

[[Page 237]]



 
                                                              Amount of
                                                              reduction
 
A chain:
  A Corporation ($12,000 x $18,000/$30,000)................       $7,200
  D Corporation ($12,000 x $3,000/$30,000).................        1,200
  E Corporation ($12,000 x $9,000/$30,000).................        3,600
                                               --------------
   Total...................................................       12,000
                                               ==============
B chain:
  D Corporation ($2,500 x $750/$750)..........       $2,500
  Limitation: M Corporation's pro-rata share            750
   of D Corporation's earnings and profits....
  Allocation of used deficit ($750) to M
   Corporation's pro rata share of the
   deficits of corporations B and G:
    B Corporation ($750 x ($1,500/$2,500))....         $450
    G Corporation ($750 x ($1,000/$2,500))....          300
                                               -------------
     Total....................................          750         $750
                                               =========================
F chain:
  F Corporation ($500 x $20,250/$22,500)...................          450
  E Corporation ($500 x $2,250/$22,500)....................           50
                                               --------------
   Total...................................................          500
 

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

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

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

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

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

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

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

[[Page 238]]

of the unused deficit for 1963 applicable to M Corporation's interest in 
B Corporation may be used under paragraph (c)(1)(i)(a) of this section 
in later years to reduce M Corporation's interest in B Corporation's 
earnings and profits.

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

[[Page 239]]

in the same separate category (as defined in Sec. 1.904-5(a)(4)(v)) as 
the recapture account to the extent that current year earnings and 
profits exceed subpart F income in a taxable year. The United States 
shareholder must include his pro rata share (determined under the rules 
of Sec. 1.951-1(e)) of each recharacterized amount in income as subpart 
F income in such separate category for the taxable year.
    (iii) Reduction of recapture account and corresponding earnings. 
Each recapture account, and post-1986 undistributed earnings in the 
separate category containing the recapture account, will be reduced in 
any taxable year by the amount which is recharacterized under paragraph 
(f)(2)(ii) of this section. In addition, each recapture account, and 
post-1986 undistributed earnings in the separate category containing the 
recapture account, will be reduced in the amount of any distribution out 
of that account (as determined under the ordering rules of section 
959(c) and paragraph (f)(3)(ii) of this section).
    (3) Distribution ordering rules--(i) Coordination of recapture and 
distribution rules. If a controlled foreign corporation distributes an 
amount out of earnings and profits described in section 959(c)(3) in a 
year in which current year earnings and profits exceed subpart F income 
and there is an amount in a recapture account for such year, the 
recapture rules will apply first.
    (ii) Distributions reduce recapture accounts first. Any distribution 
made by a controlled foreign corporation out of earnings and profits 
described in section 959(c)(3) shall be treated as made first on a 
proportionate basis out of the recapture accounts in each separate 
category to the extent thereof (even if the amount in the recapture 
account exceeds post-1986 undistributed earnings in the separate 
category containing the recapture account). Any remaining distribution 
shall be treated as made on a proportionate basis out of the remaining 
earnings and profits of the controlled foreign corporation in each 
separate category. See section 904(d)(3)(D).
    (4) Examples. The application of paragraphs (e) and (f) of this 
section may be illustrated by the following examples:

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

[[Page 240]]

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

[[Page 241]]

((100u) opening balance + 100u current earnings -95u inclusion), 55u of 
passive limitation earnings and profits (50u opening balance + 100u 
current foreign personal holding company income -95u inclusion), and 40u 
of earnings and profits subject to the separate limitation for dividends 
from the noncontrolled section 902 corporation (50u opening balance + 
(10u) expense).
    Example 3. (i) A, a U.S. person, is the sole shareholder of CFC, a 
controlled foreign corporation whose functional currency is the u. At 
the beginning of 1998, CFC has post-1986 undistributed earnings of 275u, 
all of which are general limitation earnings described in section 
904(d)(1)(I). CFC has no previously-taxed earnings and profits described 
in section 959(c)(1) or (c)(2). In 1998, CFC has a (200u) loss in the 
shipping category described in section 904(d)(1)(D), 100u of foreign 
personal holding company income that is passive income described in 
section 904(d)(1)(A), and 125u of general limitation manufacturing 
earnings that are not subpart F income. CFC's subpart F income for 1998, 
100u, exceeds CFC's current earnings and profits, 25u, by 75u. Under 
section 952(c)(1)(A) and paragraph (e) of this section, subpart F income 
is limited to CFC's current earnings and profits of 25u, all of which is 
included in A's gross income under section 951(a)(1)(A). The 75u of 
CFC's 1998 subpart F income that is not included in A's income in 1998 
by reason of section 952(c)(1)(A) is subject to recapture under section 
952(c)(2) and paragraph (f) of this section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture account, the rules of paragraphs (e)(1) and (2) of this 
section apply. Under paragraph (e)(1) of this section, the amount of 
CFC's subpart F income in excess of earnings and profits for 1998, 75u, 
reduces the 100u of passive limitation foreign personal holding company 
income. Thus, A includes 25u of passive limitation foreign personal 
holding company income in gross income, and CFC has 75u in its passive 
limitation/foreign personal holding company income recapture account.
    (iii) For purposes of computing post-1986 undistributed earnings in 
each separate category the rules of sections 902 and 960, including the 
rules of Sec. 1.960-1(i), apply. Under Sec. 1.960-1(i), the shipping 
limitation deficit of (200u) is allocated proportionately to reduce 
general limitation earnings of 400u and passive limitation earnings of 
100u. Thus, general limitation earnings are reduced by 160u to 240u 
(400u general limitation earnings/500u total earnings in positive 
separate categories x (200u) shipping deficit = 160u reduction), and 
passive limitation earnings are reduced by 40u to 60u (100u passive 
earnings/500u total earnings in positive separate categories x (200u) 
shipping deficit = 40u reduction). Five-twelfths of CFC's post-1986 
foreign income taxes with respect to passive limitation earnings are 
deemed paid by A under section 960 with respect to the subpart F 
inclusion (25u inclusion/60u passive earnings). After the inclusion and 
deemed-paid taxes are computed, at the close of 1998 CFC has 400u of 
general limitation earnings (275u opening balance + 125u current 
earnings), 75u of passive limitation earnings (100u of foreign personal 
holding company income -25u inclusion), and a (200u) deficit in shipping 
limitation earnings.
    Example 4. (i) The facts are the same as in Example 3 with the 
addition of the following facts. In 1999, CFC earns 50u of general 
limitation earnings that are not subpart F income and 75u of passive 
limitation income that is foreign personal holding company income. Thus, 
CFC has 125u of current earnings and profits. CFC distributes 200u to A. 
Under paragraph (f)(3)(i) of this section, the recapture rules are 
applied first. Thus, the amount by which 1999 current earnings and 
profits exceed subpart F income, 50u, is recharacterized as passive 
limitation foreign personal holding company income. CFC's total subpart 
F income for 1999 is 125u of passive limitation foreign personal holding 
company income (75u current earnings plus 50u recapture account), and 
the passive limitation/foreign personal holding company income recapture 
account is reduced from 75u to 25u.
    (ii) CFC has 150u of previously-taxed earnings and profits described 
in section 959(c)(2) (25u attributable to 1998 and 125u attributable to 
1999), all of which is passive limitation earnings and profits. Under 
section 959(c), 150u of the 200u distribution is deemed to be made from 
earnings and profits described in section 959(c)(2). The remaining 50u 
is deemed to be made from earnings and profits described in section 
959(c)(3). Under paragraph (f)(3)(ii) of this section, the dividend 
distribution is deemed to be made first out of the passive limitation 
recapture account to the extent thereof (25u). Under paragraph 
(f)(2)(iii) of this section, the passive limitation recapture account is 
reduced from 25u to 0. The remaining distribution of 25u is treated as 
made out of CFC's general limitation earnings and profits.
    (iii) For purposes of computing post-1986 undistributed earnings, 
the rules of section 902 and 960, including the rules of Sec. 1.960-
1(i), apply. Thus, the shipping limitation accumulated deficit of (200u) 
reduces general limitation earnings and profits of 450u and passive 
limitation earnings and profits of 150u on a proportionate basis. Thus, 
100% of CFC's post-1986 foreign income taxes with respect to passive 
limitation earnings are deemed paid by A under section 960 with respect 
to the 1999 subpart F inclusion of 125u (100u inclusion (numerator 
limited to denominator)/100u passive earnings). No post-1986 foreign

[[Page 242]]

income taxes remain to be deemed paid under section 902 in connection 
with the 25u distribution from the passive limitation/foreign personal 
holding company income recapture account. One-twelfth of CFC's post-1986 
foreign income taxes with respect to general limitation earnings are 
deemed paid by A under section 902 with respect to the distribution of 
25u general limitation earnings and profits described in section 
959(c)(3) (25u inclusion/300u general limitation earnings). After the 
deemed-paid taxes are computed, at the close of 1999 CFC has 425u of 
general limitation earnings and profits (400u opening balance + 50u 
current earnings--25u distribution), 0 of passive limitation earnings 
(75u recapture account + 75u current foreign personal holding company 
income--125u inclusion--25u distribution), and a (200u) deficit in 
shipping limitation earnings.

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

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

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

[T.D. 6795, 30 FR 938, Jan. 29, 1965, as amended by T.D. 6892, 31 FR 
11144, Aug. 23, 1966; T.D. 7293, 38 FR 32802, Nov. 28, 1973; T.D. 7545, 
43 FR 19652, May 8, 1978; T.D. 7862, 47 FR 56490, Dec. 17, 1982; T.D. 
7893, 48 FR 22508, May 19, 1983; T.D. 7894, 48 FR 22516, May 19, 1983; 
T.D. 8331, 56 FR 2846, Jan. 25, 1991; T.D. 8704, 62 FR 18, Jan. 2, 1997; 
T.D. 9008, 67 FR 48023, July 23, 2002; T.D. 9882, 84 FR 69107, Dec. 17, 
2019]



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

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

[[Page 243]]

only in such business, would be taxable as a mutual insurance company to 
which part II (sections 821 through 826) of subchapter L of chapter 1 of 
the Code applies or as a mutual marine insurance or other insurance 
company to which part III (sections 831 and 832) of subchapter L of 
chapter 1 of the Code applies, shall, subject to the special rules of 
paragraph (c) of this section, be--
    (a) The sum of--
    (1) The gross income, as defined in section 832(b)(1);
    (2) The amount of losses incurred, as defined in section 832(b)(5); 
and
    (3) The amount of expenses incurred, as defined in section 
832(b)(6); reduced by
    (b) The amount of interest which under section 103 is excluded from 
gross income.
    (b) Determination of taxable income--(1) In general. Except as 
provided in subparagraph (2) of this paragraph, the taxable income of a 
foreign corporation for any taxable year shall, subject to the special 
rules of paragraph (c) of this section, be determined by treating such 
foreign corporation as a domestic corporation taxable under section 11 
and by applying the principles of section 63.
    (2) Insurance taxable income. The taxable income for any taxable 
year of a controlled foreign corporation which is engaged in the 
business of reinsuring or issuing insurance or annuity contracts and 
which, if it were a domestic corporation engaged only in such business, 
would be taxable as an insurance company to which subchapter L of 
chapter 1 of the Code applies shall, subject to the special rules of 
paragraph (c) of this section, be determined by treating such 
corporation as a domestic corporation taxable under subchapter L of 
chapter 1 of the Code and by applying the principles of Sec. Sec. 
1.953-4 and 1.953-5 for determining taxable income.
    (c) Special rules for purposes of this section--(1) Nonapplication 
of certain provisions. Except where otherwise distinctly expressed, the 
provisions of subchapters F, G, H, L, M, N, S, and T of chapter 1 of the 
Internal Revenue Code shall not apply and, for taxable years of a 
controlled foreign corporation beginning after March 3, 1997, the 
provisions of section 103 of the Internal Revenue Code shall not apply.
    (2) Application of principles of Sec. 1.964-1. The determinations 
with respect to a foreign corporation shall be made as follows:
    (i) Books of account. The books of account to be used shall be those 
regularly maintained by the corporation for the purpose of accounting to 
its shareholders.
    (ii) Accounting principles. Except as provided in subparagraphs (3) 
and (4) of this paragraph, the accounting principles to be employed are 
those described in paragraph (b) of Sec. 1.964-1. Thus, in applying 
accounting principles generally accepted in the United States for 
purposes of reflecting in the financial statements of a domestic 
corporation the operations of foreign affiliates, no adjustment need be 
made unless such adjustment will have a material effect, within the 
meaning of paragraph (a) of Sec. 1.964-1.
    (iii) Translation into United States dollars--(a) In general. Except 
as provided in (b) of this subdivision, the amounts determined in 
accordance with subdivision (ii) of this subparagraph shall be 
translated into United States dollars in accordance with the principles 
of paragraph (d) of Sec. 1.964-1.
    (b) Special rule. In any case in which the value of the foreign 
currency in relation to the United States dollar fluctuates more than 10 
percent during any translation period (within the meaning of paragraph 
(d)(6) of Sec. 1.964-1), the subpart F income and non-subpart F income 
shall be separately translated as if each constituted all the income of 
the controlled foreign corporation for the translation period.
    (iv) Tax accounting methods. The tax accounting methods to be 
employed are those established or adopted by or on behalf of the foreign 
corporation under paragraph (c) of Sec. 1.964-1. Thus, such accounting 
methods must be consistent with the manner of treating inventories, 
depreciation, and elections referred to in subdivisions (ii), (iii), and 
(iv) of paragraph (c)(1) of Sec. 1.964-1 and used for purposes of such 
paragraph; however, if, in accordance with paragraph (c)(6) of Sec. 
1.964-1, a foreign corporation receives foreign base company

[[Page 244]]

income before any elections are made or before an accounting method is 
adopted by or on behalf of such corporation under paragraph (c)(3) of 
Sec. 1.964-1, the determinations of whether an exclusion set forth in 
section 954(b) applies shall be made as if no elections had been made 
and no accounting method had been adopted.
    (v) Exchange gain or loss--(a) Exchange gain or loss, determined in 
accordance with the principles of Sec. 1.964-1(e), shall be taken into 
account for purposes of determining gross income and taxable income.
    (b) Exchange gain or loss shall be treated as foreign base company 
shipping income (or as a deduction allocable thereto) to the extent that 
it is attributable to foreign base company shipping operations. The 
extent to which exchange gain or loss is attributable to foreign base 
company shipping operations may be determined under any reasonable 
method which is consistently applied from year to year. For example, the 
extent to which the exchange gain or loss is attributable to foreign 
base company shipping operations may be determined on the basis of the 
ratio which the foreign based company shipping income of the corporation 
for the taxable year bears to its total gross income for the taxable 
year, such ratio to be determined without regard to this subdivision 
(v).
    (c) The remainder of the exchange gain or loss shall be allocated 
between subpart F income and non-subpart F income under any reasonable 
method which is consistently applied from year to year. For example, 
such remainder may be allocated to subpart F income in the same ratio 
that the gross subpart F income (exclusive of foreign base company 
shipping income) of the corporation for the taxable year bears to its 
total gross income (exclusive of foreign base company shipping income) 
for the taxable year, such ratio to be determined without regard to this 
subdivision (v).
    (3) Necessity for recognition of gain or loss. Gross income of a 
foreign corporation (including an insurance company) includes gain or 
loss only if such gain or loss would be recognized under the provisions 
of the Internal Revenue Code if the foreign corporation were a domestic 
corporation taxable under section 11 (subject to the modifications of 
subparagraph (1) of this paragraph). See section 1002. However, a 
foreign corporation shall not be treated as a domestic corporation for 
purposes of determining whether section 367 applies.
    (4) Gross income and gross receipts. The term ``gross income'' may 
not have the same meaning as the term ``gross receipts''. For example, 
in a manufacturing, merchandising, or mining business, gross income 
means the total sales less the cost of goods sold, plus any income from 
investments and from incidental or outside operations or sources.
    (5) Treatment of capital loss and net operating loss. In determining 
taxable income of a foreign corporation for any taxable year--
    (i) Capital loss carryback and carryover. The capital loss carryback 
and carryover provided by section 1212(a) shall not be allowed.
    (ii) Net operating loss deduction. The net operating loss deduction 
under section 172(a) or the operations loss deduction under section 812 
shall not be allowed.
    (6) Corporations which have insurance income. For purposes of 
paragraphs (a)(2) and (b)(2) of this section, in determining whether a 
controlled foreign corporation which is engaged in the business of 
reinsuring or issuing insurance or annuity contracts and which, if it 
were a domestic corporation engaged only in such business, would be 
taxable as an insurance company to which subchapter L of chapter 1 of 
the Code applies, it is immaterial that--
    (i) The corporation would be exempt from taxation as an organization 
described in section 501(a),
    (ii) The corporation would not be taxable as an insurance company to 
which subchapter L of the Code applies, or
    (iii) The corporation would be subject to the alternative tax for 
small mutual insurance companies provided by section 821(c).

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

[[Page 245]]



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

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


For such purposes, the effective date of the contract is the date on 
which coverage under the contract begins, and the anniversary of the 
contract is the annual return of the effective date. The period of 
coverage under a contract is the period beginning with the effective 
date of the contract and ending with the date on which the coverage 
under

[[Page 246]]

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

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

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

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



Sec. 1.953-2  Actual United States risks.

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


For purposes of section 953(a), the term ``United States'' is used in a 
geographical sense and includes only the States and the District of 
Columbia. Therefore, the reinsuring or the issuing of insurance or 
annuity contracts by a controlled foreign corporation in connection with 
property located in a foreign country or a possession of the United 
States, in connection with activity in a foreign country or a 
possession, or in connection with the lives or health of citizens of the 
United States who are not residents of the United States will not give 
rise to income to which paragraph (a) of Sec. 1.953-1 applies, unless 
the income derived by the controlled foreign corporation from such 
contracts constitutes income derived in connection with risks which are 
deemed to be United States risks, as defined in Sec. 1.953-3.
    (b) Property in the United States. The term ``property in the United 
States'' means property, as defined in subparagraph (1) of this 
paragraph, which is in the United States, within the meaning of 
subparagraph (2) of this paragraph.
    (1) Property defined. The term ``property'' means any interest of an 
insured in tangible (including real and personal) or intangible 
property. Such interests include, but are not limited to, those of an 
owner, landlord, tenant, mortgagor, mortgagee, trustee, beneficiary, or 
partner. Thus, for example, if insurance is issued against loss from

[[Page 247]]

fire and theft with respect to an insured's home and its contents, such 
risks are risks in connection with property, whether the insured is the 
owner or lessee and whether the contents include furniture or cash and 
securities. Furthermore, if insurance is issued against all risks of 
damage or loss with respect to the automobile of an insured, such risks 
are risks in connection with property, whether the risks insured against 
may be caused by the insured, another person, or natural forces.
    (2) United States location--(i) In general. Property will be 
considered property in the United States when it is exclusively located 
in the United States. Conversely, property will be considered property 
not in the United States when it is exclusively located outside the 
United States. In addition, property which is ordinarily located in, but 
temporarily located outside, the United States will be considered 
property in the United States both when it is ordinarily located in, and 
when it is temporarily located outside, the United States if the premium 
which is attributable to the reinsuring or issuing of any insurance 
contract in connection with such property cannot be allocated to, or 
apportioned between, risks incurred when such property is actually 
located in the United States and risks incurred when it is actually 
located outside the United States. If such premium can be so allocated 
or apportioned on a reasonable basis, however, such property will be 
considered property not in the United States when it is actually located 
outside the United States. However, property will not be considered 
property in the United States if it is neither property which is 
exclusively located in the United States nor property which is 
ordinarily located in, but temporarily located outside, the United 
States. The rules prescribed in subdivision (ii) of this subparagraph 
shall apply in determining whether a premium can be allocated or 
apportioned on a reasonable basis to or between risks incurred when 
property is actually located in the United States and risks incurred 
when such property is actually located outside the United States. The 
rules prescribed in subdivisions (iii) through (x) of this subparagraph 
shall apply in determining whether property is, or will be considered, 
exclusively located in or outside the United States and whether property 
is, or will be considered, ordinarily located in the United States; such 
rules also limit the rule of premium allocation and apportionment 
prescribed in this subdivision and subdivision (ii) of this 
subparagraph. The determinations required by this subparagraph shall be 
made with respect to the location of property during the policy period 
applicable to the taxable year of the insuring or reinsuring 
corporation, or, if more than one policy period exists with respect to 
such taxable year, such determinations shall be made separately with 
respect to the location of property during each such policy period.
    (ii) Premium allocation or apportionment. Whether a premium can be 
allocated or apportioned on a reasonable basis to or between risks 
incurred when property is actually located in the United States and 
risks incurred when such property is actually located outside the United 
States shall depend on the intention of the parties to the insurance 
contract, as determined from its provisions and the facts and 
circumstances preceding its execution. Contract provisions on the basis 
of which the premium reasonably may be so allocated or apportioned 
include, but are not limited to, provisions which separately describe 
each risk covered, the period of coverage of each risk, the special 
warranties for each risk, the premium for each risk (or the basis for 
determining such premium), and the conditions of paying the premium for 
each risk. For purposes of this subdivision, it shall be unnecessary 
formally to make a separate policy with respect to each risk covered or 
with respect to each clause attached to the policy, provided that the 
intention of the parties to the contract is reasonably clear. For 
example, if in the ordinary course of carrying on an insurance business 
an insurance policy is issued which covers fire, theft, and water damage 
risks incurred when property is actually located in the United States 
and marine risks incurred when such property is actually located outside 
the United States and

[[Page 248]]

which, pursuant to accepted insurance principles, properly describes the 
premium rates as percentages of the amount of coverage as ``.825% plus 
.3% fire, etc. risks plus .12% water risks = 1.245%'', a reasonable 
basis exists to allocate a $124.50 premium paid for $10,000 of such 
coverage to $82.50 for foreign risks and $42.00 ($30.00 + $12.00) to 
United States risks.
    (iii) Property in general--(a) Ordinary and temporary location. 
Except as otherwise provided in subdivisions (iv) through (x) of this 
subparagraph, the determination of whether property is ordinarily 
located in the United States will depend on all the facts and 
circumstances in each case. Property is ordinarily located in the United 
States if its location in the United States is regular, usual, or often 
occurring. However, in all cases property will be considered ordinarily 
located in the United States if it is actually located in the United 
States for an aggregate of more than 50 percent of the days in the 
applicable policy period whereas property will, under no circumstances, 
be considered ordinarily located in the United States if it is actually 
located in the United States for an aggregate of not more than 30 
percent of the days in the applicable policy period. Property which is 
ordinarily located in the United States is temporarily located outside 
the United States when it is actually located outside the United States. 
For purposes of determining the number and percent of the days in an 
applicable policy period, the term ``day'' means, not any 24-
consecutive-hour period, but a continuous period of twenty-four hours 
commencing from midnight and ending with the following midnight; in 
determining the location of property for such purposes, an amount of 
time which is at least one-half of such a day, but less than the entire 
day, shall be considered a day, and an amount of time which is less than 
one-half of such a day shall not be considered a day.
    (b) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

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

    (iv) Commercial motor vehicles, ships, aircraft, railroad rolling 
stock, and containers. Any motor vehicle, ship, aircraft, railroad 
rolling stock, or any container transported thereby, which

[[Page 249]]

is used exclusively in the commercial transportation of persons or 
property to or from the United States (including such transportation 
from one place to another in the United States) and is ordinarily 
located in the United States will be considered property in the United 
States both when such property is ordinarily located in, and when such 
property is temporarily located outside, the United States. Whether such 
property is used in the transportation of persons or property to or from 
the United States and is ordinarily located in the United States are 
issues to be determined from all the facts and circumstances in each 
case. However, in all cases such transportation property will be 
considered ordinarily located in the United States if either more than 
50 percent of the miles traversed during the applicable policy period in 
the use of such property are traversed within the United States or such 
property is located in the United States more than 50 percent of the 
time during such period. Further, such transportation property will not 
at any time be considered property in the United States if either not 
more than 30 percent of the miles traversed during the applicable policy 
period in the use of such property are traversed within the United 
States or such property is located in the United States for not more 
than 30 percent of the time during such period. Nevertheless, if not 
more than 30 percent of the miles traversed during the applicable policy 
period in the use of such transportation property are traversed within 
the United States, such property will be considered ordinarily located 
in the United States if it is located in the United States more than 50 
percent of the time during such period Moreover, if such transportation 
property is located in the United States for not more than 30 percent of 
the time during the applicable policy period, such property will be 
considered ordinarily located in the United States if more than 50 
percent of the miles traversed during such period in the use of such 
property are traversed within the United States. If such transportation 
property is considered property in the United States because more than 
50 percent of the miles traversed during the applicable policy period in 
the use of such property are traversed within the United States, the 
apportionment of premium provided in subdivision (i) of this 
subparagraph shall be made on a mileage basis. If, however, such 
property is considered property in the United States because such 
property is located in the United States more than 50 percent of the 
time during the applicable policy period, the apportionment of premium 
provided in subdivision (i) of this subparagraph shall be made on a time 
basis.
    (v) Noncommercial motor vehicles, ships, aircraft, and railroad 
rolling stock. Except as provided in subdivision (iv) of this 
subparagraph, any motor vehicle, ship or boat, aircraft, or railroad 
rolling stock which at any time is actually located in the United States 
and which either (a) is registered with the United States, a State 
(including any political subdivision thereof), or any agency thereof or 
(b), if not so registered, is owned by a citizen, resident, or 
corporation of the United States will be considered property which is 
ordinarily located in the United States. Unless the premium which is 
attributable to the reinsuring or issuing of any insurance contract in 
connection with such property considered ordinarily located in the 
United States is specifically allocated under the contract to risks 
incurred when such property is actually located in the United States and 
to risks incurred when it is actually located outside the United States, 
such property will be considered property in the United States both when 
it is ordinarily located in, and when it is temporarily located outside, 
the United States; under no circumstances will such property be 
considered outside the United States on the basis of any apportionment 
of such premium.
    (vi) Property exported or imported by railroad or motor vehicle. Any 
property which is exported from, or imported to, the United States by 
railroad or motor vehicle will be considered property ordinarily located 
in the United States which, when such property is not actually located 
in the United States, is temporarily located outside the United States. 
For example, if an insurance

[[Page 250]]

contract reinsured or issued in connection with property exported from 
the United States by motor vehicle covers risks commencing when such 
property is loaded on the motor vehicle at the United States warehouse 
and terminating when such property is unloaded at the foreign warehouse, 
and if the premium payable with respect to risks incurred when the 
property is in the United States and risks incurred when the property is 
in the foreign country is not separately stated, such property will be 
considered property in the United States only until such property is 
actually located outside the United States, provided that the premium 
can be properly apportioned (for example) on the basis of time or 
mileage, between risks incurred when the property is actually located in 
the United States and risks incurred when it is actually located outside 
the United States. If in such case the premium is not so apportionable, 
such property will be considered property in the United States both when 
such property is ordinarily located in, and when it is temporarily 
located outside, the United States.
    (vii) Property exported by ship or aircraft. If an insurance 
contract which is reinsured or issued in connection with property which 
is exported from the United States by ship or aircraft covers risks all 
of which terminate when such property is placed aboard a ship or 
aircraft at the United States port of exit for shipment from the United 
States, such property will be considered property in the United States. 
If such insurance contract covers risks all of which commence when such 
property is placed aboard a ship or aircraft at the United States port 
of exit for shipment from the United States, such property will be 
considered property not in the United States. If such insurance contract 
covers risks commencing before, and terminating after, such property is 
placed aboard a ship or aircraft at the United States port of exit for 
shipment from the United States, such property will be considered 
property ordinarily located in the United States which, after such 
property is placed aboard such ship or aircraft at the United States 
port of exit, is temporarily located outside the United States. The 
application of this subdivision may be illustrated by the following 
example:

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

    (viii) Property imported by ship or aircraft. If an insurance 
contract which is reinsured or issued in connection with property which 
is imported to the United States by ship or aircraft covers risks all of 
which terminate when such property is unloaded at the United States port 
of entry, such property will be considered property not in the United 
States. If such insurance contract covers risks all of which commence 
after such property is unloaded at the United States port of entry, such 
property will be considered property in the United States. If such 
insurance contract covers risks commencing before, and terminating 
after, such property is unloaded at the United States port of entry, 
such property will be considered property ordinarily located in the 
United States which, before such property is unloaded at the United

[[Page 251]]

States port of entry, is temporarily located outside the United States. 
For an illustration pertaining to the allocation or apportionment of the 
premium, see the example in subdivision (vii) of this subparagraph.
    (ix) Shipments originating and terminating in the United States. Any 
property which is shipped from one place in the United States to another 
place in the United States, on or over a foreign country, the high seas, 
or the coastal waters of the United States will be considered property 
actually located at all times in the United States. For example, 
property which is shipped from New York City to Los Angeles via the 
Panama Canal or from San Francisco to Hawaii or Alaska will be 
considered property actually located at all times in the United States.
    (x) Shipments originating and terminating in a foreign country. Any 
property which is shipped by any means, or a combination of means, of 
transportation from one foreign country to another foreign country, or 
from a contiguous foreign country to the same contiguous foreign 
country, on or over the United States will be considered property 
exclusively located outside the United States. Notwithstanding the 
foregoing, any property which is shipped by any means, or a combination 
of means, of transportation from one contiguous foreign country to 
another contiguous foreign country on or over the United States will be 
considered property ordinarily located in the United States which, when 
such property is not actually located in the United States, is 
temporarily located outside the United States.
    (c) Liability from United States activity. The term ``liability 
arising out of activity in the United States'' means a loss, as 
described in subparagraph (1) of this paragraph, or a liability, as 
described in subparagraph (2) of this paragraph, which could arise from 
activity performed in the United States, as defined in subparagraph (3) 
of this paragraph.
    (1) Loss described. The term ``loss'' includes all loss of an 
insured which could arise from the occurrence of the event insured 
against except that such term does not include any loss in connection 
with property described in paragraph (b) of this section. For example, 
such term includes, in the case of a promoter of outdoor sporting 
events, the loss which could arise from the cancellation of such an 
event because of inclement weather.
    (2) Liability described. The term ``liability'' includes all 
liability of an insured in tort, contract, property, or otherwise. It 
includes, for example, the liability of a principal for the acts of his 
agent, of a husband for the acts of his spouse, and of a parent for the 
acts of his child. The term not only includes the direct liability which 
may be incurred, for example, by a tortfeasor to the person harmed, but 
also the indirect liability which may be incurred, for example, by a 
manufacturer to the purchaser at retail for a breach of warranty.
    (3) Activity in the United States--(i) In general. A loss or 
liability will be considered a loss or liability which could arise from 
activity performed in the United States if the loss or liability would 
result, if at all, from an activity exclusively carried on in the United 
States. Conversely, a loss or liability will be considered a loss or 
liability which could not arise from activity performed in the United 
States if the loss or liability would result, if at all, from an 
activity exclusively carried on outside the United States. In addition, 
a loss or liability will be considered a loss or liability which could 
arise from activity performed in the United States if the loss or 
liability would result, if at all, from an activity ordinarily carried 
on in, but partly carried on outside, the United States. If the premium 
which is attributable to the reinsuring or issuing of any insurance 
contract in connection with an activity ordinarily carried on in, but 
partly carried on outside, the United States can, on a reasonable basis, 
be allocated to, or apportioned between, the risks incurred with respect 
to the activity carried on in, and the risks incurred with respect to 
the activity carried on outside, the United States, such loss or 
liability will be considered a loss or liability which could not arise 
from activity performed in the United States to the extent the loss or 
liability would

[[Page 252]]

result, if at all, from that activity carried on outside the United 
States. However, a loss or liability will not be considered a loss or 
liability which could arise from an activity performed in the United 
States if such loss or liability would result, if at all, from an 
activity which is neither exclusively carried on in the United States 
nor ordinarily carried on in, but partly carried on outside, the United 
States. The principles of paragraph (b)(2)(ii) of this section for 
allocating or apportioning a premium on a reasonable basis to or between 
risks incurred when property is actually located in the United States 
and risks incurred when such property is actually located outside the 
United States shall apply for allocating or apportioning a premium on a 
reasonable basis to or between the risks incurred with respect to the 
activity carried on in, and the risks incurred with respect to the 
activity carried on outside, the United States. The rules prescribed in 
subdivisions (ii) through (vi) of this subparagraph shall apply in 
determining whether an activity is, or will be considered, exclusively 
carried on in or outside the United States and whether an activity is, 
or will be considered, ordinarily carried on in the United States and in 
determining what is the activity which is performed by the insured from 
which a loss or liability results or could result; such rules also limit 
the rule of premium allocation and apportionment prescribed in this 
subdivision. The determinations required by this subparagraph shall be 
made with respect to the location of an activity of the insured 
performed during the policy period applicable to the taxable year of the 
insuring or reinsuring corporation, or, if more than one policy period 
exists with respect to such taxable year, such determinations shall be 
made separately with respect to the location of the activity during each 
such policy period.
    (ii) Substantial activity carried on in the United States. The term 
``activity'' is used in its broadest sense and includes the performance 
of an act unlawfully undertaken, the wrongful performance of an act 
lawfully undertaken, and the wrongful failure to perform an act lawfully 
required to be undertaken. With respect to a loss described in 
subparagraph (1) of this paragraph, the term ``activity'' includes the 
occurrence of the event insured against. The determination of whether an 
activity ordinarily is carried on in, but is partly carried on outside, 
the United States will depend on all the facts and circumstances in each 
case. An activity ordinarily is carried on in the United States if a 
substantial amount of such activity is carried on in the United States. 
Factors which will be taken into account in determining whether a 
substantial amount of activity is carried on in the United States are 
those which are connected with the activity and include, but are not 
limited to, the location of the insured's assets, the place where 
personal services are performed, and the place where sales occur, but 
only if such assets, services, and sales are connected with the 
activity. In all cases an activity will be considered substantially 
carried on in the United States if more than 50 percent of the insured's 
total assets, personal services, and sales, if any, connected with such 
activity are located, performed, or occur in the United States. On the 
other hand, an activity will, under no circumstances, be considered 
substantially carried on in the United States if not more than 30 
percent of the insured's total assets, personal services, and sales, if 
any, connected with such activity are located, performed, or occur in 
the United States. For this purpose, the mean of the value of the total 
assets at the beginning and end of the policy period shall be used, 
determined by taking assets into account at their actual value (not 
reduced by liabilities), which, in the absence of affirmative evidence 
to the contrary, shall be deemed to be (a) face value in the case of 
bills receivable, accounts receivable, notes receivable, and open 
accounts held by an insured using the cash receipts and disbursements 
method of accounting and (b) adjusted basis in the case of all other 
assets. Personal services shall be measured by the amount of 
compensation paid or accrued for such services, and sales shall be 
measured by the volume of gross sales. An activity is carried on partly 
outside the United States if it is carried on,

[[Page 253]]

whether substantially or in substantially, outside the United States.
    (iii) Manufacturing, producing, constructing, or assembling 
activity. If a person who manufactures, produces, constructs, or 
assembles property is liable with regard to the consumption or use of 
such property, such liability will be considered to result from the 
activity performed of manufacturing, producing, constructing, or 
assembling such property. If such person manufactures, produces, 
constructs, or assembles more than one type of product, the liability 
with regard to the consumption or use of one of such products will be 
considered to result from the activity performed of manufacturing, 
producing, constructing, or assembling that particular product. For 
example, the liability of a building contractor, which constructs 
apartment buildings only in the United States, for the improper 
construction of, or the failure to construct, an apartment building, 
will be considered to result from an activity exclusively carried on in 
the United States and will be considered a liability which could arise 
from activity performed in the United States. In further illustration, 
the liability (which is covered by a single policy of insurance) of a 
domestic corporation, which assembles refrigerators exclusively in the 
United States and manufactures automobiles both in a foreign country and 
in the United States through substantial activity carried on in each of 
such countries, for the negligent manufacturing of a part for one of the 
automobiles by the foreign branch, will be considered to result from an 
activity ordinarily carried on in, but partly carried on outside, the 
United States and will be considered a liability which could arise from 
activity performed in the United States.
    (iv) Selling activity. If a person is liable with regard to selling 
activity performed, such liability will be considered, except as 
provided in subdivisions (iii), (v), and (vi) of this subparagraph, to 
result from such selling activity. A person will be considered to be 
engaged in selling activity if such person engages in an activity 
resulting in the sale of property. Thus, it is immaterial that, under 
the Code, such activity would not constitute engaging in or carrying on 
a trade or business in the country in which such activity is carried on, 
the property in the goods does not pass in such country, or delivery of 
the property is not made in such country. For example, if a foreign 
wholesale distributor, which manages its entire business operations in a 
foreign country and sells its inventory exclusively in the United 
States--its only contact in the United States being the promotion of 
such sales to United States retail outlets by advertising in trade 
publications and distributing sales catalogues--is liable for a breach 
of warranty with regard to the sale of property to a United States 
retail outlet, such liability will be considered to result from an 
activity exclusively carried on in the United States and will be 
considered a liability which could arise from activity performed in the 
United States.
    (v) Liability from service or driving activity--(a) In general. If a 
person is liable with regard to any service activity performed, or is 
liable with regard to driving activity performed in connection with a 
motor vehicle, ship or boat, aircraft, or railroad rolling stock, 
whether or not exclusively used in the commercial transportation of 
persons or property, such liability will be considered to result from 
such service or driving activity. For example, if an oil company which 
drills for oil exclusively in a foreign country is liable with regard to 
the negligent handling by its employees of explosives in the course of 
such drilling there, such liability will be considered to result from an 
activity exclusively carried on outside the United States and will be 
considered a liability which could not arise from activity performed in 
the United States. In further illustration, if a corporation which 
services machinery exclusively in a foreign country under servicing 
contracts is liable with regard to the negligent repairing of a machine 
under such a contract, such liability will be considered to result from 
an activity exclusively carried on outside the United States and will be 
considered a liability which could not arise from activity performed in 
the United States.

[[Page 254]]

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

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

    (vi) Liability from delivery of property. If the person who is 
obligated to deliver property is liable with regard to such delivery, 
such liability will be considered to result from the activity performed 
of delivering such property.

[[Page 255]]

For example, if a corporation which exports all of its inventory from 
the United States to foreign countries or possessions of the United 
States is liable with regard to its failure to make delivery outside the 
United States of inventory it has sold, such liability will be 
considered to result from an activity exclusively carried on outside the 
United States and will be considered a liability which could not arise 
from activity performed in the United States. In further illustration, 
if a corporation which exports all of its inventory from a foreign 
country to the United States is liable with regard to its improper 
delivery in the United States of inventory it has sold, such liability 
will be considered to result from an activity exclusively carried on in 
the United States and will be considered a liability which could arise 
from activity performed in the United States.
    (d) Lives or health of United States residents. Risks in connection 
with the lives or health of residents of the United States include those 
risks which are the subject of insurance contracts referred to in 
section 801(a), relating to the definition of a life insurance company. 
If the insured is a resident of the United States at the time the 
insurance contract is approved, the risk is in connection with the life 
or health of a resident of the United States for the period of coverage 
under the contract. However, if during such period of coverage the 
insured notifies the insurer, or circumstances known to the insurer 
indicate, that the insured is no longer a resident of the United States, 
the risk shall cease to be a risk in connection with the life or health 
of a resident of the United States for the policy period in which the 
insured gives such notice or such circumstances are known to the 
insurer, and for each subsequent policy period. Conversely, if the 
insured is a resident of a particular foreign country at the time the 
insurance contract is approved, the risk is in connection with the life 
or health of a resident of such foreign country for the period of 
coverage under the contract. However, if during such period of coverage 
the insured notifies the insurer, or circumstances known to the insurer 
indicate, that the insured is no longer a resident of such foreign 
country, the risk shall cease to be a risk in connection with the life 
or health of a resident of such particular foreign country for the 
policy period in which the insured gives such notice or such 
circumstances are known to the insurer, and for each subsequent policy 
period. In determining the country of residence of an insured, the 
principles of Sec. Sec. 301.7701(b)-1 through 301.7701(b)-9 of this 
chapter, relating to the determination of residence and nonresidence in 
the United States and of foreign residence, shall apply. Citizens of the 
United States are not residents of the United States merely because of 
their citizenship. The application of this paragraph may be illustrated 
by the following example:

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

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

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



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

    (a) Artificial arrangements. For purposes of paragraph (a) of Sec. 
1.953-1, the term ``United States risks'' also includes under section 
953(a)(1)(B) risks

[[Page 256]]

which are deemed to be United States risks. They are risks (other than 
United States risks described in section 953(a)(1)(A) and Sec. 1.953-2) 
which a controlled foreign corporation reinsures under an insurance or 
annuity contract, or with respect to which a controlled foreign 
corporation issues any insurance or annuity contract, in accordance with 
any arrangement whereby another corporation which is not a controlled 
foreign corporation receives an amount of premiums (for reinsuring or 
issuing any insurance or annuity contract in connection with the United 
States risks described in section 953(a)(1)(A) and Sec. 1.953-2) which 
is substantially equal to the amount of premiums which the controlled 
foreign corporation receives under its contracts. Arrangements to which 
this rule applies include those entered into by the controlled foreign 
corporation, by its United States shareholders, or by a related person.
    (b) Evidence of arrangements. The determination of the existence of 
an arrangement referred to in paragraph (a) of this section shall depend 
on all the facts and circumstances in each case. In making this 
determination, it will be recognized that arrangements of this type 
generally are orally entered into outside the United States and that 
direct evidence of such an arrangement is not ordinarily available. 
Therefore, in determining the existence of such an arrangement, 
consideration will be given to whether or not there is substantial 
similarity between the type, location, profit margin expected, and loss 
experience of the risks which the corporation which is not a controlled 
foreign corporation insures or reinsures and the risks which the 
controlled foreign corporation insures or reinsures. Further, 
consideration will be given to the existence of prior similar 
arrangements between, and the identity of the directors or shareholders 
of, the corporation which is not a controlled foreign corporation, its 
shareholders, or related persons and the controlled foreign corporation, 
its shareholders, or related persons. However, the absence of such prior 
arrangements or identity of directors or shareholders will not of itself 
establish the nonexistence of an arrangement referred to in paragraph 
(a) of this section. In determining whether the amounts received by the 
controlled foreign corporation and the corporation which is not a 
controlled foreign corporation are substantially equal, the period in 
which the controlled foreign corporation receives premiums need not be 
the same as, or identical in length with, that of the corporation which 
is not a controlled foreign corporation nor limited to a taxable year of 
the controlled foreign corporation.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples:

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

[[Page 257]]

Corporation derived in 1964 and 1965 from reinsuring the risks of R 
Corporation is income derived from the insurance of United States risks 
described in section 953(a)(1)(B).
    Example 3. Assume the same facts as in example 1, except that 
foreign corporation C is also a wholly owned subsidiary of R 
Corporation. Assume that C Corporation uses the calendar year as its 
taxable year. Assume further that M Corporation and R Corporation agree 
that from July 1, 1963, through December 31, 1963, B Corporation and C 
Corporation together will reinsure the United States risks described in 
section 953(a)(1)(A) of M Corporation. The amount of premiums received 
by B Corporation in respect of such United States risks is equal to one-
third of the amount received by A Corporation in respect of the risks 
which are not United States risks described in section 953(a)(1)(A), and 
the amount of premiums received by C Corporation in respect of such 
United States risks is equal to two-thirds of the amount so received by 
A Corporation. The income of A Corporation derived in 1964 from 
reinsuring the risks of R Corporation is income derived from the 
insurance of United States risks described in section 953(a)(1)(B).
    Example 4. Assume the same facts as in example 3, except that 
controlled foreign corporation D is also a wholly owned subsidiary of M 
Corporation and uses the calendar year as its taxable year. Assume 
further that M Corporation and R Corporation agree that in 1964 R 
Corporation will pay premiums of $300,000 to A Corporation and $700,000 
to D Corporation to reinsure all risks of R Corporation which are not 
United States risks described in section 953(a)(1)(A), and that in 1963 
M Corporation will pay premiums of $400,000 to B Corporation and 
$600,000 to C Corporation to reinsure all risks of M Corporation which 
are United States risks described in section 953(a)(1)(A). The income of 
A Corporation and D Corporation derived in 1964 from reinsuring the 
risks of R Corporation is income derived from the insurance of United 
States risks described in section 953(a)(1)(B).
    Example 5. Controlled foreign corporation A is a wholly owned 
subsidiary of domestic insurance corporation M. Controlled foreign 
corporation B is a wholly owned subsidiary of domestic insurance 
corporation N. All corporations use the calendar year as the taxable 
year. As a result of an arrangement between M Corporation and N 
Corporation, in 1963 A Corporation reinsures all the United States risks 
described in section 953(a)(1)(A) of N Corporation, and B Corporation 
reinsures all the United States risks described in section 953(a)(1)(A) 
of M Corporation. The premiums and other consideration received by A 
Corporation and B Corporation in respect of such reinsurance are not 
substantially equal. The income of A Corporation and B Corporation in 
1962 from reinsuring the risks of N Corporation and M Corporation, 
respectively, is income derived from the insurance of United States 
risks described in section 953(a)(1)(A) and is not income derived from 
the insurance or United States risks described in section 953(a)(1)(B).
    Example 6. Assume the same facts as in example 5, except that B 
Corporation is not a controlled foreign corporation. The income of A 
Corporation in 1963 from reinsuring the risks of N Corporation is income 
derived from the insurance of United States risks described in section 
953(a)(1)(A) and is not income derived from the insurance of United 
States risks described in section 953(a)(1)(B).

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



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

    (a) Taxable income defined--(1) Life insurance taxable income. For a 
controlled foreign corporation which is engaged in the business of 
reinsuring or issuing insurance or annuity contracts and which, if it 
were a domestic corporation engaged only in such business, would be 
taxable as a life insurance company to which part I (sections 801 
through 820) of subchapter L of the Code applies, the term ``taxable 
income'' means for purposes of paragraph (a) of Sec. 1.953-1 the gain 
from operations, as defined in section 809(b) and as modified by this 
section, derived from, and attributable to, the insurance of United 
States risks. For purposes of determining such taxable income, the 
provisions of section 802(b) (relating to the definition of life 
insurance company taxable income) shall not apply. Determinations for 
purposes of this subparagraph shall be made without regard to section 
501(a).
    (2) Mutual and other insurance taxable income. For a controlled 
foreign corporation which is engaged in the business of reinsuring or 
issuing insurance or annuity contracts and which, if it were a domestic 
corporation engaged only in such business, would be taxable as a mutual 
insurance company to which part II (sections 821 through 826) of 
subchapter L of the Code applies or a mutual marine insurance or other 
insurance company to which part III (sections 831 and 832) of subchapter 
L of the Code applies, the term ``taxable income'' means for purposes of 
paragraph (a) of Sec. 1.953-1 taxable income, as defined in section 
832(a) and as modified

[[Page 258]]

by this section, derived from, and attributable to, the insurance of 
United States risks. Determinations for purposes of this subparagraph 
shall be made without regard to section 501(a).
    (3) Corporations not qualifying as insurance companies. For special 
rules applicable under this section in the case of a controlled foreign 
corporation which, if it were a domestic corporation, would not qualify 
as an insurance company, see Sec. 1.953-5.
    (b) Certain provisions inapplicable. In determining taxable income 
under this section, the following provisions of subchapter L of the Code 
shall not apply:
    (1) Section 809(d)(4), relating to the operations loss deduction;
    (2) Section 809(d)(5), relating to certain nonparticipating 
contracts;
    (3) Section 809(d)(6), relating to certain accident and health 
insurance and group life insurance;
    (4) Section 809(d)(10), relating to small business deduction;
    (5) Section 817(b), relating to gain on property held on December 
31, 1958, and certain substituted property acquired after 1958; and
    (6) Section 832(c)(5), relating to capital losses.
    (c) Computation of reserves required by law--(1) Law applicable in 
determining reserves. The reserves which will be taken into account as 
reserves required by law under section 801(b)(2), both in determining 
for any taxable year whether a controlled foreign corporation is a 
controlled foreign corporation described in paragraph (a)(1) or (2) of 
this section and in determining taxable income of such corporation for 
the taxable year under paragraph (a) of this section, shall be the 
following reserves:
    (i) Reserves required by the law of a State. The reserves which are 
required by the law of the State or States to which the insurance 
business of the controlled foreign corporation is subject, but only with 
respect to its United States business, if any, which is taxable under 
section 819(a).
    (ii) Reserves deemed to be required. To the extent of such 
controlled foreign corporation's insurance business not taxable under 
section 819(a)--
    (a) Except as provided in (b) of this subdivision (ii), the reserves 
which would result if such reserves were determined by applying the 
minimum standards of the law of New York as if such controlled foreign 
corporation were an insurance company transacting all of its insurance 
business (other than its United States business which is taxable under 
section 819(a)) for such taxable year in such State, and
    (b) With respect to all risks covered by insurance ceded to such 
controlled foreign corporation by an insurance company to which apply 
the provisions of subchapter L of the Code (determined without regard to 
section 501(a)) and in respect of which an election is made by or on 
behalf of such controlled foreign corporation to determine its reserves 
in accordance with this subdivision (b), the amount of reserves against 
such risks which would result if all of such reserves were determined by 
applying the law of the State, to which the risks in the hands of such 
insurance company are subject, as if such controlled foreign corporation 
were an insurance company engaged in reinsuring such risks in such 
State.
    (2) Rules of application. For purposes of subparagraph (1) of this 
paragraph, the following rules shall apply:
    (i) Life insurance reserves computed on preliminary term basis. For 
purposes of determining under paragraph (a) of this section the taxable 
income of a controlled foreign corporation, an election may be made by 
or on behalf of such corporation that the amount of reserves which are 
taken into account as life insurance reserves with respect to contracts 
for which reserves are computed on a preliminary term basis shall be 
determined as provided in section 818(c). This election shall apply, 
subject to section 818(c), to all life insurance reserves of the 
controlled foreign corporation, whether or not reserves applicable to 
the United States business taxable under section 819(a). However, 
reserves determined as provided in section 818(c) shall not be taken 
into account in determining whether a controlled foreign corporation is 
a controlled foreign corporation described in paragraph (a)(1) or (2) of 
this section.
    (ii) Actual reserves required. (a) A controlled foreign corporation 
will be considered to have a reserve only to the

[[Page 259]]

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

[[Page 260]]

risks. For example, the deductions allowed by section 809(d)(1), 
relating to death benefits, section 809(d)(3), relating to dividends to 
policyholders, and section 809(d)(7), relating to the assumption by 
another person of liabilities under insurance contracts, shall be 
allocated to the insurance of United States risks to the extent they 
relate directly to the premiums received for reinsuring or issuing 
insurance or annuity contracts in connection with United States risks. 
Next, determine all items of income, expenses, losses, and other 
deductions which directly relate to the premiums received for the 
reinsuring or the issuing of any insurance or annuity contract in 
connection with foreign risks and allocate such items to the reinsuring 
of foreign risks. Finally, determine all items of income, expenses, 
losses, and other deductions which relate to the premiums received for 
the reinsuring or the issuing of any insurance or annuity contract in 
connection with both United States risks and foreign risks, and, except 
as provided in paragraph (g) of this section, apportion such items 
between the insurance of United States risks and the insurance of 
foreign risks in the manner prescribed in subparagraph (2) or (3) of 
this paragraph, as the case may be. As used in this section, the term 
``foreign risks'' means risks which are not United States risks as 
defined in Sec. 1.953-2 or Sec. 1.953-3.
    (2) Method of apportionment in determination of life insurance 
taxable income--(i) Investment yield and net long-term capital gain. 
Unless they can be allocated to the insurance of United States risks, as 
provided in subparagraph (1) of this paragraph, in determining a 
controlled foreign corporation's taxable income for any taxable year 
under paragraph (a)(1) of this section--
    (a) The investment yield under section 804(c),
    (b) The amount (if any) under section 809(b)(1)(B) by which the net 
long-term capital gain exceeds the net short-term capital loss, and
    (c) Those deductions allowed under section 809(d)(8), (9), and (12) 
which relate to gross investment income shall be apportioned to the 
reinsuring and issuing of insurance and annuity contracts in connection 
with United States risks in an amount which bears the same ratio to each 
of such amounts of investment yield, excess gain, and deductions as the 
sum of the mean of each of the items described in section 810(c) at the 
beginning and end of the taxable year attributable to reinsuring and 
issuing any insurance and annuity contracts in connection with United 
States risks bears to the sum of the mean of each of the items described 
in section 810(c) at the beginning and end of the taxable year 
attributable to reinsuring and issuing all insurance and annuity 
contracts. Thus, for example, if the ratio which the sum of the mean of 
each of the items described in section 810(c) at the beginning and end 
of the taxable year attributable to reinsuring and issuing insurance and 
annuity contracts in connection with United States risks bears to the 
sum of the mean of each of the items described in section 810(c) at the 
beginning and end of the taxable year attributable to reinsuring and 
issuing all insurance and annuity contracts in one to three, then, 
unless an allocation to the insurance of United States risks can be made 
as provided in subparagraph (1) of this paragraph, one-third of each of 
such amounts of investment yield, excess gain, and deductions shall be 
apportioned to the reinsuring and issuing of insurance and annuity 
contracts in connection with United States risks, and two-thirds of each 
of such amounts shall be apportioned to the reinsuring and issuing of 
insurance and annuity contracts in connection with foreign risks.
    (ii) Other income and deductions--(a) Amount taken into account. In 
determining a controlled foreign corporation's taxable income for any 
taxable year under paragraph (a)(1) of this section, all items of income 
taken into account under section 809(c)(3), relating to other amounts of 
gross income, and the other deductions allowed under section 809(d)(12) 
to the extent that such other deductions do not relate to gross 
investment income shall be apportioned to the reinsuring and issuing of 
insurance and annuity contracts in connection with United States risks 
in an amount which bears the same ratio to each of such items of income 
or of

[[Page 261]]

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

    Example. Controlled foreign corporation A, incorporated under, and 
engaged in an insurance business subject to, the laws of foreign country 
X, is a wholly owned subsidiary of domestic corporation M. Both 
corporations use the calendar year as the taxable year. Corporation M is 
a life insurance company as defined in section 801(a); A Corporation 
would, if it were a domestic corporation, be taxable under part I of 
subchapter L of the Code. In 1963, A Corporation derives income from the 
insurance of United States risks as a result of reinsuring the life 
insurance policies issued by M Corporation on lives of residents of the 
United States. In 1963, A Corporation also issues policies of life 
insurance on individuals who are not residents of the United States, but 
its premiums from the reinsuring of United States risks exceed he 5-

[[Page 262]]

percent minimum premium requirement prescribed in paragraph (b) of Sec. 
1.953-1. Based upon the facts set forth in paragraph (a) of this 
example, A Corporation for 1963 has taxable income under this section of 
$40,200, which is attributable to the reinsuring of life insurance 
contracts in connection with United States risks, determined in the 
manner provided in paragraphs (b), (c), and (d) of this example.
    (a) A summary of the entire operations of A Corporation for 1963, 
determined under this section as though such corporation were a domestic 
life insurance company but without applying paragraph (f) of this 
section, is as follows:

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

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

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

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

(i) Premiums under section 809(c)(1)               $200,000
 attributable to reinsuring U.S. risks
 (paragraph (a)(5))...........................
(ii) Plus: Net decrease in reserves under       ...........     $200,000
 section 809(c)(2) attributable to reinsuring
 U.S. risks (paragraph (a)(6))................
                                                            ------------
(iii) Less: Net increase in reserves under section               $40,000
 809(d)(2) attributable to reinsuring U.S. risks (paragraph
 (a)(7))...................................................
                                                            ------------
                                                ...........     $160,000
 

    (2) The denominator determined under paragraph (f)(2)(ii)(c) of this 
section is $570,000, determined as follows:

(i) Premiums under section 809(c)(1)               $600,000
 attributable to all insurance (paragraph
 (a)(5))......................................
(ii) Plus: Net decrease in reserves under            10,000
 section 809(c)(2) attributable to all
 insurance (paragraph (a)(6)).................
                                               --------------
                                                ...........     $610,000
(iii) Less: Net increase in reserves under section                40,000
 809(d)(2) attributable to all insurance (paragraph (a)(7))
                                                            ------------
                                                ...........     $570,000
 

    (3) Ratio which the numerator determined under subparagraph (1) 
bears to the denominator determined under subparagraph (2) ($160,000/
$570,000)--28%.
    (4) Amount of deductions attributable to reinsuring of U.S. risks 
(28% of $60,000)--$16,800.
    (d) The taxable income of A Corporation for 1963 which constitutes 
its income derived from the insurance of United States risks for 
purposes of paragraph (a) of Sec. 1.953-1 is $40,200, determined as 
follows:

[[Page 263]]



----------------------------------------------------------------------------------------------------------------
                                                 Attributable to all     Attributable to       Attributable to
                                                      insurance          reinsuring U.S.      insuring foreign
                                               ----------------------         risks                 risks
                                                                     -------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Item:
  (1) Investment yield under section 804(c)       $90,000  .........    $36,000  .........    $54,000
   (paragraph (a)(1), unallocable but as
   apportioned under paragraph (b)(4).........
  (2) Less: Required interest under section        60,000  .........     25,000  .........     35,000
   809(a)(2) (paragraph (a)(3))...............
                                               -----------           -----------           -----------
  (3) Life insurance company's share of         .........    $30,000  .........    $11,000  .........    $19,000
   investment yield under section 809(b)(1)(A)
Plus sum of:
  (4) Premiums under section 809(c)(1)            600,000  .........    200,000  .........    400,000
   (paragraph (a)(5)).........................
  (5) Net decrease in reserves under section       10,000    610,000       None    200,000     10,000    410,000
   809(c)(2) (paragraph (a)(6))...............
                                               -----------------------------------------------------------------
     Sum determined under section 809(b)(1)...  .........    640,000  .........    211,000  .........    429,000
Less sum of:
  (6) Net increase in reserves under section       40,000  .........     40,000  .........       None
   809(d)(2) (paragraph (a)(7))...............
  (7) Deductions allowed under section             10,000  .........      4,000  .........      6,000
   809(d)(8), (9), and (12) which relate to
   gross investment income (paragraph (a)(4)),
   unallocable but as apportioned under
   paragraph (b)(5)...........................
  (8) Deductions allowed under section 809(d)
   (other than deduction allowed under section
   809(d)(2) and other than those deductions
   allowed under section 809(d)(8), (9), and
   (12) which relate to gross investment
   income) (paragraph (a)(8)):................
    (i) Allocable.............................    330,000  .........    110,000  .........    220,000
    (ii) Unallocable, but as apportioned under     60,000    440,000     16,800    170,800     43,200    269,200
     paragraph (c)(4).........................
                                               -----------------------------------------------------------------
     Gain from operations.....................  .........    200,000  .........     40,200  .........    159,800
----------------------------------------------------------------------------------------------------------------


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



Sec. 1.953-5  Corporations not qualifying as insurance companies.

    (a) In general. A controlled foreign corporation is not excluded 
from the application of paragraph (a) of Sec. 1.953-1 because such 
corporation, if it were a domestic corporation, would not be taxable as 
an insurance company to which subchapter L of the Code applies. Thus, if 
a controlled foreign corporation reinsures or issues insurance or 
annuity contracts in connection with United States risks, as defined in 
Sec. 1.953-2 or Sec. 1.953-3, and satisfies the 5-percent minimum 
premium requirement prescribed in paragraph (b) of Sec. 1.953-1, such 
corporation may derive income from the insurance of United States risks 
even though the primary and predominant business activity of such 
corporation during the taxable year is not the issuing of insurance or 
annuity contracts or the reinsuring of risks underwritten by insurance 
companies.
    (b) Income from insurance of United States risks by noninsurance 
company. For purposes of paragraph (a) of Sec. 1.953-1, the taxable 
income derived from the reinsuring or the issuing of any insurance or 
annuity contract in connection with United States risks by a controlled 
foreign corporation which, if it were a domestic corporation, would not 
be taxable as an insurance company to which subchapter L of the Code 
applies shall be determined under Sec. 1.953-4, subject to, and to the 
extent not inconsistent with, the special rules prescribed in paragraph 
(c) or (d) of this section, whichever applies.
    (c) Special rules in determining taxable income--(1) In general. The 
rules prescribed in this paragraph apply in order to exclude from the 
determination under Sec. 1.953-4 of the taxable income described in 
paragraph (b) of this section those items of the controlled foreign

[[Page 264]]

corporation's gross income and deductions which are not attributable to 
the reinsuring and issuing of insurance and annuity contracts.
    (2) Life insurance taxable income--(i) Amount of investment yield 
taken into account. For purposes of determining the taxable income of a 
controlled foreign corporation which would not be taxable as an 
insurance company to which subchapter L of the Code applies if it were a 
domestic corporation but would be taxable as an insurance company to 
which part I of such subchapter applies if it were a domestic insurance 
company engaged in the business of only reinsuring or issuing the 
insurance or annuity contracts which have been reinsured or issued by 
such corporation, the investment yield under section 804(c), the amount 
(if any) by which the net long-term capital gain exceeds the net short-
term capital loss, and all items of income taken into account under 
section 809(c)(3) shall be taken into account, subject to the provisions 
of paragraphs (e) and (f) of Sec. 1.953-4, in an amount which bears the 
same ratio to each of such amounts of investment yield, excess gain, and 
income items, as the case may be, as the numerator determined under 
subdivision (ii) of this subparagraph bears to the denominator 
determined under subdivision (iii) of this subparagraph.
    (ii) Numerator. The numerator used for purposes of the apportionment 
under subdivision (i) of this subparagraph shall be the sum of--
    (a) The mean of each of the items described in section 810(c) at the 
beginning and end of the taxable year, determined in accordance with the 
rules prescribed in paragraph (c) of Sec. 1.953-4 for purposes of 
determining taxable income of a controlled foreign corporation under 
paragraph (a) of Sec. 1.953-4,
    (b) The mean of other liabilities at the beginning and end of the 
taxable year which are attributable to the reinsuring and issuing of 
insurance and annuity contracts, and
    (c) The mean of the earnings and profits accumulated by the 
controlled foreign corporation at the beginning and end of the taxable 
year (determined without diminution by reason of any distributions made 
during the taxable year) which are attributable to the reinsuring and 
issuing of insurance and annuity contracts.
    (iii) Denominator. The denominator used for purposes of the 
apportionment under subdivision (i) of this subparagraph shall be the 
mean of the value of the total assets held by the controlled foreign 
corporation at the beginning and end of the taxable year, determined by 
taking assets into account at their actual value (not reduced by 
liabilities), which, in the absence of affirmative evidence to the 
contrary, shall be deemed to be (a) face value in the case of bills 
receivable, accounts receivable, notes receivable, and open accounts 
held by a controlled foreign corporation using the cash receipts and 
disbursements method of accounting and (b) adjusted basis in the case of 
all other assets.
    (3) Mutual and other insurance taxable income--(i) Amount of 
insurance income taken into account. For purposes of determining the 
taxable income of a controlled foreign corporation which, if it were a 
domestic corporation, would not be taxable as an insurance company to 
which subchapter L of the Code applies but which if it were a domestic 
insurance company engaged in the business of only reinsuring or issuing 
the insurance or annuity contracts which have been reinsured or issued 
by such corporation, would be taxable as a mutual insurance company to 
which part II of subchapter L of the Code applies, or would be taxable 
as a mutual marine insurance or other insurance company to which part 
III of subchapter L of the Code applies, the sum of the items of gross 
income referred to in section 832(b)(1) (except the gross amount earned 
during the taxable year from underwriting income described in section 
832(b)(1)(A)) reduced by the deductions allowable under section 832(c) 
which are related to such items of gross income shall be taken into 
account, subject to the provisions of paragraphs (e) and (f) of Sec. 
1.953-4, in an amount which bears the same proportion to the sum of such 
items of gross income reduced by such deductions as the numerator 
determined under subdivision (ii) of this subparagraph bears to the 
denominator determined under subdivision (iii) of this subparagraph.

[[Page 265]]

    (ii) Numerator. The numerator used for purposes of the apportionment 
under subdivision (i) of this subparagraph shall be the sum of--
    (a) The mean of the controlled foreign corporation's unearned 
premiums at the beginning and end of the taxable year, determined under 
section 832(b)(4)(B) and in accordance with the rules prescribed in 
paragraph (c) of Sec. 1.953-4 for purposes of determining taxable 
income of a controlled foreign corporation under paragraph (a) of Sec. 
1.953-4,
    (b) The mean of such corporation's unpaid losses at the beginning 
and end of the taxable year, determined under section 832(b)(5)(B),
    (c) The mean of the items described in section 810(c)(4) at the 
beginning and end of the taxable year, to the extent allowable to such 
corporation under section 832(c)(11),
    (d) The mean of other liabilities at the beginning and end of the 
taxable year which are attributable to the reinsuring and issuing of 
insurance and annuity contracts, and
    (e) The mean of the earnings and profits accumulated by such 
corporation at the beginning and end of the taxable year (determined 
without diminution by reason of any distributions made during the 
taxable year) which are attributable to the reinsuring and issuing of 
insurance and annuity contracts.
    (iii) Denominator. The denominator used for purposes of the 
apportionment under subdivision (i) of this subparagraph shall be the 
mean of the value of the total assets held by the controlled foreign 
corporation at the beginning and end of the taxable year, determined in 
the manner prescribed in subparagraph (2)(iii) of this paragraph.
    (d) Separate accounting. The special rules prescribed in paragraph 
(c) of this section shall not apply if the district director determines 
that the controlled foreign corporation, in good faith and unaffected by 
considerations of tax liability, regularly employs in its books of 
account a detailed segregation of receipts, expenditures, assets, 
liabilities, and net worth which clearly reflects the income derived 
from the reinsuring or issuing of insurance or annuity contracts. The 
district director, in making such determination, shall give effect to 
any foreign law, satisfactory evidence of which is presented by the 
United States shareholder to the district director, which requires a 
reasonable segregation of the insurance assets of the controlled foreign 
corporation.

[T.D. 6781, 29 FR 18211, Dec. 23, 1964]



Sec. 1.953-6  Relationship of sections 953 and 954.

    (a) Priority of application. For purposes of determining the subpart 
F income of a controlled foreign corporation under section 952 for any 
taxable year, the provisions of section 954, relating to foreign base 
company income, shall be applied, after first applying section 953, only 
with respect to income which is not income derived from the insurance of 
United States risks under section 953. For example, the provisions of 
section 954 may be applied with respect to the income of a controlled 
foreign corporation which is not income derived from the insurance of 
United States risks under section 953 because such corporation does not 
satisfy the 5-percent minimum premium requirement prescribed in 
paragraph (b) of Sec. 1.953-1, even though such corporation has taxable 
income, as determined under Sec. 1.953-4, which is attributable to the 
reinsuring or the issuing of any insurance or annuity contracts in 
connection with United States risks. In addition, the provisions of 
section 954 may apply with respect to the income of a controlled foreign 
corporation to the extent such income is not allocated or apportioned 
under Sec. 1.953-4 to the insurance of United States risks.
    (b) Decrease in income not material. It is not material that the 
income of a controlled foreign corporation is decreased as a result of 
the application of paragraph (a) of this section. Thus, in applying 
Sec. 1.953-4 to the income of a controlled foreign corporation 
described in paragraph (c)(2) of Sec. 1.953-5 which would, but for 
paragraph (a) of this section, be subject to the provisions of section 
954, there shall be allowed, in determining the taxable income derived 
from the insurance of United States risks under Sec. 1.953-4, a 
deduction under section 809(a)(1) for

[[Page 266]]

the share of each and every item of investment yield set aside for 
policyholders; it is not material that in determining foreign base 
company income such deduction would not be allowed under section 
954(b)(5). Further, income of a controlled foreign corporation which is 
required to be taken into account under section 953 in determining 
income derived from the insurance of United States risks and would, but 
for the provisions of paragraph (a) of this section, constitute foreign 
base company income under section 954 shall not be taken into account 
under section 954(b)(3)(B) in determining whether foreign base company 
income exceeds 70 percent of gross income for the taxable year.
    (c) Increase in income not material. It is not material that the 
income of a controlled foreign corporation is increased as a result of 
the application of paragraph (a) of this section. Thus, in applying 
Sec. 1.953-4 to income of a controlled foreign corporation which would, 
but for paragraph (a) of this section, be subject to the provisions of 
section 954, it is not material that the dividends, interest, and gains 
from the sale or exchange of stock or securities derived from certain 
investments which would not be included in foreign personal holding 
company income under section 954(c)(3)(B) are included under section 953 
in income derived from the insurance of United States risks. Further, 
income of a controlled foreign corporation which is required to be taken 
into account under section 953 in determining income derived from the 
insurance of United States risks and would, but for paragraph (a) of 
this section, constitute foreign base company income shall not be 
excluded under section 954(b)(3)(A) for the taxable year.

[T.D. 6781, 29 FR 18212, Dec. 23, 1964]



Sec. 1.954-0  Introduction.

    (a) Effective dates--(1) Final regulations--(i) In general. Except 
as otherwise specifically provided, the provisions of Sec. Sec. 1.954-1 
and 1.954-2 apply to taxable years of a controlled foreign corporation 
beginning after November 6, 1995. If any of the rules described in 
Sec. Sec. 1.954-1 and 1.954-2 are inconsistent with provisions of other 
regulations under subpart F, these final regulations are intended to 
apply instead of such other regulations.
    (ii) Election to apply final regulations retroactively--(A) Scope of 
election. An election may be made to apply the final regulations 
retroactively with respect to any taxable year of the controlled foreign 
corporation beginning on or after January 1, 1987. If such an election 
is made, these final regulations must be applied in their entirety for 
such taxable year and all subsequent taxable years. All references to 
section 11 in the final regulations shall be deemed to include section 
15, where applicable.
    (B) Manner of making election. An election under this paragraph 
(a)(1)(ii) is binding on all United States shareholders of the 
controlled foreign corporation and must be made--
    (1) By the controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns for the taxable year of such 
United States shareholders in which or with which the taxable year of 
the CFC ends, and including any additional information required by 
applicable administrative pronouncements, or
    (2) In such other manner as may be prescribed in applicable 
administrative pronouncements.
    (C) Time for making election. An election may be made under this 
paragraph (a)(1)(ii) with respect to a taxable year of the controlled 
foreign corporation beginning on or after January 1, 1987 only if the 
time for filing a return or claim for refund has not expired for the 
taxable year of any United States shareholder of the controlled foreign 
corporation in which or with which such taxable year of the controlled 
foreign corporation ends.
    (D) Revocation of election. An election made under this paragraph 
(a)(1)(ii) may not be revoked.
    (2) Temporary regulations. The provisions of Sec. Sec. 4.954-1 and 
4.954-2 of this chapter apply to taxable years of a controlled foreign 
corporation beginning after December 31, 1986 and on or before November 
6, 1995. However, the provisions of Sec. 4.954-2(b)(6) of this chapter

[[Page 267]]

continue to apply. For transactions entered into on or before October 
10, 1995, taxpayers may rely on Notice 89-90, 1989-2 C.B. 407, in 
applying the temporary regulations.
    (3) Sec. Sec. 1.954A-1 and 1.954A-2. The provisions of Sec. Sec. 
1.954A-1 and 1.954A-2 (as contained in 26 CFR part 1 edition revised 
April 1, 1995) apply to taxable years of a controlled foreign 
corporation beginning before January 1, 1987. All references therein to 
sections of the Code are to the Internal Revenue Code of 1954 prior to 
the amendments made by the Tax Reform Act of 1986.
    (b) [Reserved]

[T.D. 8618, 60 FR 46508, Sept. 7, 1995; T.D. 8618, 60 FR 62024, Dec. 4, 
1995; T.D. 8767, 63 FR 14615, Mar. 26, 1998; T.D. 9039, 68 FR 4917, Jan. 
31, 2003; T.D. 9883, 84 FR 63803, Nov. 19, 2019; T.D. 9902, 85 FR 44649, 
July 23, 2020]



Sec. 1.954-1  Foreign base company income.

    (a) In general--(1) Purpose and scope. Section 954 and Sec. Sec. 
1.954-1 and 1.954-2 provide rules for computing the foreign base company 
income of a controlled foreign corporation. Foreign base company income 
is included in the subpart F income of a controlled foreign corporation 
under the rules of section 952. Subpart F income is included in the 
gross income of a United States shareholder of a controlled foreign 
corporation under the rules of section 951 and thus is subject to 
current taxation under section 1, 11 or 55 of the Internal Revenue Code. 
The determination of whether a foreign corporation is a controlled 
foreign corporation, the subpart F income of which is included currently 
in the gross income of its United States shareholders, is made under the 
rules of section 957.
    (2) Gross foreign base company income. The gross foreign base 
company income of a controlled foreign corporation consists of the 
following categories of gross income (determined after the application 
of section 952(b))--
    (i) Foreign personal holding company income, as defined in section 
954(c);
    (ii) Foreign base company sales income, as defined in section 
954(d);
    (iii) Foreign base company services income, as defined in section 
954(e);
    (iv) Foreign base company shipping income, as defined in section 
954(f); and
    (v) Foreign base company oil related income, as defined in section 
954(g).
    (3) Adjusted gross foreign base company income. The term adjusted 
gross foreign base company income means the gross foreign base company 
income of a controlled foreign corporation as adjusted by the de minimis 
and full inclusion rules of paragraph (b) of this section.
    (4) Net foreign base company income. The term net foreign base 
company income means the adjusted gross foreign base company income of a 
controlled foreign corporation reduced so as to take account of 
deductions (including taxes) properly allocable or apportionable to such 
income under the rules of section 954(b)(5) and paragraph (c) of this 
section.
    (5) Adjusted net foreign base company income. The term adjusted net 
foreign base company income means the net foreign base company income of 
a controlled foreign corporation reduced, first, by any items of net 
foreign base company income excluded from subpart F income pursuant to 
section 952(c) and, second, by any items excluded from subpart F income 
pursuant to the high tax exception of section 954(b). See paragraph 
(d)(4)(ii) of this section. The term foreign base company income as used 
in the Internal Revenue Code and elsewhere in the Income Tax Regulations 
means adjusted net foreign base company income, unless otherwise 
provided.
    (6) Insurance income. The term gross insurance income includes all 
gross income taken into account in determining insurance income under 
section 953. The term adjusted gross insurance income means gross 
insurance income as adjusted by the de minimis and full inclusion rules 
of paragraph (b) of this section. The term net insurance income means 
adjusted gross insurance income reduced under section 953 so as to take 
into account deductions (including taxes) properly allocable or 
apportionable to such income. The term adjusted net insurance income 
means net insurance income reduced by any items of net insurance income 
that are excluded from subpart F income pursuant to section 952(b) or 
pursuant to the high tax exception of section 954(b). The term insurance 
income as used in subpart F of the Internal

[[Page 268]]

Revenue Code and in the regulations under that subpart means adjusted 
net insurance income, unless otherwise provided.
    (7) Additional items of adjusted net foreign base company income or 
adjusted net insurance income by reason of section 952(c). Earnings and 
profits of the controlled foreign corporation that are recharacterized 
as foreign base company income or insurance income under section 952(c) 
are items of adjusted net foreign base company income or adjusted net 
insurance income, respectively. Amounts subject to recharacterization 
under section 952(c) are determined after adjusted net foreign base 
company income and adjusted net insurance income are otherwise 
determined under subpart F and are not again subject to any exceptions 
or special rules that would affect the amount of subpart F income. Thus, 
for example, items of gross foreign base company income or gross 
insurance income that are excluded from adjusted gross foreign base 
company income or adjusted gross insurance income because the de minimis 
test is met are subject to recharacterization under section 952(c). 
Further, the de minimis and full inclusion tests of paragraph (b) of 
this section, and the high tax exception of paragraph (d) of this 
section, for example, do not apply to such amounts.
    (b) Computation of adjusted gross foreign base company income and 
adjusted gross insurance income--(1) De minimis and full inclusion 
tests--(i) De minimis test--(A) In general. Except as provided in 
paragraph (b)(1)(i)(C) of this section, adjusted gross foreign base 
company income and adjusted gross insurance income are equal to zero if 
the sum of the gross foreign base company income and the gross insurance 
income of a controlled foreign corporation is less than the lesser of--
    (1) 5 percent of gross income; or
    (2) $1,000,000.
    (B) Currency translation. Controlled foreign corporations having a 
functional currency other than the United States dollar shall translate 
the $1,000,000 threshold using the exchange rate provided under section 
989(b)(3) for amounts included in income under section 951(a).
    (C) Coordination with sections 864(d) and 881(c). Adjusted gross 
foreign base company income or adjusted gross insurance income of a 
controlled foreign corporation always includes income from trade or 
service receivables described in section 864(d)(1) or (6), and portfolio 
interest described in section 881(c), even if the de minimis test of 
this paragraph (b)(1)(i) is otherwise satisfied.
    (ii) Seventy percent full inclusion test. Except as provided in 
section 953, adjusted gross foreign base company income consists of all 
gross income of the controlled foreign corporation other than gross 
insurance income and amounts described in section 952(b), and adjusted 
gross insurance income consists of all gross insurance income other than 
amounts described in section 952(b), if the sum of the gross foreign 
base company income and the gross insurance income for the taxable year 
exceeds 70 percent of gross income. See paragraph (d)(6) of this 
section, under which certain items of full inclusion foreign base 
company income may nevertheless be excluded from subpart F income.
    (2) Character of gross income included in adjusted gross foreign 
base company income. The gross income included in the adjusted gross 
foreign base company income of a controlled foreign corporation 
generally retains its character as foreign personal holding company 
income, foreign base company sales income, foreign base company services 
income, foreign base company shipping income, or foreign base company 
oil related income. However, gross income included in adjusted gross 
foreign base company income because the full inclusion test of paragraph 
(b)(1)(ii) of this section is met is termed full inclusion foreign base 
company income, and constitutes a separate category of adjusted gross 
foreign base company income for purposes of allocating and apportioning 
deductions under paragraph (c) of this section.
    (3) Coordination with section 952(c). Income that is included in 
subpart F income because the full inclusion test of paragraph (b)(1)(ii) 
of this section is met does not reduce amounts that, under section 
952(c), are subject to recharacterization.

[[Page 269]]

    (4) Anti-abuse rule--(i) In general. For purposes of applying the de 
minimis test of paragraph (b)(1)(i) of this section, the income of two 
or more controlled foreign corporations shall be aggregated and treated 
as the income of a single corporation if a principal purpose for 
separately organizing, acquiring, or maintaining such multiple 
corporations is to prevent income from being treated as foreign base 
company income or insurance income under the de minimis test. A purpose 
may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately).
    (ii) Presumption. Two or more controlled foreign corporations are 
presumed to have been organized, acquired or maintained to prevent 
income from being treated as foreign base company income or insurance 
income under the de minimis test of paragraph (b)(1)(i) of this section 
if the corporations are related persons, as defined in paragraph 
(b)(4)(iii) of this section, and the corporations are described in 
paragraph (b)(4)(ii)(A), (B), or (C) of this section. This presumption 
may be rebutted by proof to the contrary.
    (A) The activities carried on by the controlled foreign 
corporations, or the assets used in those activities, are substantially 
the same activities that were previously carried on, or assets that were 
previously held, by a single controlled foreign corporation. Further, 
the United States shareholders of the controlled foreign corporations or 
related persons (as determined under paragraph (b)(4)(iii) of this 
section) are substantially the same as the United States shareholders of 
the one controlled foreign corporation in a prior taxable year. A 
presumption made in connection with the requirements of this paragraph 
(b)(4)(ii)(A) may be rebutted by proof that the activities carried on by 
each controlled foreign corporation would constitute a separate branch 
under the principles of Sec. 1.367(a)-6T(g)(2) if carried on directly 
by a United States person.
    (B) The controlled foreign corporations carry on a business, 
financial operation, or venture as partners directly or indirectly in a 
partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3 of 
this chapter) that is a related person (as defined in paragraph 
(b)(4)(iii) of this section) with respect to each such controlled 
foreign corporation.
    (C) The activities carried on by the controlled foreign corporations 
would constitute a single branch operation under Sec. 1.367(a)-6T(g)(2) 
if carried on directly by a United States person.
    (iii) Related persons. For purposes of this paragraph (b), two or 
more persons are related persons if they are in a relationship described 
in section 267(b). In determining for purposes of this paragraph (b) 
whether two or more corporations are members of the same controlled 
group under section 267(b)(3), a person is considered to own stock owned 
directly by such person, stock owned with the application of section 
1563(e)(1), and stock owned with the application of section 267(c). In 
determining for purposes of this paragraph (b) whether a corporation is 
related to a partnership under section 267(b)(10), a person is 
considered to own the partnership interest owned directly by such person 
and the partnership interest owned with the application of section 
267(e)(3).
    (iv) Example. The following example illustrates the application of 
this paragraph (b)(4).

    Example. (i)(1) USP is the sole United States shareholder of three 
controlled foreign corporations: CFC1, CFC2 and CFC3. The three 
controlled foreign corporations all have the same taxable year. The 
three controlled foreign corporations are partners in FP, a foreign 
entity classified as a partnership under section 7701(a)(2) and Sec. 
301.7701-3 of the regulations. For their current taxable years, each of 
the controlled foreign corporations derives all of its income other than 
foreign base company income from activities conducted through FP, and 
its foreign base company income from activities conducted both jointly 
through FP and separately without FP. Based on the facts in the table 
below, the foreign base company income derived by each controlled 
foreign corporation for its current taxable year, including income 
derived from FP, is less than five percent of the gross income of each 
controlled foreign corporation and is less than $1,000,000:

[[Page 270]]



----------------------------------------------------------------------------------------------------------------
                                                                       CFC1            CFC2            CFC3
----------------------------------------------------------------------------------------------------------------
Gross income....................................................      $4,000,000      $8,000,000     $12,000,000
Five percent of gross income....................................         200,000         400,000         600,000
Foreign base company income.....................................         199,000         398,000         597,000
----------------------------------------------------------------------------------------------------------------

    (2) Thus, without the application of the anti-abuse rule of this 
paragraph (b)(4), each controlled foreign corporation would be treated 
as having no foreign base company income after the application of the de 
minimis test of section 954(b)(3)(A) and paragraph (b)(1)(i) of this 
section.
    (ii) However, under these facts, the requirements of paragraph 
(b)(4)(i) of this section are met unless the presumption of paragraph 
(b)(4)(ii) of this section is successfully rebutted. The sum of the 
foreign base company income of the controlled foreign corporations is 
$1,194,000. Thus, the amount of gross foreign base company income of 
each controlled foreign corporation will not be reduced by reason of the 
de minimis rule of section 954(b)(3)(A) and this paragraph (b).

    (c) Computation of net foreign base company income--(1) General 
rule. The net foreign base company income of a controlled foreign 
corporation (as defined in paragraph (a)(4) of this section) is computed 
under the rules of this paragraph (c)(1). The principles of Sec. 1.904-
5(k) shall apply where payments are made between controlled foreign 
corporations that are related persons (within the meaning of section 
954(d)(3)). Consistent with these principles, only payments described in 
Sec. 1.954-2(b)(4)(ii)(B)(2) may be offset as provided in Sec. 1.904-
5(k)(2).
    (i) Deductions against gross foreign base company income. The net 
foreign base company income of a controlled foreign corporation is 
computed first by taking into account deductions in the following 
manner:
    (A) First, the gross amount of each item of income described in 
paragraph (c)(1)(iii) of this section is determined.
    (B) Second, any expenses definitely related to less than all gross 
income as a class shall be allocated and apportioned under the 
principles of sections 861, 864 and 904(d) to the gross income described 
in paragraph (c)(1)(i)(A) of this section.
    (C) Third, foreign personal holding company income that is passive 
within the meaning of section 904 (determined before the application of 
the high-taxed income rule of Sec. 1.904-4(c)) is reduced (but not 
below zero) by related person interest expense allocable to passive 
income under Sec. 1.904-5(c)(2); such interest must be further 
allocated and apportioned to items described in paragraph (c)(1)(iii)(B) 
of this section.
    (D) Fourth, the amount of each item of income described in paragraph 
(c)(1)(iii) of this section is reduced by other expenses allocable and 
apportionable to such income under the principles of sections 861, 864 
and 904(d).
    (ii) Losses reduce subpart F income by operation of earnings and 
profits limitation. Except as otherwise provided in Sec. 1.954-2(g)(4), 
if after applying the rules of paragraph (c)(1)(i) of this section, the 
amount remaining in any category of foreign base company income or 
foreign personal holding company income is less than zero, the loss in 
that category may not reduce any other category of foreign base company 
income or foreign personal holding company income except by operation of 
the earnings and profits limitation of section 952(c)(1).
    (iii) Items of income--(A) Income other than passive foreign 
personal holding company income. A single item of income (other than 
foreign personal holding company income that is passive) is the 
aggregate amount from all transactions that falls within a single 
separate category (as defined in Sec. 1.904-5(a)(4)(v)), and either--
    (1) Falls within a single category of foreign personal holding 
company income as--
    (i) Dividends, interest, rents, royalties and annuities;
    (ii) Gain from certain property transactions;
    (iii) Gain from commodities transactions;
    (iv) Foreign currency gain; or
    (v) Income equivalent to interest; or
    (2) Falls within a single category of foreign base company income, 
other than foreign personal holding company income, as--

[[Page 271]]

    (i) Foreign base company sales income;
    (ii) Foreign base company services income; or
    (iii)--(iv) [Reserved]
    (v) Full inclusion foreign base company income.
    (3) For purposes of paragraph (c)(1)(iii)(A) of this section, the 
aggregate amount from all transactions that falls within a single 
separate category (as defined in Sec. 1.904-5(a)(4)(v)) and is 
described in paragraph (c)(1)(iii)(A)(1)(i) of this section is a single 
item of income. Similarly, the aggregate amount from all transactions 
that falls within a single separate category (as defined in Sec. 1.904-
5(a)(4)(v)) and is described in each one of paragraphs 
(c)(1)(iii)(A)(1)(ii) through (c)(1)(iii)(A)(1)(v) of this section is in 
each case a separate single item of income. The same principles apply 
for transactions described in each one of paragraphs 
(c)(1)(iii)(A)(2)(i) through (v) of this section.
    (B) Passive foreign personal holding company income. A single item 
of foreign personal holding company income that is passive is an amount 
of income that falls within a single group of passive income under the 
grouping rules of Sec. 1.904-4(c)(3), (4) and (5) and a single category 
of foreign personal holding company income described in paragraphs 
(c)(1)(iii)(A)(1) (i) through (v).
    (iv) Treatment of deductions or loss attributable to disqualified 
basis. For purposes of paragraph (c)(1)(i) of this section (and in the 
case of insurance income, paragraph (a)(6) of this section), in 
determining the amount of a net item of foreign base company income or 
insurance income, deductions or loss described in Sec. 1.951A-2(c)(5) 
or (c)(6) are not allocated and apportioned to gross foreign base 
company income or gross insurance income.
    (2) Computation of net foreign base company income derived from same 
country insurance income. Deductions relating to foreign base company 
income attributable to the issuing (or reinsuring) of any insurance or 
annuity contract in connection with risks located in the country under 
the laws of which the controlled foreign corporation is created or 
organized shall be allocated and apportioned in accordance with the 
rules set forth in section 953.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income--(1) Application of high tax exception. 
Adjusted net foreign base company income (or adjusted net insurance 
income) equals the net foreign base company income (or net insurance 
income) of a controlled foreign corporation, reduced by any net item of 
such income that qualifies for the high tax exception provided by 
section 954(b)(4) and this paragraph (d). Any item of income that is 
portfolio interest, as described in section 881(c), does not qualify for 
the high tax exception. See paragraph (c)(1)(iii) of this section for 
the definition of the term item of income. For rules concerning the 
treatment for foreign tax credit purposes of amounts excluded from 
subpart F under section 954(b)(4), see Sec. 1.904-4(c). For rules 
concerning the application of the high-tax exception of sections 
954(b)(4) and 951A(c)(2)(A)(i)(III) to tentative gross tested income 
items, see Sec. 1.951A-2(c)(1)(iii), (c)(3)(ii), and (c)(7) and (8). A 
net item of income qualifies for the high tax exception only if--
    (i) An election is made under section 954(b)(4) and paragraph (d)(5) 
of this section to exclude the income from the computation of subpart F 
income; and
    (ii) It is established that the net item of income was subject to 
foreign income taxes at an effective rate that is greater than 90 
percent of the maximum rate of tax specified in section 11 for the 
taxable year of the controlled foreign corporation.
    (2) Effective rate at which taxes are imposed. The effective rate 
with respect to a net item of income shall be determined separately for 
each controlled foreign corporation. The effective rate at which taxes 
are imposed on a net item of income is--
    (i) The United States dollar amount of foreign income taxes paid or 
accrued with respect to the net item of income, determined under 
paragraph (d)(3) of this section; divided by
    (ii) The United States dollar amount of the net item of foreign base 
company income or insurance income, described in paragraph (c)(1)(iii) 
of this section, increased by the amount of

[[Page 272]]

foreign income taxes referred to in paragraph (d)(2)(i) of this section.
    (3) Taxes paid or accrued with respect to an item of income--(i) In 
general. The amount of foreign income taxes paid or accrued by a 
controlled foreign corporation with respect to a net item of income for 
purposes of section 954(b)(4) and this paragraph (d) is the U.S. dollar 
amount of the controlled foreign corporation's current year taxes (as 
defined in Sec. 1.960-1(b)(4)) that are allocated and apportioned under 
Sec. 1.960-1(d)(3)(ii) to the subpart F income group (as defined in 
Sec. 1.960-1(d)(2)(ii)(B)) that corresponds with the net item of 
income.
    (ii) [Reserved]
    (iii) Effect of potential and actual changes in taxes paid or 
accrued. Except as otherwise provided in this paragraph (d)(3)(iii), the 
amount of foreign income taxes paid or accrued with respect to a net 
item of income, determined in the manner provided in this paragraph (d), 
does not take into account any potential reduction in foreign income 
taxes that may occur by reason of a future distribution to shareholders 
of all or part of such income. However, to the extent the foreign income 
taxes paid or accrued by the controlled foreign corporation are 
reasonably certain to be returned by the foreign jurisdiction imposing 
such taxes to a shareholder, directly or indirectly, through any means 
(including, but not limited to, a refund, credit, payment, discharge of 
an obligation, or any other method) on a subsequent distribution to such 
shareholder, the foreign income taxes are not treated as paid or accrued 
for purposes of this paragraph (d)(3). In addition, foreign income taxes 
that have not been paid or accrued because they are contingent on a 
future distribution of earnings are not taken into account for purposes 
of this paragraph (d)(3). If, pursuant to section 905(c) and Sec. 
1.905-3(b)(2), a redetermination of U.S. tax liability is required to 
account for the effect of a foreign tax redetermination (as defined in 
Sec. 1.905-3(a)), this paragraph (d) is applied in the adjusted year 
taking into account the adjusted amount of the redetermined foreign tax.
    (4) Special rules--(i) Consistency rule. An election to exclude 
income from the computation of subpart F income for a taxable year must 
be made consistently with respect to all items of passive foreign 
personal holding company income eligible to be excluded for the taxable 
year. Thus, high-taxed passive foreign personal holding company income 
of a controlled foreign corporation must either be excluded in its 
entirety, or remain subject to subpart F in its entirety.
    (ii) Coordination with earnings and profits limitation. If the 
amount of income included in subpart F income for the taxable year is 
reduced by the earnings and profits limitation of section 952(c)(1), the 
amount of income that is a net item of income, within the meaning of 
paragraph (c)(1)(iii) of this section, is determined after the 
application of the rules of section 952(c)(1).
    (iii) Example. The following example illustrates the provisions of 
paragraph (d)(4)(ii) of this section. All of the taxes referred to in 
the following example are foreign income taxes. For simplicity, this 
example assumes that the amount of taxes that are taken into account as 
a deduction under section 954(b)(5) and the amount of the gross-up 
required under sections 960 and 78 are equal. Therefore, this example 
does not separately illustrate the deduction for taxes and gross-up.

    Example. During its 1995 taxable year, CFC, a controlled foreign 
corporation, earns royalty income, net of taxes, of $100 that is foreign 
personal holding company income. CFC has no expenses associated with 
this royalty income. CFC pays $50 of foreign income taxes with respect 
to the royalty income. For 1995, CFC has current earnings and profits of 
$50. CFC's subpart F income, as determined prior to the application of 
this paragraph (d), exceeds its current earnings and profits. Thus, 
under paragraph (d)(4)(ii) of this section, the amount of CFC's only net 
item of income, the royalty income, will be limited to $50. The 
remaining $50 will be subject to recharacterization in a subsequent 
taxable year under section 952(c)(2). Because the amount of foreign 
income taxes paid with respect to this net item of income is $50, the 
effective rate of tax on the item, for purposes of this paragraph (d), 
is 50 percent ($50 of taxes/$50 net item + $50 of taxes). Accordingly, 
an election under paragraph (d)(5) of this section may be made to 
exclude the item of income from the computation of subpart F income.


[[Page 273]]


    (5) Procedure. An election made under the procedure provided by this 
paragraph (d)(5) is binding on all United States shareholders of the 
controlled foreign corporation and must be made--
    (i) By the controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns, and including any additional 
information required by applicable administrative pronouncements; or
    (ii) In such other manner as may be prescribed in applicable 
administrative pronouncements.
    (6) Coordination of full inclusion and high tax exception rules. 
Notwithstanding paragraph (b)(1)(ii) of this section, full inclusion 
foreign base company income will be excluded from subpart F income if 
more than 90 percent of the adjusted gross foreign base company income 
and adjusted gross insurance company income of a controlled foreign 
corporation (determined without regard to the full inclusion test of 
paragraph (b)(1) of this section) is attributable to net amounts 
excluded from subpart F income pursuant to an election to have the high 
tax exception described in section 954(b)(4) and this paragraph (d) 
apply.
    (e) Character of income--(1) Substance of the transaction. For 
purposes of section 954, income shall be characterized in accordance 
with the substance of the transaction, and not in accordance with the 
designation applied by the parties to the transaction. For example, an 
amount that is designated as rent by the taxpayer but actually 
constitutes income from the sale of property, royalties, or income from 
services shall not be characterized as rent but shall be characterized 
as income from the sale of property, royalties or income from services, 
as the case may be. Local law shall not be controlling in characterizing 
income.
    (2) Separable character. To the extent the definitional provisions 
of section 953 or 954 describe the income or gain derived from a 
transaction, or any portion or portions thereof, that income or gain, or 
portion or portions thereof, is so characterized for purposes of subpart 
F. Thus, a single transaction may give rise to income in more than one 
category of foreign base company income described in paragraph (a)(2) of 
this section. For example, if a controlled foreign corporation, in its 
business of purchasing personal property and selling it to related 
persons outside its country of incorporation, also performs services 
outside its country of incorporation with respect to the property it 
sells, the sales income will be treated as foreign base company sales 
income and the services income will be treated as foreign base company 
services income for purposes of these rules.
    (3) Predominant character. The portion of income or gain derived 
from a transaction that is included in the computation of foreign 
personal holding company income is always separately determinable and 
thus must always be segregated from other income and separately 
classified under paragraph (e)(2) of this section. However, the portion 
of income or gain derived from a transaction that would meet a 
particular definitional provision under section 954 or 953 (other than 
the definition of foreign personal holding company income) in unusual 
circumstances may not be separately determinable. If such portion is not 
separately determinable, it must be classified in accordance with the 
predominant character of the transaction. For example, if a controlled 
foreign corporation engineers, fabricates, and installs a fixed offshore 
drilling platform as part of an integrated transaction, and the portion 
of income that relates to services is not accounted for separately from 
the portion that relates to sales, and is otherwise not separately 
determinable, then the classification of income from the transaction 
shall be made in accordance with the predominant character of the 
arrangement.
    (4) Coordination of categories of gross foreign base company income 
or gross insurance income--(i) In general. The computations of gross 
foreign base company income and gross insurance income are limited by 
the following rules:
    (A) If income is foreign base company shipping income, pursuant to 
section 954(f), it shall not be considered insurance income or income in 
any other

[[Page 274]]

category of foreign base company income.
    (B) If income is foreign base company oil related income, pursuant 
to section 954(g), it shall not be considered insurance income or income 
in any other category of foreign base company income, except as provided 
in paragraph (e)(4)(i)(A) of this section.
    (C) If income is insurance income, pursuant to section 953, it shall 
not be considered income in any category of foreign base company income 
except as provided in paragraph (e)(4)(i)(A) or (B) of this section.
    (D) If income is foreign personal holding company income, pursuant 
to section 954(c), it shall not be considered income in any other 
category of foreign base company income, other than as provided in 
paragraph (e)(4)(i)(A), (B) or (C) of this section.
    (ii) Income excluded from other categories of gross foreign base 
company income. Income shall not be excluded from a category of gross 
foreign base company income or gross insurance income under this 
paragraph (e)(4) by reason of being included in another category of 
gross foreign base company income or gross insurance income, if the 
income is excluded from that other category by a more specific provision 
of section 953 or 954. For example, income derived from a commodity 
transaction that is excluded from foreign personal holding company 
income under Sec. 1.954-2(f) as income from a qualified active sale may 
be included in gross foreign base company income if it also meets the 
definition of foreign base company sales income. See Sec. 1.954-2(a)(2) 
for the coordination of overlapping categories within the definition of 
foreign personal holding company income.
    (f) Definition of related person--(1) Persons related to controlled 
foreign corporation. Unless otherwise provided, for purposes of section 
954 and Sec. Sec. 1.954-1 through 1.954-8 inclusive, the following 
persons are considered under section 954(d)(3) to be related persons 
with respect to a controlled foreign corporation:
    (i) Individuals. An individual, whether or not a citizen or resident 
of the United States, who controls the controlled foreign corporation.
    (ii) Other persons. A foreign or domestic corporation, partnership, 
trust or estate that controls or is controlled by the controlled foreign 
corporation, or is controlled by the same person or persons that control 
the controlled foreign corporation.
    (2) Control--(i) Corporations. With respect to a corporation, 
control means the ownership, directly or indirectly, of stock possessing 
more than 50 percent of the total voting power of all classes of stock 
entitled to vote or of the total value of the stock of the corporation.
    (ii) Partnerships. With respect to a partnership, control means the 
ownership, directly or indirectly, of more than 50 percent (by value) of 
the capital or profits interest in the partnership.
    (iii) Trusts and estates. With respect to a trust or estate, control 
means the ownership, directly or indirectly, of more than 50 percent (by 
value) of the beneficial interest in the trust or estate.
    (iv) Direct or indirect ownership. For purposes of section 954(d)(3) 
and this paragraph (f), to determine direct or indirect ownership--
    (A) The principles of Sec. 1.958-1 and section 958(a) apply without 
regard to whether a corporation, partnership, trust, or estate is 
foreign or domestic or whether an individual is a citizen or resident of 
the United States; and
    (B) The principles of Sec. 1.958-2 and section 958(b) apply, except 
that--
    (1) Neither section 318(a)(3), nor Sec. 1.958-2(d) or the 
principles thereof, applies to attribute stock or other interests to a 
corporation, partnership, estate, or trust; and
    (2) Neither section 318(a)(4), nor Sec. 1.958-2(e) or the 
principles thereof, applies to treat dividends, interest, rents, or 
royalties received or accrued from a foreign corporation as received or 
accrued from a controlled foreign corporation payor if a principal 
purpose of the use of an option to acquire stock or an equity interest, 
or an interest similar to such an option, that causes the foreign 
corporation to be a controlled foreign corporation payor is to qualify 
dividends, interest, rents, or royalties paid by the foreign corporation 
for the section 954(c)(6) exception. For purposes of this paragraph 
(f)(2)(iv)(B)(2),

[[Page 275]]

an interest that is similar to an option to acquire stock or an equity 
interest includes, but is not limited to, a warrant, a convertible debt 
instrument, an instrument other than debt that is convertible into stock 
or an equity interest, a put, a stock or equity interest subject to risk 
of forfeiture, and a contract to acquire or sell stock or an equity 
interest.
    (3) Neither section 318(a)(4), nor Sec. 1.958-2(e) or the 
principles thereof, applies to treat a person that has an option to 
acquire stock or an equity interest, or an interest similar to such an 
option, as owning the stock or equity interest if a principal purpose 
for the use of the option or similar interest is to treat a person as a 
related person with respect to a controlled foreign corporation under 
this paragraph (f). For purposes of this paragraph (f)(2)(iv)(B)(3), an 
interest that is similar to an option to acquire stock or an equity 
interest includes, but is not limited to, a warrant, a convertible debt 
instrument, an instrument other than debt that is convertible into stock 
or an equity interest, a put, a stock or equity interest subject to risk 
of forfeiture, and a contract to acquire or sell stock or an equity 
interest.
    (3) Applicability dates--(i) General rule. Except as otherwise 
provided in this paragraph (f)(3), paragraph (f)(2)(iv) of this section 
applies to taxable years of controlled foreign corporations ending on or 
after November 19, 2019, and taxable years of United States shareholders 
in which or with which such taxable years end.
    (ii) Option rule in paragraph (f)(2)(iv)(B)(2) of this section. 
Paragraph (f)(2)(iv)(B)(2) of this section applies to taxable years of 
controlled foreign corporations beginning after December 31, 2006, and 
ending before November 19, 2019, and taxable years of United States 
shareholders in which or with which such taxable years end.
    (iii) Anti-abuse rule. Paragraphs (f)(2)(iv)(B)(1) and (3) of this 
section apply to taxable years of controlled foreign corporations ending 
on or after May 17, 2019, and to taxable years of United States 
shareholders in which or with which such taxable years end, with respect 
to amounts that are received or accrued by a controlled foreign 
corporation on or after May 17, 2019 to the extent the amounts are 
received or accrued in advance of the period to which such amounts are 
attributable with a principal purpose of avoiding the application of 
paragraph (f)(2)(iv)(B)(1) or (3) of this section with respect to such 
amounts.
    (g) Distributive share of partnership income--(1) Application of 
related person and country of organization tests. Unless otherwise 
provided, to determine the extent to which a controlled foreign 
corporation's distributive share of any item of gross income of a 
partnership would have been subpart F income if received by it directly, 
under Sec. 1.952-1(g), if a provision of subpart F requires a 
determination of whether an entity is a related person, within the 
meaning of section 954(d)(3), or whether an activity occurred within or 
outside the country under the laws of which the controlled foreign 
corporation is created or organized, this determination shall be made by 
reference to such controlled foreign corporation and not by reference to 
the partnership.
    (2) Application of related person test for sales and purchase 
transactions between a partnership and its controlled foreign 
corporation partner. For purposes of determining whether a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership is foreign base company sales income under section 
954(d)(1) when the item of income is derived from the sale by the 
partnership of personal property purchased by the partnership from (or 
sold by the partnership on behalf of) the controlled foreign 
corporation; or the sale by the partnership of personal property to (or 
the purchase of personal property by the partnership on behalf of) the 
controlled foreign corporation (CFC-partnership transaction), the CFC-
partnership transaction will be treated as a transaction with an entity 
that is a related person, within the meaning of section 954(d)(3), under 
paragraph (g)(1) of this section, if--
    (i) The controlled foreign corporation purchased such personal 
property from (or sold it to the partnership on behalf of), or sells 
such personal property to (or purchases it from the partnership

[[Page 276]]

on behalf of), a related person with respect to the controlled foreign 
corporation (other than the partnership), within the meaning of section 
954(d)(3); or
    (ii) The branch rule of section 954(d)(2) applies to treat as 
foreign base company sales income the income of the controlled foreign 
corporation from selling to the partnership (or a third party) personal 
property that the controlled foreign corporation has manufactured, in 
the case where the partnership purchases personal property from (or 
sells personal property on behalf of) the controlled foreign 
corporation.
    (3) Examples. The application of this paragraph (g) is illustrated 
by the following examples:

    Example 1. CFC, a controlled foreign corporation organized in 
Country A, is an 80-percent partner in Partnership, a partnership 
organized in Country A. All of the stock of CFC is owned by USP, a U.S. 
corporation. Partnership earns commission income from purchasing Product 
O on behalf of USP, from unrelated manufacturers in Country B, for sale 
in the United States. To determine whether CFC's distributive share of 
Partnership's commission income is foreign base company sales income 
under section 954(d), CFC is treated as if it purchased Product O on 
behalf of USP. Under section 954(d)(3), USP is a related person with 
respect to CFC. Thus, with respect to CFC, the sales income is deemed to 
be derived from the purchase of personal property on behalf of a related 
person. Because the property purchased is both manufactured and sold for 
use outside of Country A, CFC's country of organization, CFC's 
distributive share of the sales income is foreign base company sales 
income.
    Example 2. (i) CFC1, a controlled foreign corporation organized in 
Country A, is an 80-percent partner in Partnership, a partnership 
organized in Country B. CFC2, a controlled foreign corporation organized 
in Country B, owns the remaining 20 percent interest in Partnership. 
CFC1 and CFC2 are owned by a common U.S. parent, USP. CFC2 manufactures 
Product A in Country B. Partnership earns sales income from purchasing 
Product A from CFC2 and selling it to third parties located in Country B 
that are not related persons with respect to CFC1 or CFC2. To determine 
whether CFC1's distributive share of Partnership's sales income is 
foreign base company sales income under section 954(d), CFC1 is treated 
as if it purchased Product A from CFC2 and sold it to third parties in 
Country B. Under section 954(d)(3), CFC2 is a related person with 
respect to CFC1. Thus, with respect to CFC1, the sales income is deemed 
to be derived from the purchase of personal property from a related 
person. Because the property purchased is both manufactured and sold for 
use outside of Country A, CFC1's country of organization, CFC1's 
distributive share of the sales income is foreign base company sales 
income.
    (ii) Because Product A is both manufactured and sold for use within 
CFC2's country of organization, CFC2's distributive share of 
Partnership's sales income is not foreign base company sales income.
    Example 3. CFC, a controlled foreign corporation organized in 
Country A, is an 80 percent partner in MJK Partnership, a Country B 
partnership. CFC purchased goods from J Corp, a Country C corporation 
that is a related person with respect to CFC. CFC sold the goods to MJK 
Partnership. In turn, MJK Partnership sold the goods to P Corp, a 
Country D corporation that is unrelated to CFC. P Corp sold the goods to 
unrelated customers in Country D. The goods were manufactured in Country 
C by persons unrelated to J Corp . CFC's distributive share of the 
income of MJK Partnership from the sale of goods to P Corp will be 
treated as income from the sale of goods purchased from a related person 
for purposes of section 954(d)(1) because CFC purchased the goods from J 
Corp, a related person. Because the goods were both manufactured and 
sold for use outside of Country A, CFC's distributive share of the 
income attributable to the sale of the goods is foreign base company 
sales income. Further, CFC's income from the sale of the goods to MJK 
Partnership will also be foreign base company sales income.
    Example 4. The facts are the same as Example 3, except that MJK 
Partnership purchased the goods from P Corp and sold those goods to CFC. 
CFC sold the goods to J Corp. J Corp sold the goods to unrelated 
customers in Country C. CFC's distributive share of the income of MJK 
Partnership from the sale of the goods by the partnership to itself will 
be treated as income from the sale of goods to a related person, for 
purposes of section 954(d)(1). Because the goods were both manufactured 
and sold for use outside of Country A, CFC's distributive share of 
income attributable to the sale of the goods is foreign base company 
sales income. Further, CFC's income from the sale of the goods to J Corp 
is also foreign base company sales income.

    (h) Applicability dates--(1) Paragraph (d)(3) of this section. 
Paragraph (d)(3) of this section applies to taxable years of a 
controlled foreign corporation ending on or after December 16, 2019. For 
taxable years of a controlled foreign corporation ending on or after 
December 4, 2018, but ending before December 16, 2019, see Sec. 1.954-
1(d)(3) as contained in 26 CFR part 1 revised as of April 1, 2019.

[[Page 277]]

    (2) Paragraph (g) of this section. Paragraph (g) of this section 
applies to taxable years of a controlled foreign corporation beginning 
on or after July 23, 2002.
    (3) Paragraphs (c)(1)(iii)(A)(3), (c)(1)(iv), and (d)(3)(i) of this 
section for taxable years beginning on or after July 23, 2020. 
Paragraphs (c)(1)(iii)(A)(3), (c)(1)(iv), and (d)(3)(i) of this section 
apply to taxable years of a controlled foreign corporation beginning on 
or after July 23, 2020, and to taxable years of United States 
shareholders in which or with which such taxable years of foreign 
corporations end. In addition, taxpayers may choose to apply the rules 
in paragraphs (c)(1)(iii)(A)(3), (c)(1)(iv), and (d)(3)(i) of this 
section to taxable years of controlled foreign corporations that begin 
after December 31, 2017, and before July 23, 2020, and to taxable years 
of United States shareholders in which or with which such taxable years 
of the controlled foreign corporations end, provided that they 
consistently apply those rules and the rules in Sec. 1.951A-
2(c)(1)(iii), (c)(3)(ii), and (c)(7) and (8) to such taxable years.

[T.D. 8618, 60 FR 46509, Sept. 7, 1995; 60 FR 62024, 62025, Dec. 4, 
1995, as amended by T.D. 8704, 62 FR 20, Jan. 2, 1997; T.D. 8767, 63 FR 
14615, Mar. 26, 1998; T.D. 8827, 64 FR 37677, July 13, 1999; T.D. 9008, 
67 FR 48023, July 23, 2002; T.D. 9883, 84 FR 63803, Nov. 19, 2019; T.D. 
9882, 84 FR 69107, Dec. 17, 2019; T.D. 9902, 85 FR 44649, July 23, 2020; 
T.D. 9922, 85 FR 72070, Nov. 12, 2020]



Sec. 1.954-2  Foreign personal holding company income.

    (a) Computation of foreign personal holding company income--(1) 
Categories of foreign personal holding company income. For purposes of 
subpart F and the regulations under that subpart, foreign personal 
holding company income consists of the following categories of income--
    (i) Dividends, interest, rents, royalties, and annuities as 
described in paragraph (b) of this section;
    (ii) Gain from certain property transactions as described in 
paragraph (e) of this section;
    (iii) Gain from commodities transactions as described in paragraph 
(f) of this section;
    (iv) Foreign currency gain as described in paragraph (g) of this 
section; and
    (v) Income equivalent to interest as described in paragraph (h) of 
this section.
    (2) Coordination of overlapping categories under foreign personal 
holding company provisions--(i) In general. If any portion of income, 
gain or loss from a transaction is described in more than one category 
of foreign personal holding company income (as described in paragraph 
(a)(2)(ii) of this section), that portion of income, gain or loss is 
treated solely as income, gain or loss from the category of foreign 
personal holding company income with the highest priority.
    (ii) Priority of categories. The categories of foreign personal 
holding company income, listed from highest priority (paragraph 
(a)(2)(ii)(A) of this section) to lowest priority (paragraph 
(a)(2)(ii)(E) of this section), are--
    (A) Dividends, interest, rents, royalties, and annuities, as 
described in paragraph (b) of this section;
    (B) Income equivalent to interest, as described in paragraph (h) of 
this section without regard to the exceptions in paragraph (h)(1)(ii)(A) 
of this section;
    (C) Foreign currency gain or loss, as described in paragraph (g) of 
this section without regard to the exclusion in paragraph (g)(2)(ii) of 
this section;
    (D) Gain or loss from commodities transactions, as described in 
paragraph (f) of this section without regard to the exclusion in 
paragraph (f)(1)(ii) of this section; and
    (E) Gain or loss from certain property transactions, as described in 
paragraph (e) of this section without regard to the exceptions in 
paragraph (e)(1)(ii) of this section.
    (3) Changes in the use or purpose for which property is held--(i) In 
general. Under paragraphs (e), (f), (g) and (h) of this section, 
transactions in certain property give rise to gain or loss included in 
the computation of foreign personal holding company income if the 
controlled foreign corporation holds that property for a particular use 
or purpose. The use or purpose for which property is held is that use or 
purpose for which it was held for more

[[Page 278]]

than one- half of the period during which the controlled foreign 
corporation held the property prior to the disposition.
    (ii) Special rules--(A) Anti-abuse rule. If a principal purpose of a 
change in use or purpose of property was to avoid including gain or loss 
in the computation of foreign personal holding company income, all the 
gain or loss from the disposition of the property is treated as foreign 
personal holding company income. A purpose may be a principal purpose 
even though it is outweighed by other purposes (taken together or 
separately).
    (B) Hedging transactions. The provisions of paragraph (a)(3)(i) of 
this section shall not apply to bona fide hedging transactions, as 
defined in paragraph (a)(4)(ii) of this section. A transaction will be 
treated as a bona fide hedging transaction only so long as it satisfies 
the requirements of paragraph (a)(4)(ii) of this section.
    (iii) Example. The following example illustrates the application of 
this paragraph (a)(3).

    Example. At the beginning of taxable year 1, CFC, a controlled 
foreign corporation, purchases a building for investment. During taxable 
years 1 and 2, CFC derives rents from the building that are included in 
the computation of foreign personal holding company income under 
paragraph (b)(1)(iii) of this section. At the beginning of taxable year 
3, CFC changes the use of the building by terminating all leases and 
using it in an active trade or business. At the beginning of taxable 
year 4, CFC sells the building at a gain. The building was not used in 
an active trade or business of CFC for more than one-half of the period 
during which it was held by CFC. Therefore, the building is considered 
to be property that gives rise to rents, as described in paragraph 
(e)(2) of this section, and gain from the sale is included in the 
computation of CFC's foreign personal holding company income under 
paragraph (e) of this section.

    (4) Definitions and special rules. The following definitions and 
special rules apply for purposes of computing foreign personal holding 
company income under this section.
    (i) Interest. The term interest includes all amounts that are 
treated as interest income (including interest on a tax-exempt 
obligation) by reason of the Internal Revenue Code or Income Tax 
Regulations or any other provision of law. For example, interest 
includes stated interest, acquisition discount, original issue discount, 
de minimis original issue discount, market discount, de minimis market 
discount, and unstated interest, as adjusted by any amortizable bond 
premium or acquisition premium.
    (ii) Bona fide hedging transaction--(A) Definition. The term bona 
fide hedging transaction means a transaction that meets the requirements 
of Sec. 1.1221-2 (a) through (d) and that is identified in accordance 
with the requirements of paragraph (a)(4)(ii)(B) of this section, except 
that in applying Sec. 1.1221-2(b)(1), the risk being hedged may be with 
respect to ordinary property, section 1231 property, or a section 988 
transaction. A transaction that hedges the liabilities, inventory or 
other assets of a related person (as defined in section 954(d)(3)), that 
is entered into to assume or reduce risks of a related person, or that 
is entered into by a person other than a person acting in its capacity 
as a regular dealer (as defined in paragraph (a)(4)(iv) of this section) 
to reduce risks assumed from a related person, will not be treated as a 
bona fide hedging transaction. For an illustration of how this rule 
applies with respect to foreign currency transactions, see paragraph 
(g)(2)(ii)(D) of this section.
    (B) Identification. The identification requirements of this section 
shall be satisfied if the taxpayer meets the identification and 
recordkeeping requirements of Sec. 1.1221-2(f). However, for bona fide 
hedging transactions entered into prior to March 7, 1996 the 
identification and recordkeeping requirements of Sec. 1.1221-2 shall 
not apply. Rather, for bona fide hedging transactions entered into on or 
after July 22, 1988 and prior to March 7, 1996 the identification and 
recordkeeping requirements shall be satisfied if such transactions are 
identified by the close of the fifth day after the day on which they are 
entered into. For bona fide hedging transactions entered into prior to 
July 22, 1988, the identification and recordkeeping requirements shall 
be satisfied if such transactions are identified reasonably 
contemporaneously with the date they are entered into,

[[Page 279]]

but no later than within the normal period prescribed under the method 
of accounting of the controlled foreign corporation used for financial 
reporting purposes.
    (C) Effect of identification and non-identification--(1) 
Transactions identified. If a taxpayer identifies a transaction as a 
bona fide hedging transaction for purposes of this section, the 
identification is binding with respect to any loss arising from such 
transaction whether or not all of the requirements of paragraph 
(a)(4)(ii)(A) of this section are satisfied. Accordingly, such loss will 
be allocated against income that is not subpart F income (or, in the 
case of an election under paragraph (g)(3) of this section, against the 
category of subpart F income to which it relates) and apportioned among 
the categories of income described in section 904(d)(1). If the 
transaction is not in fact a bona fide hedging transaction described in 
paragraph (a)(4)(ii)(A) of this section, however, then any gain realized 
with respect to such transaction shall not be considered as gain from a 
bona fide hedging transaction. Accordingly, such gain shall be treated 
as gain from the appropriate category of foreign personal holding 
company income. Thus, the taxpayer's identification of the transaction 
as a hedging transaction does not itself operate to exclude gain from 
the appropriate category of foreign personal holding company income.
    (2) Inadvertent identification. Notwithstanding paragraph 
(a)(4)(ii)(C)(1) of this section, if the taxpayer identifies a 
transaction as a bona fide hedging transaction for purposes of this 
section, the characterization of the loss is determined as if the 
transaction had not been identified as a bona fide hedging transaction 
if--
    (i) The transaction is not a bona fide hedging transaction (as 
defined in paragraph (a)(4)(ii)(A) of this section);
    (ii) The identification of the transaction as a bona fide hedging 
transaction was due to inadvertent error; and
    (iii) All of the taxpayer's transactions in all open years are being 
treated on either original or, if necessary, amended returns in a manner 
consistent with the principles of this section.
    (3) Transactions not identified. Except as provided in paragraphs 
(a)(4)(ii)(C)(4) and (5) of this section, the absence of an 
identification that satisfies the requirements of paragraph 
(a)(4)(ii)(B) of this section is binding and establishes that a 
transaction is not a bona fide hedging transaction. Thus, subject to the 
exceptions, the characterization of gain or loss is determined without 
reference to whether the transaction is a bona fide hedging transaction.
    (4) Inadvertent error. If a taxpayer does not make an identification 
that satisfies the requirements of paragraph (a)(4)(ii)(B) of this 
section, the taxpayer may treat gain or loss from the transaction as 
gain or loss from a bona fide hedging transaction if--
    (i) The transaction is a bona fide hedging transaction (as defined 
in paragraph (a)(4)(ii)(A) of this section);
    (ii) The failure to identify the transaction was due to inadvertent 
error; and
    (iii) All of the taxpayer's bona fide hedging transactions in all 
open years are being treated on either original or, if necessary, 
amended returns as bona fide hedging transactions in accordance with the 
rules of this section.
    (5) Anti-abuse rule. If a taxpayer does not make an identification 
that satisfies all the requirements of paragraph (a)(4)(ii)(B) of this 
section but the taxpayer has no reasonable grounds for treating the 
transaction as other than a bona fide hedging transaction, then loss 
from the transaction shall be treated as realized with respect to a bona 
fide hedging transaction. Thus, a taxpayer may not elect to exclude loss 
from its proper characterization as a bona fide hedging transaction. The 
reasonableness of the taxpayer's failure to identify a transaction is 
determined by taking into consideration not only the requirements of 
paragraph (a)(4)(ii)(A) of this section but also the taxpayer's 
treatment of the transaction for financial accounting or other purposes 
and the taxpayer's identification of similar transactions as hedging 
transactions.
    (iii) Inventory and similar property--(A) Definition. The term 
inventory and similar property (or inventory or similar property) means 
property that is stock in trade of the controlled foreign corporation or 
other property of a kind

[[Page 280]]

that would properly be included in the inventory of the controlled 
foreign corporation if on hand at the close of the taxable year (if the 
controlled foreign corporation were a domestic corporation), or property 
held by the controlled foreign corporation primarily for sale to 
customers in the ordinary course of its trade or business.
    (B) Hedging transactions. A bona fide hedging transaction with 
respect to inventory or similar property (other than a transaction 
described in section 988(c)(1) without regard to section 
988(c)(1)(D)(i)) shall be treated as a transaction in inventory or 
similar property.
    (iv) Regular dealer. The term regular dealer means a controlled 
foreign corporation that--
    (A) Regularly and actively offers to, and in fact does, purchase 
property from and sell property to customers who are not related persons 
(as defined in section 954(d)(3)) with respect to the controlled foreign 
corporation in the ordinary course of a trade or business; or
    (B) Regularly and actively offers to, and in fact does, enter into, 
assume, offset, assign or otherwise terminate positions in property with 
customers who are not related persons (as defined in section 954(d)(3)) 
with respect to the controlled foreign corporation in the ordinary 
course of a trade or business.
    (v) Dealer property--(A) Definition. Property held by a controlled 
foreign corporation is dealer property if--
    (1) The controlled foreign corporation is a regular dealer in 
property of such kind (determined under paragraph (a)(4)(iv) of this 
section); and
    (2) The property is held by the controlled foreign corporation in 
its capacity as a dealer in property of such kind without regard to 
whether the property arises from a transaction with a related person (as 
defined in section 954(d)(3)) with respect to the controlled foreign 
corporation. The property is not held by the controlled foreign 
corporation in its capacity as a dealer if the property is held for 
investment or speculation on its own behalf or on behalf of a related 
person (as defined in section 954(d)(3)).
    (B) Securities dealers. If a controlled foreign corporation is a 
licensed securities dealer, only the securities that it has identified 
as held for investment in accordance with the provisions of section 
475(b) or section 1236 will be considered to be property held for 
investment or speculation under this section. A licensed securities 
dealer is a controlled foreign corporation that is both a securities 
dealer, as defined in section 475, and a regular dealer, as defined in 
paragraph (a)(4)(iv) of this section, and that is either--
    (1) Registered as a securities dealer under section 15(a) of the 
Securities Exchange Act of 1934 or as a Government securities dealer 
under section 15C(a) of such Act; or
    (2) Licensed or authorized in the country in which it is chartered, 
incorporated, or organized to purchase and sell securities from or to 
customers who are residents of that country. The conduct of such 
securities activities must be subject to bona fide regulation, including 
appropriate reporting, monitoring, and prudential (including capital 
adequacy) requirements, by a securities regulatory authority in that 
country that regularly enforces compliance with such requirements and 
prudential standards.
    (C) Hedging transactions. A bona fide hedging transaction with 
respect to dealer property shall be treated as a transaction in dealer 
property.
    (vi) Examples. The following examples illustrate the application of 
paragraphs (a)(4)(ii), (iv) and (v) of this section.

    Example 1. (i) CFC1 and CFC2 are related controlled foreign 
corporations (within the meaning of section 954(d)(3)) located in 
Countries F and G, respectively. CFC1 and CFC2 regularly purchase 
securities from and sell securities to customers who are not related 
persons with respect to CFC1 or CFC2 (within the meaning of section 
954(d)(3)) in the ordinary course of their businesses and regularly and 
actively hold themselves out as being willing to, and in fact do, enter 
into either side of options, forward contracts, or other financial 
instruments. CFC1 uses securities that are traded in securities markets 
in Country G to hedge positions that it enters into with customers 
located in Country F. CFC1 is not a member of a securities exchange in 
Country G, so it purchases such securities from CFC2 and unrelated 
persons that are registered as securities dealers in Country G and that 
are members of Country

[[Page 281]]

G securities exchanges. Such hedging transactions qualify as bona fide 
hedging transactions under paragraph (a)(4)(ii) of this section.
    (ii) Transactions that CFC1 and CFC2 enter into with each other do 
not affect the determination of whether they are regular dealers. 
Because CFC1 and CFC2 regularly purchase securities from and sell 
securities to customers who are not related persons within the meaning 
of section 954(d)(3) in the ordinary course of their businesses and 
regularly and actively hold themselves out as being willing to, and in 
fact do, enter into either side of options, forward contracts, or other 
financial instruments, however, they qualify as regular dealers in such 
property within the meaning of paragraph (a)(4)(iv) of this section. 
Moreover, because CFC1 purchases securities from CFC2 as bona fide 
hedging transactions with respect to dealer property, the securities are 
dealer property under paragraph (a)(4)(v)(C) of this section. Similarly, 
because CFC2 sells securities to CFC1 in the ordinary course of its 
business as a dealer, the securities are dealer property under paragraph 
(a)(4)(v)(A) of this section.
    Example 2. (i) CFC is a controlled foreign corporation located in 
Country B. CFC serves as the currency coordination center for the 
controlled group, aggregating currency risks incurred by the group and 
entering into hedging transactions that transfer those risks outside of 
the group. CFC regularly and actively holds itself out as being willing 
to, and in fact does, enter into either side of options, forward 
contracts, or other financial instruments with other members of the same 
controlled group. CFC hedges risks arising from such transactions by 
entering into transactions with persons who are not related persons 
(within the meaning of section 954(d)(3)) with respect to CFC. However, 
CFC does not regularly and actively hold itself out as being willing to, 
and does not, enter into either side of transactions with unrelated 
persons.
    (ii) CFC is not a regular dealer in property under paragraph 
(a)(4)(iv) of this section and its options, forwards, and other 
financial instruments are not dealer property within the meaning of 
paragraph (a)(4)(v) of this section.

    (vii) Debt instrument. The term debt instrument includes bonds, 
debentures, notes, certificates, accounts receivable, and other 
evidences of indebtedness.
    (5) Special rules applicable to distributive share of partnership 
income--(i) [Reserved]
    (ii) Certain other exceptions applicable to foreign personal holding 
company income. To determine the extent to which a controlled foreign 
corporation's distributive share of an item of income of a partnership 
is foreign personal holding company income--
    (A) The exceptions contained in section 954(c) that are based on 
whether the controlled foreign corporation is engaged in the active 
conduct of a trade or business, including section 954(c)(2) and 
paragraphs (b)(2) and (6), (e)(1)(ii) and (3)(ii), (iii) and (iv), 
(f)(1)(ii), (g)(2)(ii), and (h)(3)(ii) of this section, shall apply only 
if any such exception would have applied to exclude the income from 
foreign personal holding company income if the controlled foreign 
corporation had earned the income directly, determined by taking into 
account only the activities of, and property owned by, the partnership 
and not the separate activities or property of the controlled foreign 
corporation or any other person;
    (B) A controlled foreign corporation's distributive share of 
partnership income will not be excluded from foreign personal holding 
company income under the exception contained in section 954(h) unless 
the controlled foreign corporation is an eligible controlled foreign 
corporation within the meaning of section 954(h)(2) (taking into account 
the income of the controlled foreign corporation and any partnerships or 
other qualified business units, within the meaning of section 989(a), of 
the controlled foreign corporation, including the controlled foreign 
corporation's distributive share of partnership income) and the 
partnership, of which the controlled foreign corporation is a partner, 
generates qualified banking or financing income within the meaning of 
section 954(h)(3) (taking into account only the income of the 
partnership);
    (C) A controlled foreign corporation's distributive share of 
partnership income will not be excluded from foreign personal holding 
company income under the exception contained in section 954(i) unless 
the controlled foreign corporation is a qualifying insurance company, as 
defined in section 953(e)(3), and the income of the partnership would 
have been qualified insurance income, as defined in section 954(i)(2), 
if received by the controlled foreign corporation directly. See Sec. 
1.952-1(g)(1).

[[Page 282]]

    (iii) Examples. The application of paragraph (a)(5)(ii) is 
demonstrated by the following examples:

    Example 1. B Corp, a Country C corporation, is a controlled foreign 
corporation within the meaning of section 957(a). B Corp is an 80 
percent partner of RKS Partnership, a Country D partnership whose 
principal office is located in Country D. RKS Partnership is a qualified 
business unit of B Corp, within the meaning of section 989(a). B Corp, 
including income earned through RKS Partnership, derives more than 70 
percent of its gross income directly from the active and regular conduct 
of a lending or finance business, within the meaning of section 
954(h)(4), from transactions in various countries with customers which 
are not related persons. Thus, B Corp is predominantly engaged in the 
active conduct of a banking, financing, or similar business within the 
meaning of section 954(h)(2)(A)(i). B Corp conducts substantial activity 
with respect to such business within the meaning of section 
954(h)(2)(A)(ii). RKS Partnership derives more than 30 percent of its 
income from the active and regular conduct of a lending or finance 
business, within the meaning of section 954(h)(4), from transactions 
with customers which are not related persons and which are located 
solely within the home country of RKS Partnership, Country D. B Corp's 
distributive share of RKS Partnership's income from its lending or 
finance business will satisfy the special rule for income derived in the 
active conduct of banking, financing, or similar business of section 
954(h). B Corp is an eligible controlled foreign corporation within the 
meaning of section 954(h)(2) and RKS Partnership generates qualified 
banking or financing income within the meaning of section 954(h)(3). B 
Corp does not have any foreign personal holding company income with 
respect to its distributive share of RKS Partnership income attributable 
to its lending or finance business income earned in Country D.
    Example 2. D Corp, a Country F corporation, is a controlled foreign 
corporation within the meaning of section 957(a). D Corp is a qualifying 
insurance company, within the meaning of section 953(e)(3), that is 
engaged in the business of issuing life insurance contracts. D Corp has 
reserves of $100x, all of which are allocable to exempt contracts, and 
$10x of surplus, which is equal to 10 percent of the reserves allocable 
to exempt contracts. D Corp contributed the $100x of reserves and $10x 
of surplus to DJ Partnership in exchange for a 40-percent partnership 
interest. DJ Partnership is an entity organized under the laws of 
Country G and is treated as a partnership under the laws of Country G 
and Country F. DJ Partnership earns $30x of investment income during the 
taxable year that is received from persons who are not related persons 
with respect to D Corp, within the meaning of section 954(d)(3). D 
Corp's distributive share of this investment income is $12x. This income 
is treated as earned by D Corp in Country F under the tax laws of 
Country F and meets the definition of exempt insurance income in section 
953(e)(1). This $12x of investment income would be qualified insurance 
income, under section 954(i)(2), if D Corp had received the income 
directly, because the $110x invested by D Corp in DJ Partnership is 
equal to D Corp's reserves allocable to exempt contracts under section 
954(i)(2)(A) and allowable surplus under section 954(i)(2)(B)(ii). Thus, 
D Corp's distributive share of DJ Partnership's income will be excluded 
from foreign personal holding company income under section 954(i).

    (iv) [Reserved]
    (v) Effective date. This paragraph (a)(5) applies to taxable years 
of a controlled foreign corporation beginning on or after July 23, 2002.
    (b) Dividends, interest, rents, royalties, and annuities--(1) In 
general. Foreign personal holding company income includes--
    (i) Dividends, except certain dividends from related persons as 
described in paragraph (b)(4) of this section and distributions of 
previously taxed income under section 959(b);
    (ii) Interest, except export financing interest as defined in 
paragraph (b)(2) of this section and certain interest received from 
related persons as described in paragraph (b)(4) of this section;
    (iii) Rents and royalties, except certain rents and royalties 
received from related persons as described in paragraph (b)(5) of this 
section and rents and royalties derived in the active conduct of a trade 
or business as defined in paragraph (b)(6) of this section; and
    (iv) Annuities.
    (2) Exclusion of certain export financing interest--(i) In general. 
Foreign personal holding company income does not include interest that 
is export financing interest. The term export financing interest means 
interest that is derived in the conduct of a banking business and is 
export financing interest as defined in section 904(d)(2)(G). Solely for 
purposes of determining whether interest is export financing interest, 
property is treated as manufactured, produced, grown, or extracted in 
the United

[[Page 283]]

States if it is so treated under Sec. 1.927(a)-1T(c).
    (ii) Exceptions. Export financing interest does not include income 
from related party factoring that is treated as interest under section 
864(d)(1) or (6) after the application of section 864(d)(7).
    (iii) Conduct of a banking business. For purposes of this section, 
export financing interest is considered derived in the conduct of a 
banking business if, in connection with the financing from which the 
interest is derived, the corporation, through its own officers or staff 
of employees, engages in all the activities in which banks customarily 
engage in issuing and servicing a loan.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (b)(2).

    Example 1. (i) DS, a domestic corporation, manufactures property in 
the United States. In addition to selling inventory (property described 
in section 1221(1)), DS occasionally sells depreciable equipment it 
manufactures for use in its trade or business, which is property 
described in section 1221(2). Less than 50 percent of the fair market 
value, determined in accordance with section 904(d)(2)(G), of each item 
of inventory or equipment sold by DS is attributable to products 
imported into the United States. CFC, a controlled foreign corporation 
with respect to which DS is a related person (within the meaning of 
section 954(d)(3)), provides loans described in section 864(d)(6) to 
unrelated persons for the purchase of property from DS. This property is 
purchased exclusively for use or consumption outside the United States 
and outside CFC's country of incorporation.
    (ii) If, in issuing and servicing loans made with respect to 
purchases from DS of depreciable equipment used in its trade or 
business, which is property described in section 1221(2) in the hands of 
DS, CFC engages in all the activities in which banks customarily engage 
in issuing and servicing loans, the interest accrued from these loans 
would be export financing interest meeting the requirements of this 
paragraph (b)(2) and, thus, not included in foreign personal holding 
company income. However, interest from the loans made with respect to 
purchases from DS of property that is inventory in the hands of DS 
cannot be export financing interest because it is treated as income from 
a trade or service receivable under section 864(d)(6) and the exception 
under section 864(d)(7) does not apply. Thus the interest from loans 
made with respect to this inventory is included in foreign personal 
holding company income under paragraph (b)(1)(ii) of this section.
    Example 2. (i) DS, a domestic corporation, wholly owns two 
controlled foreign corporations organized in Country A, CFC1 and CFC2. 
CFC1 purchases from DS property that DS manufactures in the United 
States. CFC1 uses the purchased property as a component part of property 
that CFC1 manufactures in Country A within the meaning of Sec. 1.954-
3(a)(4). CFC2 provides loans described in section 864(d)(6) to unrelated 
persons in Country A for the purchase of the property that CFC1 
manufactures in Country A.
    (ii) The interest accrued from the loans by CFC2 is not export 
financing interest as defined in section 904(d)(2)(G) because the 
property sold by CFC1 is not manufactured in the United States under 
Sec. 1.927(a)-1T(c). No portion of the interest is export financing 
interest as defined in this paragraph (b)(2). The full amount of the 
interest is, therefore, included in foreign personal holding company 
income under paragraph (b)(1)(ii) of this section.

    (3) Treatment of tax exempt interest. For taxable years of a 
controlled foreign corporation beginning after March 3, 1997, foreign 
personal holding company income includes all interest income, including 
interest that is described in section 103 (see Sec. 1.952-2(c)(1)).
    (4) Exclusion of dividends or interest from related persons--(i) In 
general--(A) Corporate payor. Foreign personal holding company income 
received by a controlled foreign corporation does not include dividends 
or interest if the payor--
    (1) Is a corporation that is a related person with respect to the 
controlled foreign corporation, as defined in section 954(d)(3);
    (2) Is created or organized under the laws of the same foreign 
country (the country of incorporation) as is the controlled foreign 
corporation; and
    (3) Uses a substantial part of its assets in a trade or business in 
its country of incorporation, as determined under this paragraph (b)(4).
    (B) Payment by a partnership. For purposes of this paragraph (b)(4), 
if a partnership with one or more corporate partners makes a payment of 
interest, a corporate partner will be treated as the payor of the 
interest--
    (1) If the interest payment gives rise to a partnership item of 
deduction under the Internal Revenue Code or Income Tax Regulations, to 
the extent

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that the item of deduction is allocable to the corporate partner under 
section 704(b); or
    (2) If the interest payment does not give rise to a partnership item 
of deduction under the Internal Revenue Code or Income Tax Regulations, 
to the extent that a partnership item reasonably related to the payment 
would be allocated to that partner under an existing allocation under 
the partnership agreement (made pursuant to section 704(b)).
    (ii) Exceptions--(A) Dividends. Dividends are excluded from foreign 
personal holding company income under this paragraph (b)(4) only to the 
extent that they are paid out of earnings and profits that are earned or 
accumulated during a period in which--
    (1) The stock on which dividends are paid with respect to which the 
exclusion is claimed was owned by the recipient controlled foreign 
corporation directly, or indirectly through a chain of one or more 
subsidiaries each of which meets the requirements of paragraph 
(b)(4)(i)(A) of this section; and
    (2) Each of the requirements of paragraph (b)(4)(i)(A) of this 
section is satisfied or, to the extent earned or accumulated during a 
taxable year of the related foreign corporation ending on or before 
December 31, 1962, during a period in which the payor was a related 
corporation as to the controlled foreign corporation and the other 
requirements of paragraph (b)(4)(i)(A) of this section were 
substantially satisfied.
    (3) This paragraph (b)(4)(ii)(A) is illustrated by the following 
example:

    Example. A, a domestic corporation, owns all of the stock of B, a 
corporation created and organized under the laws of Country Y, and C, a 
corporation created and organized under the laws of Country X. The 
taxable year of each of the corporations is the calendar year. In Year 
1, B earns $100 of income from the sale of products in Country Y that it 
manufactured in Country Y. C had no earnings and profits in Year 1. On 
January 1 of Year 2, A contributes all of the stock of B and C to Newco, 
a Country Y corporation, in exchange for all of the stock of Newco. 
Neither B nor C earns any income in Year 2, but at the end of Year 2 B 
distributes the $100 accumulated earnings and profits to Newco. Newco's 
income from the distribution, $100, is foreign personal holding company 
income because the earnings and profits distributed by B were not earned 
or accumulated during a period in which the stock of B was owned by 
Newco and in which each of the requirements of paragraph (b)(4)(i)(A) of 
this section was satisfied.

    (B) Interest paid out of adjusted foreign base company income or 
insurance income--(1) In general. Interest may not be excluded from the 
foreign personal holding company income of the recipient under this 
paragraph (b)(4) to the extent that the deduction for the interest is 
allocated under Sec. 1.954-1(a)(4) and (c) to the payor's adjusted 
gross foreign base company income (as defined in Sec. 1.954-1(a)(3)), 
adjusted gross insurance income (as defined in Sec. 1.954-1(a)(6)), or 
any other category of income included in the computation of subpart F 
income under section 952(a).
    (2) Rule for corporations that are both recipients and payors of 
interest. If a controlled foreign corporation is both a recipient and 
payor of interest, the interest that is received will be characterized 
before the interest that is paid. In addition, the amount of interest 
paid or accrued, directly or indirectly, by the controlled foreign 
corporation to a related person (as defined in section 954(d)(3)) shall 
be offset against and eliminate any interest received or accrued, 
directly or indirectly, by the controlled foreign corporation from that 
related person. In a case in which the controlled foreign corporation 
pays or accrues interest to a related person, as defined in section 
954(d)(3), and also receives or accrues interest indirectly from the 
related person, the smallest interest payment is eliminated and the 
amounts of all other interest payments are reduced by the amount of the 
smallest interest payment.
    (C) Coordination with sections 864(d) and 881(c). Income of a 
controlled foreign corporation that is treated as interest under section 
864(d)(1) or (6), or that is portfolio interest, as defined by section 
881(c), is not excluded from foreign personal holding company income 
under section 954(c)(3)(A)(i) and this paragraph (b)(4).
    (iii) Trade or business requirement. Except as otherwise provided 
under this paragraph (b)(4), the principles of section 367(a) apply for 
purposes of determining whether the payor has a trade or business in its 
country of incorporation and whether its assets are used in

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that trade or business. Property purchased or produced for use in a 
trade or business is not considered used in a trade or business before 
it is placed in service or after it is retired from service as 
determined in accordance with the principles of sections 167 and 168.
    (iv) Substantial assets test. A substantial part of the assets of 
the payor will be considered to be used in a trade or business located 
in the payor's country of incorporation for a taxable year only if the 
average value of the payor's assets for such year that are used in the 
trade or business and are located in such country equals more than 50 
percent of the average value of all the assets of the payor (including 
assets not used in a trade or business). The average value of assets for 
the taxable year is determined by averaging the values of assets at the 
close of each quarter of the taxable year. The value of assets is 
determined under paragraph (b)(4)(v) of this section, and the location 
of assets used in a trade or business of the payor is determined under 
paragraphs (b)(4)(vi) through (xi) of this section.
    (v) Valuation of assets. For purposes of determining whether a 
substantial part of the assets of the payor are used in a trade or 
business in its country of incorporation, the value of assets shall be 
their fair market value (not reduced by liabilities), which, in the 
absence of affirmative evidence to the contrary, shall be deemed to be 
their adjusted basis.
    (vi) Location of tangible property--(A) In general. Tangible 
property (other than inventory and similar property as defined in 
paragraph (a)(4)(iii) of this section, and dealer property as defined in 
paragraph (a)(4)(v) of this section) used in a trade or business is 
considered located in the country in which it is physically located.
    (B) Exception. An item of tangible personal property that is used in 
the trade or business of a payor in the payor's country of incorporation 
is considered located within the payor's country of incorporation while 
it is temporarily located elsewhere for inspection or repair if the 
property is not placed in service in a country other than the payor's 
country of incorporation and is not to be so placed in service following 
the inspection or repair.
    (vii) Location of intangible property--(A) In general. Intangible 
property (other than inventory and similar property as defined in 
paragraph (a)(4)(iii) of this section, dealer property as defined in 
paragraph (a)(4)(v) of this section, and debt instruments) is considered 
located entirely in the payor's country of incorporation for a quarter 
of the taxable year only if the payor conducts all of its activities in 
connection with the use or exploitation of the property in that country 
during that entire quarter. For this purpose, the country in which the 
activities connected to the use or exploitation of the property are 
conducted is the country in which the expenses associated with these 
activities are incurred. Expenses incurred in connection with the use or 
exploitation of an item of intangible property are included in the 
computation provided by this paragraph (b)(4) if they would be 
deductible under section 162 or includible in inventory costs or the 
cost of goods sold if the payor were a domestic corporation. If the 
payor conducts such activities through an agent or independent 
contractor, then the expenses incurred by the payor with respect to the 
agent or independent contractor shall be deemed to be incurred by the 
payor in the country in which the expenses of the agent or independent 
contractor were incurred by the agent or independent contractor.
    (B) Exception for property located in part in the payor's country of 
incorporation. If the payor conducts its activities in connection with 
the use or exploitation of an item of intangible property, including 
goodwill (other than inventory and similar property, dealer property and 
debt instruments) during a quarter of the taxable year both in its 
country of incorporation and elsewhere, then the value of the intangible 
considered located in the payor's country of incorporation during that 
quarter is a percentage of the value of the item as of the close of the 
quarter. That percentage equals the ratio that the expenses incurred by 
the payor (described in paragraph (b)(4)(vii)(A) of this section) during 
the entire quarter by reason of activities that are connected with the 
use or exploitation of the item of intangible property and are

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conducted in the payor's country of incorporation bear to all expenses 
incurred by the payor during the entire quarter by reason of all such 
activities worldwide.
    (viii) Location of inventory and dealer property--(A) In general. 
Inventory and similar property, as defined in paragraph (a)(4)(iii) of 
this section, and dealer property, as defined in paragraph (a)(4)(v) of 
this section, are considered located entirely in the payor's country of 
incorporation for a quarter of the taxable year only if the payor 
conducts all of its activities in connection with the production and 
sale, or purchase and resale, of such property in its country of 
incorporation during that entire quarter. If the payor conducts such 
activities through an agent or independent contractor, then the location 
of such activities is the place in which they are conducted by the agent 
or independent contractor.
    (B) Inventory and dealer property located in part in the payor's 
country of incorporation. If the payor conducts its activities in 
connection with the production and sale, or purchase and resale, of 
inventory or similar property or dealer property during a quarter of the 
taxable year both in its country of incorporation and elsewhere, then 
the value of the inventory or similar property or dealer property 
considered located in the payor's country of incorporation during each 
quarter is a percentage of the value of the inventory or similar 
property or dealer property as of the close of the quarter. That 
percentage equals the ratio that the costs and expenses incurred by the 
payor during the entire quarter by reason of activities connected with 
the production and sale, or purchase and resale, of inventory or similar 
property or dealer property that are conducted in the payor's country of 
incorporation bear to all costs or expenses incurred by the payor during 
the entire quarter by reason of all such activities worldwide. A cost 
incurred in connection with the production and sale or purchase and 
resale of inventory or similar property or dealer property is included 
in this computation if it--
    (1) Would be included in inventory costs or otherwise capitalized 
with respect to inventory or similar property or dealer property under 
section 61, 263A, 471, or 472 if the payor were a domestic corporation; 
or
    (2) Would be deductible under section 162 if the payor were a 
domestic corporation and is definitely related to gross income derived 
from such property (but not to all classes of gross income derived by 
the payor) under the principles of Sec. 1.861-8.
    (ix) Location of debt instruments. For purposes of this paragraph 
(b)(4), debt instruments, other than debt instruments that are inventory 
or similar property (as defined in paragraph (a)(4)(iii) of this 
section) or dealer property (as defined in paragraph (a)(4)(v) of this 
section) are considered to be used in a trade or business only if they 
arise from the sale of inventory or similar property or dealer property 
by the payor or from the rendition of services by the payor in the 
ordinary course of a trade or business of the payor, and only until such 
time as interest is required to be charged under section 482. Debt 
instruments that arise from the sale of inventory or similar property or 
dealer property during a quarter are treated as having the same 
location, proportionately, as the inventory or similar property or 
dealer property held during that quarter. Debt instruments arising from 
the rendition of services in the ordinary course of a trade or business 
are considered located on a proportionate basis in the countries in 
which the services to which they relate are performed.
    (x) Treatment of certain stock interests. Stock in a controlled 
foreign corporation (lower-tier corporation) that is incorporated in the 
same country as the payor and that is more than 50-percent owned, 
directly or indirectly, by the payor within the meaning of section 
958(a) shall be considered located in the payor's country of 
incorporation and, solely for purposes of section 954(c)(3), used in a 
trade or business of the payor in proportion to the value of the assets 
of the lower-tier corporation that are used in a trade or business in 
the country of incorporation. The location of assets used in a trade or 
business of the lower-tier corporation shall be determined under the 
rules of this paragraph (b)(4).

[[Page 287]]

    (xi) Treatment of banks and insurance companies. [Reserved]
    (5) Exclusion of rents and royalties derived from related persons--
(i) In general--(A) Corporate payor. Foreign personal holding company 
income received by a controlled foreign corporation does not include 
rents or royalties if--
    (1) The payor is a corporation that is a related person with respect 
to the controlled foreign corporation, as defined in section 954(d)(3); 
and
    (2) The rents or royalties are for the use of, or the privilege of 
using, property within the country under the laws of which the 
controlled foreign corporation receiving the payments is created or 
organized (the country of incorporation).
    (B) Payment by a partnership. For purposes of this paragraph (b)(5), 
if a partnership with one or more corporate partners makes a payment of 
rents or royalties, a corporate partner will be treated as the payor of 
the rents or royalties--
    (1) If the rent or royalty payment gives rise to a partnership item 
of deduction under the Internal Revenue Code or Income Tax Regulations, 
to the extent the item of deduction is allocable to the corporate 
partner under section 704(b); or
    (2) If the rent or royalty payment does not give rise to a 
partnership item of deduction under the Internal Revenue Code or Income 
Tax Regulations, to the extent that a partnership item reasonably 
related to the payment would be allocated to that partner under an 
existing allocation under the partnership agreement (made pursuant to 
section 704(b)).
    (ii) Exceptions--(A) Rents or royalties paid out of adjusted foreign 
base company income or insurance income. Rents or royalties may not be 
excluded from the foreign personal holding company income of the 
recipient under this paragraph (b)(5) to the extent that deductions for 
the payments are allocated under section 954(b)(5) and Sec. 1.954-
1(a)(4) and (c) to the payor's adjusted gross foreign base company 
income (as defined in Sec. 1.954-1(a)(3)), adjusted gross insurance 
income (as defined in Sec. 1.954-1(a)(6)), or any other category of 
income included in the computation of subpart F income under section 
952(a).
    (B) Property used in part in the controlled foreign corporation's 
country of incorporation. If the payor uses the property both in the 
controlled foreign corporation's country of incorporation and elsewhere, 
the part of the rent or royalty attributable (determined under the 
principles of section 482) to the use of, or the privilege of using, the 
property outside such country of incorporation is included in the 
computation of foreign personal holding company income under this 
paragraph (b).
    (6) Exclusion of rents and royalties derived in the active conduct 
of a trade or business. Foreign personal holding company income shall 
not include rents or royalties that are derived in the active conduct of 
a trade or business and received from a person that is not a related 
person (as defined in section 954(d)(3)) with respect to the controlled 
foreign corporation. For purposes of this section, rents or royalties 
are derived in the active conduct of a trade or business only if the 
provisions of paragraph (c) or (d) of this section are satisfied.
    (c) Excluded rents--(1) Active conduct of a trade or business. Rents 
will be considered for purposes of paragraph (b)(6) of this section to 
be derived in the active conduct of a trade or business if such rents 
are derived by the controlled foreign corporation (the lessor) from 
leasing any of the following--
    (i) Property that the lessor, through its own officers or staff of 
employees, has manufactured or produced, or property that the lessor has 
acquired and, through its own officers or staff of employees, added 
substantial value to, but only if the lessor, through its officers or 
staff of employees, is regularly engaged in the manufacture or 
production of, or in the acquisition and addition of substantial value 
to, property of such kind;
    (ii) Real property with respect to which the lessor, through its own 
officers or staff of employees, regularly performs active and 
substantial management and operational functions while the property is 
leased;
    (iii) Personal property ordinarily used by the lessor in the active 
conduct

[[Page 288]]

of a trade or business, leased temporarily during a period when the 
property would, but for such leasing, be idle; or
    (iv) Property that is leased as a result of the performance of 
marketing functions by such lessor through its own officers or staff of 
employees located in a foreign country or countries, if the lessor, 
through its officers or staff of employees, maintains and operates an 
organization either in such country or in such countries (collectively), 
as applicable, that is regularly engaged in the business of marketing, 
or of marketing and servicing, the leased property and that is 
substantial in relation to the amount of rents derived from the leasing 
of such property.
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (c)(1)(i) of this section, the performance of marketing 
functions will not be considered to add substantial value to property.
    (ii) Substantiality of foreign organization. For purposes of 
paragraph (c)(1)(iv) of this section, whether an organization either in 
a foreign country or in foreign countries (collectively) is substantial 
in relation to the amount of rents is determined based on all the facts 
and circumstances. However, such an organization will be considered 
substantial in relation to the amount of rents if active leasing 
expenses, as defined in paragraph (c)(2)(iii) of this section, equal or 
exceed 25 percent of the adjusted leasing profit, as defined in 
paragraph (c)(2)(iv) of this section. In addition, for purposes of 
aircraft or vessels leased in foreign commerce, an organization will be 
considered substantial if active leasing expenses, as defined in 
paragraph (c)(2)(iii) of this section, equal or exceed 10 percent of the 
adjusted leasing profit, as defined in paragraph (c)(2)(iv) of this 
section. For purposes of paragraphs (c)(1)(iv) and (c)(2) of this 
section and Sec. 1.956-2(b)(1)(vi), the term aircraft or vessels 
includes component parts, such as engines that are leased separately 
from an aircraft or vessel.
    (iii) Active leasing expenses. The term active leasing expenses 
means the deductions incurred by an organization of the lessor in a 
foreign country that are properly allocable to rental income and that 
would be allowable under section 162 to the lessor if it were a domestic 
corporation, other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons (as defined in section 954(d)(3)) 
with respect to, the lessor;
    (B) Deductions for amounts (including rents and royalties) paid or 
incurred by the lessor for the right to use the property (or a component 
thereof) that generated the rental income;
    (C) Deductions that, although generally allowable under section 162, 
would be specifically allowable to the lessor (if the lessor were a 
domestic corporation) under any section of the Internal Revenue Code 
other than section 162;
    (D) Deductions for payments made to agents or independent 
contractors with respect to the leased property other than payments for 
insurance, utilities and other expenses for like services, or for 
capitalized repairs; and
    (E) Deductions for CST Payments or PCT Payments (as defined in Sec. 
1.482-7(b)).
    (iv) Adjusted leasing profit. The term adjusted leasing profit means 
the gross income of the lessor from rents, reduced by the sum of--
    (A) Amounts (including rents and royalties) paid or incurred by the 
lessor for the right to use the property (or a component thereof) that 
generated the rental income;
    (B) The amounts that would be allowable to such lessor (if the 
lessor were a domestic corporation) as deductions under sections 167 or 
168 with respect to such rental income; and
    (C) The amounts paid by the lessor to agents or independent 
contractors with respect to such rental income other than payments for 
insurance, utilities and other expenses for like services, or for 
capitalized repairs.
    (v) Leased in foreign commerce. For purposes of paragraphs 
(c)(1)(iv) and (c)(2)(ii) of this section, an aircraft or vessel is 
considered to be leased in foreign commerce if the aircraft or vessel is 
used in foreign commerce and is used predominantly outside the United 
States. An aircraft or vessel is considered to be used in foreign 
commerce if it is used for the transportation of

[[Page 289]]

property or passengers between a port (or airport) in the United States 
and a port (or airport) in a foreign country or between foreign ports 
(or airports). An aircraft or vessel will be considered to be used 
predominantly outside the United States if more than 50 percent of the 
miles traversed during the taxable year in the use of the aircraft or 
vessel are traversed outside the United States or if the aircraft or 
vessel is located outside the United States more than 50 percent of the 
time during the taxable year.
    (vi) Leases acquired by the CFC lessor. Except as provided in this 
paragraph (c)(2)(vi), the exception in paragraph (c)(1)(iv) of this 
section will also apply to rents from leases acquired from any person, 
if following the acquisition the lessor performs active and substantial 
management, operational, and remarketing (including remarketing for 
purposes of re-leasing or selling the property) functions with respect 
to the leased property. However, if any person is claiming a benefit 
with respect to an acquired lease pursuant to section 921 or 114 of the 
Internal Revenue Code or section 101(d) of the American Jobs Creation 
Act of 2004, (Pub. L. 108-357 (118 Stat. 1418) (2004)), the rents from 
such lease, notwithstanding paragraphs (b)(6) and (c) of this section, 
are ineligible for the exception in section 954(c)(2)(A).
    (vii) Marketing of leases. Paragraph (c)(1)(iv) of this section can 
apply whether a lessor is engaged in the marketing of leases as a form 
of financing or is engaged in marketing the property as such, and 
regardless of whether the lease is classified as a finance lease or an 
operating lease for financial accounting purposes, so long as such lease 
is treated as a lease for Federal income tax purposes.
    (viii) Cost sharing arrangements (CSAs). For purposes of paragraphs 
(c)(1)(i) and (iv) of this section, CST Payments or PCT Payments (as 
defined in Sec. 1.482-7(b)(1)) made by the lessor to another controlled 
participant (as defined in Sec. 1.482-7(j)(1)(i)) pursuant to a CSA (as 
defined in Sec. 1.482-7(a)) do not cause the activities undertaken by 
that other controlled participant to be considered to be undertaken by 
the lessor's own officers or staff of employees.
    (3) Examples. The application of this paragraph (c) is illustrated 
by the following examples.

    Example 1. Controlled foreign corporation A is regularly engaged in 
the production of office machines which it sells or leases to others and 
services. Under paragraph (c)(1)(i) of this section, the rental income 
of Corporation A from these leases is derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).
    Example 2. Controlled foreign corporation D purchases motor vehicles 
which it leases to others. In the conduct of its short-term leasing of 
such vehicles in foreign country X, Corporation D owns a large number of 
motor vehicles in country X which it services and repairs, leases motor 
vehicles to customers on an hourly, daily, or weekly basis, maintains 
offices and service facilities in country X from which to lease and 
service such vehicles, and maintains therein a sizable staff of its own 
administrative, sales, and service personnel. Corporation D also leases 
in country X on a long-term basis, generally for a term of one year, 
motor vehicles that it owns. Under the terms of the long-term leases, 
Corporation D is required to repair and service, during the term of the 
lease, the leased motor vehicles without cost to the lessee. By the 
maintenance in country X of office, sales, and service facilities and 
its complete staff of administrative, sales, and service personnel, 
Corporation D maintains and operates an organization therein that is 
regularly engaged in the business of marketing and servicing the motor 
vehicles that are leased. The deductions incurred by such organization 
satisfy the 25-percent test of paragraph (c)(2)(ii) of this section; 
thus, such organization is substantial in relation to the rents 
Corporation D receives from leasing the motor vehicles. Therefore, under 
paragraph (c)(1)(iv) of this section, such rents are derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A).
    Example 3. Controlled foreign corporation E owns a complex of 
apartment buildings that it has acquired by purchase. Corporation E 
engages a real estate management firm to lease the apartments, manage 
the buildings and pay over the net rents to Corporation E. The rental 
income of Corporation E from such leases is not derived in the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).
    Example 4. Controlled foreign corporation F acquired by purchase a 
twenty-story office building in a foreign country, three floors of which 
it occupies and the rest of which it leases. Corporation F acts as 
rental agent for the leasing of offices in the building and employs a 
substantial staff to perform other management and maintenance functions. 
Under paragraph (c)(1)(ii) of this section, the rents received by 
Corporation F from such

[[Page 290]]

leasing operations are derived in the active conduct of a trade or 
business for purposes of section 954(c)(2)(A).
    Example 5. Controlled foreign corporation G owns equipment that it 
ordinarily uses to perform contracts in foreign countries to drill oil 
wells. For occasional brief and irregular periods it is unable to obtain 
contracts requiring immediate performance sufficient to employ all such 
equipment. During such a period it sometimes leases such idle equipment 
temporarily. After the expiration of such temporary leasing of the 
property, Corporation G continues the use of such equipment in the 
performance of its own drilling contracts. Under paragraph (c)(1)(iii) 
of this section, rents Corporation G receives from such leasing of idle 
equipment are derived in the active conduct of a trade or business for 
purposes of section 954(c)(2)(A).
    Example 6. The facts are the same as in Example 2, except that 
controlled foreign corporation D purchases aircraft which it leases to 
others. If Corporation D incurs active leasing expenses, as defined in 
paragraph (c)(2)(iii) of this section, equal to or in excess of 10 
percent of its adjusted leasing profit, as defined in paragraph 
(c)(2)(iv) of this section, the organization maintained and operated by 
Corporation D in country X is substantial in relation to the amount of 
rents Corporation D receives from leasing the aircraft. Therefore, under 
paragraph (c)(1)(iv) of this section, such rents are derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A). If a particular aircraft subject to lease was not leased 
by the lessee corporation in foreign commerce, for example, because 50 
percent or less of the miles during the taxable year were traversed 
outside the United States and the aircraft was located in the United 
States for 50 percent or more of the taxable year, Corporation D is not 
prevented from otherwise showing that it actively carries on a trade or 
business with regard to the rents derived from that aircraft under 
paragraph (c)(2)(ii) of this section, based on its facts and 
circumstances or a showing that active leasing expenses equal or exceed 
25 percent of the adjusted leasing profit.

    (d) Excluded royalties--(1) Active conduct of a trade or business. 
Royalties will be considered for purposes of paragraph (b)(6) of this 
section to be derived in the active conduct of a trade or business if 
such royalties are derived by the controlled foreign corporation (the 
licensor) from licensing--
    (i) Property that the licensor, through its own officers or staff of 
employees, has developed, created, or produced, or property that the 
licensor has acquired and, through its own officers or staff of 
employees, added substantial value to, but only so long as the licensor, 
through its officers or staff of employees, is regularly engaged in the 
development, creation, or production of, or in the acquisition and 
addition of substantial value to, property of such kind; or
    (ii) Property that is licensed as a result of the performance of 
marketing functions by such licensor through its own officers or staff 
of employees located in a foreign country or countries, if the licensor, 
through its officers or staff of employees, maintains and operates an 
organization either in such foreign country or in such foreign countries 
(collectively), as applicable, that is regularly engaged in the business 
of marketing, or of marketing and servicing, the licensed property and 
that is substantial in relation to the amount of royalties derived from 
the licensing of such property.
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (d)(1)(i) of this section, the performance of marketing 
functions will not be considered to add substantial value to property.
    (ii) Substantiality of foreign organization. For purposes of 
paragraph (d)(1)(ii) of this section, whether an organization either in 
a foreign country or in foreign countries (collectively) is substantial 
in relation to the amount of royalties is determined based on all of the 
facts and circumstances. However, such an organization will be 
considered substantial in relation to the amount of royalties if active 
licensing expenses, as defined in paragraph (d)(2)(iii) of this section, 
equal or exceed 25 percent of the adjusted licensing profit, as defined 
in paragraph (d)(2)(iv) of this section.
    (iii) Active licensing expenses. The term active licensing expenses 
means the deductions incurred by an organization of the licensor in a 
foreign country that are properly allocable to royalty income and that 
would be allowable under section 162 to the licensor if it were a 
domestic corporation, other than--

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    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons (as defined in section 954(d)(3)) 
with respect to, the licensor;
    (B) Deductions for royalties paid or incurred;
    (C) Deductions that, although generally allowable under section 162, 
would be specifically allowable to the licensor (if the controlled 
foreign corporation were a domestic corporation) under any section of 
the Internal Revenue Code other than section 162;
    (D) Deductions for payments made to agents or independent 
contractors with respect to the licensed property; and
    (E) Deductions for CST Payments or PCT Payments (as defined in Sec. 
1.482-7(b)).
    (iv) Adjusted licensing profit. The term adjusted licensing profit 
means the gross income of the licensor from royalties, reduced by the 
sum of--
    (A) The royalties paid or incurred by the licensor with respect to 
such royalty income;
    (B) The amounts that would be allowable to such licensor as 
deductions under section 167 or 197 (if the licensor were a domestic 
corporation) with respect to such royalty income; and
    (C) The amounts paid by the licensor to agents or independent 
contractors with respect to such royalty income.
    (v) Cost sharing arrangements (CSAs). For purposes of paragraphs 
(d)(1)(i) and (ii) of this section, CST Payments or PCT Payments (as 
defined in Sec. 1.482-7(b)(1)) made by the licensor to another 
controlled participant (as defined in Sec. 1.482-7(j)(1)(i)) pursuant 
to a CSA (as defined in Sec. 1.482-7(a)) do not cause the activities 
undertaken by that other controlled participant to be considered to be 
undertaken by the licensor's own officers or staff of employees.
    (3) Examples. The application of this paragraph (d) is illustrated 
by the following examples.

    Example 1. Controlled foreign corporation A, through its own staff 
of employees, owns and operates a research facility in foreign country 
X. At the research facility, employees of Corporation A who are 
scientists, engineers, and technicians regularly perform experiments, 
tests, and other technical activities, that ultimately result in the 
issuance of patents that it sells or licenses. Under paragraph (d)(1)(i) 
of this section, royalties received by Corporation A for the privilege 
of using patented rights that it develops as a result of such research 
activity are derived in the active conduct of a trade or business for 
purposes of section 954(c)(2)(A), but only so long as the licensor is 
regularly engaged in the development, creation or production of, or in 
the acquisition of and addition of substantial value to, property of 
such kind.
    Example 2. Assume that Corporation A in Example 1, in addition to 
receiving royalties for the use of patents that it develops, receives 
royalties for the use of patents that it acquires by purchase and 
licenses to others without adding any value thereto. Corporation A 
generally consummates royalty agreements on such purchased patents as 
the result of inquiries received by it from prospective licensees when 
the fact becomes known in the business community, as a result of the 
filing of a patent, advertisements in trade journals, announcements, and 
contacts by employees of Corporation A, that Corporation A has acquired 
rights under a patent and is interested in licensing its rights. 
Corporation A does not, however, maintain and operate an organization in 
a foreign country that is regularly engaged in the business of marketing 
the purchased patents. The royalties received by Corporation A for the 
use of the purchased patents are not derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).
    Example 3. Controlled foreign corporation B receives royalties for 
the use of patents that it acquires by purchase. The primary business of 
Corporation B, operated on a regular basis, consists of licensing 
patents that it has purchased raw from inventors and, through the 
efforts of a substantial staff of employees consisting of scientists, 
engineers, and technicians, made susceptible to commercial application. 
For example, Corporation B, after purchasing patent rights covering a 
chemical process, designs specialized production equipment required for 
the commercial adaptation of the process and, by so doing, substantially 
increases the value of the patent. Under paragraph (d)(1)(i) of this 
section, royalties received by Corporation B from the use of such patent 
are derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).
    Example 4. Controlled foreign corporation C receives royalties for 
the use of a patent that it developed through its own staff of employees 
at its facility in country X. Corporation C has developed no other 
patents. It does not regularly employ a staff of scientists, engineers 
or technicians to create new products to be patented. Further, it does 
not purchase and license patents developed by others to which it has 
added substantial value. The royalties received by Corporation C are not 
derived from the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).

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    Example 5. Controlled foreign corporation D finances independent 
persons in the development of patented items in return for an ownership 
interest in such items from which it derives a percentage of royalty 
income, if any, subsequently derived from the use by others of the 
protected right. Corporation D also attempts to increase its royalty 
income from such patents by contacting prospective licensees and 
rendering to licensees advice that is intended to promote the use of the 
patented property. Corporation D does not, however, maintain and operate 
an organization in a foreign country that is regularly engaged in the 
business of marketing the patents. Royalties received by Corporation D 
for the use of such patents are not derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).

    (e) Certain property transactions--(1) In general--(i) Inclusions. 
Gain from certain property transactions described in section 
954(c)(1)(B) includes the excess of gains over losses from the sale or 
exchange of--
    (A) Property that gives rise to dividends, interest, rents, 
royalties or annuities, as described in paragraph (e)(2) of this 
section;
    (B) Property that is an interest in a partnership, trust or REMIC; 
and
    (C) Property that does not give rise to income, as described in 
paragraph (e)(3) of this section.
    (ii) Exceptions. Gain or loss from certain property transactions 
described in section 954(c)(1)(B) and paragraph (e)(1)(i) of this 
section does not include gain or loss from the sale or exchange of--
    (A) Inventory or similar property, as defined in paragraph 
(a)(4)(iii) of this section;
    (B) Dealer property, as defined in paragraph (a)(4)(v) of this 
section; or
    (C) Property that gives rise to rents or royalties described in 
paragraph (b)(6) of this section that are derived in the active conduct 
of a trade or business from persons that are not related persons (as 
defined in section 954(d)(3)) with respect to the controlled foreign 
corporation.
    (iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for 
the treatment of losses in excess of gains from the sale or exchange of 
property described in paragraph (e)(1)(i) of this section.
    (iv) Dual character property. Property may, in part, constitute 
property that gives rise to certain income as described in paragraph 
(e)(2) of this section or, in part, constitute property that does not 
give rise to any income as described in paragraph (e)(3) of this 
section. However, property that is described in paragraph (e)(1)(i)(B) 
of this section cannot be dual character property. Dual character 
property must be treated as two separate properties for purposes of 
paragraph (e)(2) or (3) of this section. Accordingly, the sale or 
exchange of such dual character property will give rise to gain or loss 
that in part must be included in the computation of foreign personal 
holding company income under paragraph (e)(2) or (3) of this section, 
and in part is excluded from such computation. Gain or loss from the 
disposition of dual character property must be bifurcated under this 
paragraph (e)(1)(iv) pursuant to the method that most reasonably 
reflects the relative uses of the property. Reasonable methods may 
include comparisons in terms of gross income generated or the physical 
division of the property. In the case of real property, the physical 
division of the property will in most cases be the most reasonable 
method available. For example, if a controlled foreign corporation owns 
an office building, uses 60 percent of the building in its trade or 
business, and rents out the other 40 percent, then 40 percent of the 
gain recognized on the disposition of the property would reasonably be 
treated as gain that is included in the computation of foreign personal 
holding company income under this paragraph (e)(1). This paragraph 
(e)(1)(iv) addresses the contemporaneous use of property for dual 
purposes. For rules concerning changes in the use of property affecting 
its classification for purposes of this paragraph (e), see paragraph 
(a)(3) of this section.
    (2) Property that gives rise to certain income--(i) In general. 
Property the sale or exchange of which gives rise to foreign personal 
holding company income under this paragraph (e)(2) includes property 
that gives rise to dividends, interest, rents, royalties or annuities 
described in paragraph (b) of this section, including--
    (A) Property that gives rise to export financing interest described 
in paragraph (b)(2) of this section; and

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    (B) Property that gives rise to income from related persons 
described in paragraph (b)(4) or (5) of this section.
    (ii) Gain or loss from the disposition of a debt instrument. Gain or 
loss from the sale, exchange or retirement of a debt instrument is 
included in the computation of foreign personal holding company income 
under this paragraph (e) unless--
    (A) In the case of gain--
    (1) It is interest (as defined in paragraph (a)(4)(i) of this 
section); or
    (2) It is income equivalent to interest (as described in paragraph 
(h) of this section); and
    (B) In the case of loss--
    (1) It is directly allocated to, or treated as an adjustment to, 
interest income (as described in paragraph (a)(4)(i) of this section) or 
income equivalent to interest (as defined in paragraph (h) of this 
section) under any provision of the Internal Revenue Code or Income Tax 
Regulations; or
    (2) It is required to be apportioned in the same manner as interest 
expense under section 864(e) or any other provision of the Internal 
Revenue Code or Income Tax Regulations.
    (3) Property that does not give rise to income. Except as otherwise 
provided in this paragraph (e)(3), for purposes of this section, the 
term property that does not give rise to income includes all rights and 
interests in property (whether or not a capital asset) including, for 
example, forwards, futures and options. Property that does not give rise 
to income shall not include--
    (i) Property that gives rise to dividends, interest, rents, 
royalties or annuities described in paragraph (e)(2) of this section;
    (ii) Tangible property (other than real property) used or held for 
use in the controlled foreign corporation's trade or business that is of 
a character that would be subject to the allowance for depreciation 
under section 167 or 168 and the regulations under those sections 
(including tangible property described in Sec. 1.167(a)-2);
    (iii) Real property that does not give rise to rental or similar 
income, to the extent used or held for use in the controlled foreign 
corporation's trade or business;
    (iv) Intangible property (as defined in section 936(h)(3)(B)), 
goodwill or going concern value, to the extent used or held for use in 
the controlled foreign corporation's trade or business;
    (v) Notional principal contracts (but see paragraphs (f)(2), (g)(2) 
and (h)(3) of this section for rules that include income from certain 
notional principal contracts in gains from commodities transactions, 
foreign currency gains and income equivalent to interest, respectively); 
or
    (vi) Other property that is excepted from the general rule of this 
paragraph (e)(3) by the Commissioner in published guidance. See Sec. 
601.601(d)(2) of this chapter.
    (f) Commodities transactions--(1) In general--(i) Inclusion in 
foreign personal holding company income. Foreign personal holding 
company income includes the excess of gains over losses from commodities 
transactions.
    (ii) Exception. Gains and losses from qualified active sales and 
qualified hedging transactions are excluded from the computation of 
foreign personal holding company income under this paragraph (f).
    (iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for 
the treatment of losses in excess of gains from commodities 
transactions.
    (2) Definitions--(i) Commodity. For purposes of this section, the 
term commodity includes tangible personal property of a kind that is 
actively traded or with respect to which contractual interests are 
actively traded.
    (ii) Commodities transaction. The term commodities transaction means 
the purchase or sale of a commodity for immediate (spot) delivery or 
deferred (forward) delivery, or the right to purchase, sell, receive, or 
transfer a commodity, or any other right or obligation with respect to a 
commodity accomplished through a cash or off-exchange market, an 
interbank market, an organized exchange or board of trade, or an over-
the-counter market, or in a transaction effected between private parties 
outside of any market. Commodities transactions include, but are not 
limited to--
    (A) A futures or forward contract in a commodity;

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    (B) A leverage contract in a commodity purchased from a leverage 
transaction merchant;
    (C) An exchange of futures for physical transaction;
    (D) A transaction, including a notional principal contract, in which 
the income or loss to the parties is measured by reference to the price 
of a commodity, a pool of commodities, or an index of commodities;
    (E) The purchase or sale of an option or other right to acquire or 
transfer a commodity, a futures contract in a commodity, or an index of 
commodities; and
    (F) The delivery of one commodity in exchange for the delivery of 
another commodity, the same commodity at another time, cash, or 
nonfunctional currency.
    (iii) Qualified active sale--(A) In general. The term qualified 
active sale means the sale of commodities in the active conduct of a 
commodities business as a producer, processor, merchant or handler of 
commodities if substantially all of the controlled foreign corporation's 
business is as an active producer, processor, merchant or handler of 
commodities. The sale of commodities held by a controlled foreign 
corporation other than in its capacity as an active producer, processor, 
merchant or handler of commodities is not a qualified active sale. For 
example, the sale by a controlled foreign corporation of commodities 
that were held for investment or speculation would not be a qualified 
active sale.
    (B) Active conduct of a commodities business. For purposes of this 
paragraph, a controlled foreign corporation is engaged in the active 
conduct of a commodities business as a producer, processor, merchant or 
handler of commodities only with respect to commodities for which each 
of the following conditions is satisfied--
    (1) It holds the commodities directly, and not through an agent or 
independent contractor, as inventory or similar property (as defined in 
paragraph (a)(4)(iii) of this section) or as dealer property (as defined 
in paragraph (a)(4)(v) of this section); and
    (2) With respect to such commodities, it incurs substantial expenses 
in the ordinary course of a commodities business from engaging in one or 
more of the following activities directly, and not through an 
independent contractor--
    (i) Substantial activities in the production of the commodities, 
including planting, tending or harvesting crops, raising or slaughtering 
livestock, or extracting minerals;
    (ii) Substantial processing activities prior to the sale of the 
commodities, including the blending and drying of agricultural 
commodities, or the concentrating, refining, mixing, crushing, aerating 
or milling of commodities; or
    (iii) Significant activities as described in paragraph 
(f)(2)(iii)(B)(3) of this section.
    (3) For purposes of paragraph (f)(2)(iii)(B)(2)(iii) of this 
section, the significant activities must relate to--
    (i) The physical movement, handling and storage of the commodities, 
including preparation of contracts and invoices, arranging freight, 
insurance and credit, arranging for receipt, transfer or negotiation of 
shipping documents, arranging storage or warehousing, and dealing with 
quality claims;
    (ii) Owning and operating facilities for storage or warehousing; or
    (iii) Owning or chartering vessels or vehicles for the 
transportation of the commodities.
    (C) Substantially all. Substantially all of the controlled foreign 
corporation's business is as an active producer, processor, merchant or 
handler of commodities if the sum of its gross receipts from all of its 
qualified active sales (as defined in this paragraph (f)(2)(iii) without 
regard to the substantially all requirement) of commodities and its 
gross receipts from all of its qualified hedging transactions (as 
defined in paragraph (f)(2)(iv) of this section, applied without regard 
to the substantially all requirement of this paragraph (f)(2)(iii)(C)) 
equals or exceeds 85 percent of its total gross receipts for the taxable 
year (computed as though the corporation were a domestic corporation). 
In computing gross receipts, the District Director may disregard any 
sale or hedging transaction that has as a principal purpose manipulation 
of the 85 percent gross receipts test. A purpose may be a principal 
purpose even

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though it is outweighed by other purposes (taken together or 
separately).
    (D) Activities of employees of a related entity. For purposes of 
this paragraph (f), activities of employees of an entity related to the 
controlled foreign corporation, who are made available to and supervised 
on a day-to-day basis by, and whose salaries are paid by (or reimbursed 
to the related entity by), the controlled foreign corporation, are 
treated as activities engaged in directly by the controlled foreign 
corporation.
    (iv) Qualified hedging transaction entered into prior to January 31, 
2003--(A) In general. The term qualified hedging transaction means a 
bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of 
this section, with respect to qualified active sales (other than 
transactions described in section 988(c)(1) without regard to section 
988(c)(1)(D)(i)).
    (B) Exception. The term qualified hedging transaction does not 
include transactions that are not reasonably necessary to the conduct of 
business of the controlled foreign corporation as a producer, processor, 
merchant or handler of a commodity in the manner in which such business 
is customarily and usually conducted by others.
    (C) Effective date. This paragraph (f)(2)(iv) applies to gain or 
loss realized by a controlled foreign corporation with respect to a 
qualified hedging transaction entered into prior to January 31, 2003.
    (v) Qualified hedging transaction entered into on or after January 
31, 2003--(A) In general. The term qualified hedging transaction means a 
bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of 
this section, with respect to one or more commodities transactions 
reasonably necessary to the conduct of any business by a producer, 
processor, merchant or handler of commodities in a manner in which such 
business is customarily and usually conducted by others. For purposes of 
this paragraph (f)(2)(v), a producer, processor, merchant or handler of 
commodities includes a controlled foreign corporation that regularly 
uses commodities in a manufacturing, construction, utilities, or 
transportation business.
    (B) Exception. The term qualified hedging transaction does not 
include a transaction described in section 988(c)(1) (without regard to 
section 988(c)(1)(D)(i)).
    (C) Examples. The following examples illustrate the provisions of 
this paragraph (f)(2)(v):

    Example 1. CFC1 is a controlled foreign corporation located in 
country A. CFC1 manufactures and sells machinery in country B using 
aluminum and component parts purchased from third parties that contain 
significant amounts of aluminum. CFC1 conducts its manufacturing 
business in a manner in which such business is customarily and usually 
conducted by others. To protect itself against increases in the price of 
aluminum used in the machinery it manufactures, CFC1 enters into futures 
purchase contracts for the delivery of aluminum. These futures purchase 
contracts are bona fide hedging transactions. As CFC1 purchases aluminum 
and component parts containing significant amounts of aluminum in the 
spot market for use in its business, it closes out an equivalent amount 
of aluminum futures purchase contracts by entering into offsetting 
aluminum futures sales contracts. The aluminum futures purchase 
contracts are qualified hedging transactions as defined in paragraph 
(f)(2)(v)(A) of this section. Accordingly, any gain or loss on such 
aluminum futures purchase contracts is excluded from the computation of 
foreign personal holding company income.
    Example 2. CFC2 is a controlled foreign corporation located in 
country B. CFC2 operates an airline business within country B in a 
manner in which such business is customarily and usually conducted by 
others. To protect itself against increases in the price of aviation 
fuel, CFC2 enters into forward contracts for the purchase of aviation 
fuel. These forward purchase contracts are bona fide hedging 
transactions. As CFC2 purchases aviation fuel in the spot market for use 
in its business, it closes out an equivalent amount of its forward 
purchase contracts for cash pursuant to a contractual provision that 
permits CFC2 to terminate the contract and make or receive a one-time 
payment representing the contract's fair market value. The aviation fuel 
forward purchase contracts are qualified hedging transactions as defined 
in paragraph (f)(2)(v)(A) of this section. Accordingly, any gain or loss 
on such aviation fuel forward purchase contracts is excluded from the 
computation of foreign personal holding company income.

    (D) Effective date. This paragraph (f)(2)(v) applies to gain or loss 
realized by a controlled foreign corporation with respect to a qualified 
hedging

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transaction entered into on or after January 31, 2003.
    (vi) Financial institutions not a producer, etc. For purposes of 
this paragraph (f), a corporation is not a producer, processor, merchant 
or handler of commodities if its business is primarily financial. For 
example, the business of a controlled foreign corporation is primarily 
financial if its principal business is making a market in notional 
principal contracts based on a commodities index.
    (g) Foreign currency gain or loss--(1) Scope and purpose. This 
paragraph (g) provides rules for the treatment of foreign currency gains 
and losses. Paragraph (g)(2) of this section provides the general rule. 
Paragraph (g)(3) of this section provides an election to include foreign 
currency gains or losses that would otherwise be treated as foreign 
personal holding company income under this paragraph (g) in the 
computation of another category of subpart F income. Paragraph (g)(4) of 
this section provides an alternative election to treat any net foreign 
currency gain or loss as foreign personal holding company income. 
Paragraph (g)(5) of this section provides rules for certain gains and 
losses not subject to this paragraph (g).
    (2) In general--(i) Inclusion. Except as otherwise provided in this 
paragraph (g), foreign personal holding company income includes the 
excess of foreign currency gains over foreign currency losses 
attributable to any section 988 transactions (foreign currency gain or 
loss). Section 1.954-1(c)(1)(ii) provides rules for the treatment of 
foreign currency losses in excess of foreign currency gains. However, if 
an election is made under paragraph (g)(4) of this section, the excess 
of foreign currency losses over foreign currency gains to which the 
election would apply may be apportioned to, and offset, other categories 
of foreign personal holding company income.
    (ii) Exclusion for business needs--(A) General rule. Foreign 
currency gain or loss directly related to the business needs of the 
controlled foreign corporation is excluded from foreign personal holding 
company income.
    (B) Business needs. Foreign currency gain or loss is directly 
related to the business needs of a controlled foreign corporation if--
    (1) The foreign currency gain or loss--
    (i) Arises from a transaction (other than a hedging transaction) 
entered into, or property used or held for use, in the normal course of 
the controlled foreign corporation's trade or business, other than the 
trade or business of trading foreign currency;
    (ii) Arises from a transaction or property that does not itself (and 
could not reasonably be expected to) give rise to subpart F income other 
than foreign currency gain or loss;
    (iii) Does not arise from a transaction described in section 
988(c)(1)(B)(iii); and
    (iv) Is clearly determinable from the records of the controlled 
foreign corporation as being derived from such transaction or property; 
or
    (2) The foreign currency gain or loss arises from a bona fide 
hedging transaction, as defined in paragraph (a)(4)(ii) of this section, 
with respect to a transaction or property that satisfies the 
requirements of paragraphs (g)(2)(ii)(B)(1) (i) through (iii) of this 
section, provided that any gain or loss arising from such transaction or 
property that is attributable to changes in exchange rates is clearly 
determinable from the records of the CFC as being derived from such 
transaction or property. For purposes of this paragraph 
(g)(2)(ii)(B)(2), a hedging transaction will satisfy the aggregate 
hedging rules of Sec. 1.1221-2(c)(3) only if all (or all but a de 
minimis amount) of the aggregate risk being hedged arises in connection 
with transactions or property that satisfy the requirements of 
paragraphs (g)(2)(ii)(B)(1) (i) through (iii) of this section, provided 
that any gain or loss arising from such transactions or property that is 
attributable to changes in exchange rates is clearly determinable from 
the records of the CFC as being derived from such transactions or 
property.
    (C) Regular dealers--(1) General rule. Transactions in dealer 
property (as defined in paragraph (a)(4)(v) of this section) described 
in section 988(c)(1)(B) or (C) that are entered into by a controlled 
foreign corporation that is a regular dealer (as defined in paragraph

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(a)(4)(iv) of this section) in such property in its capacity as a dealer 
will be treated as directly related to the business needs of the 
controlled foreign corporation under paragraph (g)(2)(ii)(A) of this 
section.
    (2) Certain interest-bearing liabilities treated as dealer 
property--(i) In general. For purposes of this paragraph (g)(2)(ii)(C), 
an interest-bearing liability incurred by a controlled foreign 
corporation that is denominated in (or determined by reference to) a 
non-functional currency shall be treated as dealer property of the type 
described in paragraph (g)(2)(ii)(C)(1) of this section if the 
liability, by being denominated in such currency, reduces the controlled 
foreign corporation's currency risk with respect to dealer property, and 
the liability is identified on the controlled foreign corporation's 
records as a liability treated as dealer property before the close of 
the day on which the liability is incurred.
    (ii) Failure to identify certain liabilities. If a controlled 
foreign corporation identifies certain interest-bearing liabilities as 
liabilities treated as dealer property under paragraph 
(g)(2)(ii)(C)(2)(i) of this section but fails to so identify other 
interest-bearing liabilities that manage its currency risk with respect 
to assets held that constitute dealer property, the Commissioner may 
treat such other liabilities as properly identified as dealer property 
under paragraph (g)(2)(ii)(C)(2)(i) of this section if the Commissioner 
determines that the failure to identify such other liabilities had as 
one of its principal purposes the avoidance of Federal income tax.
    (iii) Effective date. This paragraph (g)(2)(ii)(C)(2) applies only 
to gain or loss from an interest-bearing liability entered into by a 
controlled foreign corporation on or after January 31, 2003.
    (D) Example. The following example illustrates the provisions of 
this paragraph (g)(2).

    Example. (i) CFC1 and CFC2 are controlled foreign corporations 
located in Country B, and are members of the same controlled group. CFC1 
is engaged in the active conduct of a trade or business that does not 
produce any subpart F income. CFC2 serves as the currency coordination 
center for the controlled group, aggregating currency risks incurred by 
the group and entering into hedging transactions that transfer those 
risks outside of the group. Pursuant to this arrangement, and to hedge 
the currency risk on a non-interest bearing receivable incurred by CFC1 
in the normal course of its business, on Day 1 CFC1 enters into a 
forward contract to sell Japanese Yen to CFC2 in 30 days. Also on Day 1, 
CFC2 enters into a forward contract to sell Yen to unrelated Bank X on 
Day 30. CFC2 is not a regular dealer in Yen spot and forward contracts, 
and the Yen is not the functional currency for either CFC1 or CFC2.
    (ii) Because the forward contract entered into by CFC1 to sell Yen 
hedges a transaction entered into in the normal course of CFC1's 
business that does not give rise to subpart F income, it qualifies as a 
bona fide hedging transaction as defined in paragraph (a)(4)(ii) of this 
section. Therefore, CFC1's foreign exchange gain or loss from that 
forward contract will not be treated as foreign personal holding company 
income or loss under this paragraph (g).
    (iii) Because the forward contract to purchase Yen was entered into 
by CFC2 in order to assume currency risks incurred by CFC1 it does not 
qualify as a bona fide hedging transaction, as defined in paragraph 
(a)(4)(ii) of this section. Thus, foreign exchange gain or loss 
recognized by CFC2 from that forward contract will be foreign personal 
holding company income. Because CFC2 entered into the forward contract 
to sell Yen in order to hedge currency risks of CFC1, that forward 
contract also does not qualify as a bona fide hedging transaction. Thus, 
CFC2's foreign currency gain or loss arising from that forward contract 
will be foreign personal holding company income.

    (iii) Special rule for foreign currency gain or loss from an 
interest-bearing liability. Except as provided in paragraph 
(g)(2)(ii)(C)(2) or (g)(5)(iv) of this section, foreign currency gain or 
loss arising from an interest-bearing liability is characterized as 
subpart F income and non-subpart F income in the same manner that 
interest expense associated with the liability would be allocated and 
apportioned between subpart F income and non-subpart F income under 
Sec. Sec. 1.861-9T and 1.861-12T.
    (3) Election to characterize foreign currency gain or loss that 
arises from a specific category of subpart F income as gain or loss in 
that category--(i) In general. For taxable years of a controlled foreign 
corporation beginning on or after November 6, 1995, the controlling 
United States shareholders of the controlled foreign corporation may 
elect,

[[Page 298]]

under this paragraph (g)(3), to exclude foreign currency gain or loss 
otherwise includible in the computation of foreign personal holding 
company income under this paragraph (g) from the computation of foreign 
personal holding company income under this paragraph (g) and include 
such foreign currency gain or loss in the category (or categories) of 
subpart F income (described in section 952(a), or, in the case of 
foreign base company income, described in Sec. 1.954-1(c)(1)(iii)(A) 
(1) or (2)) to which such gain or loss relates. If an election is made 
under this paragraph (g)(3) with respect to a category (or categories) 
of subpart F income described in section 952(a), or, in the case of 
foreign base company income, described in Sec. 1.954-1(c)(1)(iii)(A) 
(1) or (2), the election shall apply to all foreign currency gain or 
loss that arises from--
    (A) A transaction (other than a hedging transaction) entered into, 
or property used or held for use, in the normal course of the controlled 
foreign corporation's trade or business that gives rise to income in 
that category (or categories) and that is clearly determinable from the 
records of the controlled foreign corporation as being derived from such 
transaction or property; and
    (B) A bona fide hedging transaction, as defined in paragraph 
(a)(4)(ii) of this section, with respect to a transaction or property 
described in paragraph (g)(3)(i)(A) of this section. For purposes of 
this paragraph (g)(3)(i)(B), a hedging transaction will satisfy the 
aggregate hedging rules of Sec. 1.1221-2(c)(3) only if all (or all but 
a de minimis amount) of the aggregate risk being hedged arises in 
connection with transactions or property that generate the same category 
of subpart F income described in section 952(a), or, in the case of 
foreign base company income, described in Sec. 1.954-1(c)(1)(iii)(A) 
(1) or (2).
    (ii) Time and manner of election. The controlling United States 
shareholders, as defined in Sec. 1.964-1(c)(5), make the election on 
behalf of the controlled foreign corporation by filing a statement with 
their original income tax returns for the taxable year of such United 
States shareholders ending with or within the taxable year of the 
controlled foreign corporation for which the election is made, clearly 
indicating that such election has been made. If the controlling United 
States shareholders elect to apply these regulations retroactively, 
under Sec. 1.954-0(a)(1)(ii), the election under this paragraph (g)(3) 
may be made by the amended return filed pursuant to the election under 
Sec. 1.954-0(a)(1)(ii). The controlling United States shareholders 
filing the election statement described in this paragraph (g)(3)(ii) 
must provide copies of the election statement to all other United States 
shareholders of the electing controlled foreign corporation. Failure to 
provide copies of such statement will not cause an election under this 
paragraph (g)(3) to be voidable by the controlled foreign corporation or 
the controlling United States shareholders. However, the District 
Director has discretion to void the election if it is determined that 
three was no reasonable cause for the failure to provide copies of such 
statement. The statement shall include the following information--
    (A) The name, address, taxpayer identification number, and taxable 
year of such United States shareholder;
    (B) The name, address, and taxable year of the controlled foreign 
corporation for which the election is effective; and
    (C) Any additional information required by the Commission by 
administrative pronouncement.
    (iii) Revocation of election. This election is effective for the 
taxable year of the controlled foreign corporation for which it is made 
and all subsequent taxable years of such corporation unless revoked by 
or with the consent of the Commissioner.
    (iv) Example. The following example illustrates the provisions of 
this paragraph (g)(3).

    Example. (i) CFC, a controlled foreign corporation, is a sales 
company that earns foreign base company sales income under section 
954(d). CFC makes an election under this paragraph (g)(3) to treat 
foreign currency gains or losses that arise from a specific category (or 
categories) of subpart F income (as described in section 952(a), or, in 
the case of foreign base company income, as described in Sec. 1.954-
1(c)(1)(iii)(A) (1) or (2)) as that type of income. CFC aggregates the 
currency risk

[[Page 299]]

on all of its transactions that generate foreign base company sales 
income and hedges this net currency exposure.
    (ii) Assuming no more than a de minimis amount of risk in the pool 
of risks being hedged arises from transactions or property that generate 
income other than foreign base company sales income, pursuant to its 
election under (g)(3), CFC's net foreign currency gain from the pool and 
the hedging transactions will be treated as foreign base company sales 
income under section 954(d), rather than as foreign personal holding 
company income under section 954(c)(1)(D). If the pool of risks and the 
hedging transactions generate a net foreign base company sales loss, 
however, CFC must apply the rules of Sec. 1.954-1(c)(1)(ii).

    (4) Election to treat all foreign currency gains or losses as 
foreign personal holding company income--(i) In general. If the 
controlling United States shareholders make an election under this 
paragraph (g)(4), the controlled foreign corporation shall include in 
its computation of foreign personal holding company income the excess of 
foreign currency gains over losses or the excess of foreign currency 
losses over gains attributable to any section 988 transaction (except 
those described in paragraph (g)(5) of this section) and any section 
1256 contract that would be a section 988 transaction but for section 
988(c)(1)(D). Separate elections for section 1256 contracts and section 
988 transactions are not permitted. An election under this paragraph 
(g)(4) supersedes an election under paragraph (g)(3) of this section.
    (ii) Time and manner of election. The controlling United States 
shareholders, as defined in Sec. 1.964-1(c)(5), make the election on 
behalf of the controlled foreign corporation in the same time and manner 
as provided in paragraph (g)(3)(ii) of this section.
    (iii) Revocation of election. This election is effective for the 
taxable year of the controlled foreign corporation for which it is made 
and all subsequent taxable years of such corporation unless revoked by 
or with the consent of the Commissioner.
    (5) Gains and losses not subject to this paragraph--(i) Capital 
gains and losses. Gain or loss that is treated as capital gain or loss 
under section 988(a)(1)(B) is not foreign currency gain or loss for 
purposes of this paragraph (g). Such gain or loss is treated as gain or 
loss from the sale or exchange of property that is included in the 
computation of foreign personal holding company income under paragraph 
(e)(1) of this section. Paragraph (a)(2) of this section provides other 
rules concerning income described in more than one category of foreign 
personal holding company income.
    (ii) Income not subject to section 988. Gain or loss that is not 
treated as foreign currency gain or loss by reason of section 988 (a)(2) 
or (d) is not foreign currency gain or loss for purposes of this 
paragraph (g). However, such gain or loss may be included in the 
computation of other categories of foreign personal holding company 
income in accordance with its characterization under section 988 (a)(2) 
or (d) (for example, foreign currency gain that is treated as interest 
income under section 988(a)(2) will be included in the computation of 
foreign personal holding company income under paragraph (b)(ii) of this 
section).
    (iii) Qualified business units using the dollar approximate separate 
transactions method. This paragraph (g) does not apply to any DASTM gain 
or loss computed under Sec. 1.985-3(d). Such gain or loss is allocated 
under the rules of Sec. 1.985-3 (e)(2)(iv) or (e)(3). However, the 
provisions of this paragraph (g) do apply to section 988 transactions 
denominated in a currency other than the United States dollar or the 
currency that would be the qualified business unit's functional currency 
were it not hyperinflationary.
    (iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]
    (h) Income equivalent to interest--(1) In general--(i) Inclusion in 
foreign personal holding company income. Except as provided in this 
paragraph (h), foreign personal holding company income includes income 
equivalent to interest as defined in paragraph (h)(2) of this section.
    (ii) Exceptions--(A) Liability hedging transactions. Income, gain, 
deduction or loss that is allocated and apportioned in the same manner 
as interest expense under the provisions of Sec. 1.861-9T is not income 
equivalent to interest for purposes of this paragraph (h).
    (B) Interest. Amounts treated as interest under section 954(c)(1)(A) 
and

[[Page 300]]

paragraph (b) of this section are not income equivalent to interest for 
purposes of this paragraph (h).
    (2) Definition of income equivalent to interest--(i) In general. The 
term income equivalent to interest includes income that is derived 
from--
    (A) A transaction or series of related transactions in which the 
payments, net payments, cash flows or return predominantly reflect the 
time value of money;
    (B) Transactions in which the payments (or a predominant portion 
thereof) are, in substance, for the use or forbearance of money;
    (C) Notional principal contracts, to the extent provided in 
paragraph (h)(3) of this section;
    (D) Factoring, to the extent provided in paragraph (h)(4) of this 
section;
    (E) Conversion transactions, but only to the extent that gain 
realized with respect to such a transaction is treated as ordinary 
income under section 1258;
    (F) The performance of services, to the extent provided in paragraph 
(h)(5) of this section;
    (G) The commitment by a lender to provide financing, if any portion 
of such financing is actually provided;
    (H) Transfers of debt securities subject to section 1058;
    (I) Any guaranteed payments for the use of capital under section 
707(c); and
    (J) Other transactions, as provided by the Commissioner in published 
guidance. See Sec. 601.601(d)(2) of this chapter.
    (ii) Income from the sale of property. Income from the sale of 
property will not be treated as income equivalent to interest by reason 
of paragraph (h)(2)(i)(A) or (B) of this section. Income derived by a 
controlled foreign corporation will be treated as arising from the sale 
of property only if the corporation in substance carries out sales 
activities. Accordingly, an arrangement that is designed to lend the 
form of a sales transaction to a transaction that in substance 
constitutes an advance of funds will be disregarded. For example, if a 
controlled foreign corporation acquires property on 30-day payment terms 
from one person and sells that property to another person on 90-day 
payment terms and at prearranged prices and terms such that the foreign 
corporation bears no substantial economic risk with respect to the 
purchase and sale other than the risk of non-payment, the foreign 
corporation has not in substance derived income from the sale of 
property.
    (3) Notional principal contracts--(i) In general. Income equivalent 
to interest includes income from notional principal contracts 
denominated in the functional currency of the taxpayer (or a qualified 
business unit of the taxpayer, as defined in section 989(a)), the value 
of which is determined solely by reference to interest rates or interest 
rate indices, to the extent that the income from such transactions 
accrues on or after August 14, 1989.
    (ii) Regular dealers. Income equivalent to interest does not include 
income earned by a regular dealer (as defined in paragraph (a)(4)(iv) of 
this section) from notional principal contracts that are dealer property 
(as defined in paragraph (a)(4)(v) of this section).
    (4) Income equivalent to interest from factoring--(i) General rule. 
Income equivalent to interest includes factoring income. Except as 
provided in paragraph (h)(4)(ii) of this section, the term factoring 
income includes any income (including any discount income or service 
fee, but excluding any stated interest) derived from the acquisition and 
collection or disposition of a factored receivable. The amount of income 
equivalent to interest realized with respect to a factored receivable is 
the difference (if a positive number) between the amount paid for the 
receivable by the foreign corporation and the amount that it collects on 
the receivable (or realizes upon its sale of the receivable). The rules 
of this paragraph (h)(4) apply only with respect to the tax treatment of 
factoring income derived from the acquisition and collection or 
disposition of a factored receivable and shall not affect the 
characterization of an expense or loss of either the person whose goods 
or services gave rise to a factored receivable or the obligor under a 
receivable.
    (ii) Exceptions. Factoring income shall not include--
    (A) Income treated as interest under section 864(d)(1) or (6) 
(relating to income derived from trade or service receivables of related 
persons), even if such income is treated as not described

[[Page 301]]

in section 864(d)(1) by reason of the same-country exception of section 
864(d)(7);
    (B) Income derived from a factored receivable if payment for the 
acquisition of the receivable is made on or after the date on which 
stated interest begins to accrue, but only if the rate of stated 
interest equals or exceeds 120 percent of the Federal short-term rate 
(as defined under section 1274) (or the analogous rate for a currency 
other than the dollar) as of the date on which the receivable is 
acquired by the foreign corporation; or
    (C) Income derived from a factored receivable if payment for the 
acquisition of the receivable by the foreign corporation is made only on 
or after the anticipated date of payment of all principal by the obligor 
(or the anticipated weighted average date of payment of a pool of 
purchased receivables).
    (iii) Factored receivable. For purposes of this paragraph (h)(4), 
the term factored receivable includes any account receivable or other 
evidence of indebtedness, whether or not issued at a discount and 
whether or not bearing stated interest, arising out of the disposition 
of property or the performance of services by any person, if such 
account receivable or evidence of indebtedness is acquired by a person 
other than the person who disposed of the property or provided the 
services that gave rise to the account receivable or evidence of 
indebtedness. For purposes of this paragraph (h)(4), it is immaterial 
whether the person providing the property or services agrees to transfer 
the receivable at the time of sale (as by accepting a third-party charge 
or credit card) or at a later time.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (h)(4).

    Example 1. DP, a domestic corporation, owns all of the outstanding 
stock of FS, a controlled foreign corporation. FS acquires accounts 
receivable arising from the sale of property by unrelated corporation X. 
The receivables have a face amount of $100, and after 30 days bear 
stated interest equal to at least 120 percent of the applicable Federal 
short-term rate (determined as of the date the receivables are acquired 
by FS). FS purchases the receivables from X for $95 on Day 1 and 
collects $100 plus stated interest from the obligor under the 
receivables on Day 40. Income (other than stated interest) derived by FS 
from the factored receivables is factoring income within the meaning of 
paragraph (h)(4)(i) of this section and, therefore, is income equivalent 
to interest.
    Example 2. The facts are the same as in Example 1, except that, 
rather than collecting $100 plus stated interest from the obligor under 
the factored receivables on Day 40, FS sells the receivables to 
controlled foreign corporation Y on Day 15 for $97. Both the income 
derived by FS on the factored receivables and the income derived by Y 
(other than stated interest) on the receivables are factoring income 
within the meaning of paragraph (h)(4)(i) of this section, and 
therefore, constitute income equivalent to interest.
    Example 3. The facts are the same as in Example 1, except that FS 
purchases the receivables from X for $98 on Day 30. Income derived by FS 
from the factored receivables is excluded from factoring income under 
paragraph (h)(4)(ii)(B) of this section and, therefore, does not give 
rise to income equivalent to interest.
    Example 4. The facts are the same as in Example 3, except that it is 
anticipated that all principal will be paid by the obligor of the 
receivables by Day 30. Income derived by FS from this maturity factoring 
of the receivables is excluded from factoring income under paragraph 
(h)(4)(ii)(C) of this section and, therefore, does not give rise to 
income equivalent to interest.
    Example 5. The facts are the same as in Example 4, except that FS 
sells the factored receivables to Y for $99 on Day 45, at which time 
stated interest is accruing on the unpaid balance of $100. Because 
interest was accruing at the time Y acquired the receivables at a rate 
equal to at least 120 percent of the applicable Federal short-term rate, 
income derived by Y from the factored receivables is excluded from 
factoring income under paragraph (h)(4)(ii)(B) of this section and, 
therefore, does not give rise to income equivalent to interest.
    Example 6. DP, a domestic corporation engaged in an integrated 
credit card business, owns all of the outstanding stock of FS, a 
controlled foreign corporation. On Day 1, individual A uses a credit 
card issued by DP to purchase shoes priced at $100 from X, a foreign 
corporation unrelated to DP, FS, or A. On Day 7, X transfers the 
receivable (which does not bear stated interest) arising from A's 
purchase to FS in exchange for $95. FS collects $100 from A on Day 45. 
Income derived by FS on the factored receivable is factoring income 
within the meaning of paragraph (h)(4)(i) of this section and, 
therefore, is income equivalent to interest.


[[Page 302]]


    (5) Receivables arising from performance of services. If payment for 
services performed by a controlled foreign corporation is not made until 
more than 120 days after the date on which such services are performed, 
then the income derived by the controlled foreign corporation 
constitutes income equivalent to interest to the extent that interest 
income would be imputed under the principles of section 483 or the 
original issue discount provisions (sections 1271 through 1275), if--
    (i) Such provisions applied to contracts for the performance of 
services;
    (ii) The time period referred to in sections 483(c)(1) and 
1274(c)(1)(B) were 120 days rather than six months; and
    (iii) The time period referred to in section 483(c)(1)(A) were 120 
days rather than one year.
    (6) Examples. The following examples illustrate the application of 
this paragraph (h).

    Example 1. CFC, a controlled foreign corporation, promises that 
Corporation A may borrow up to $500 in principal for one year beginning 
at any time during the next three months at an interest rate of 10 
percent. In exchange, Corporation A pays CFC a commitment fee of $2. 
Pursuant to this agreement, CFC lends $80 to Corporation A. As a result, 
the entire $2 fee is included in the computation of CFC's foreign 
personal holding company income under paragraph (h)(2)(i)(G) of this 
section.
    Example 2. (i) At the beginning of its current taxable year, CFC, a 
controlled foreign corporation, purchases at face value a one-year debt 
instrument issued by Corporation A having a $100 principal amount and 
bearing a floating rate of interest set at the London Interbank Offered 
Rate (LIBOR) plus one percentage point. Contemporaneously, CFC borrows 
$100 from Corporation B for one year at a fixed interest rate of 10 
percent, using the debt instrument as security.
    (ii) During its current taxable year, CFC accrues $11 of interest 
from Corporation A on the bond. Because interest is excluded from the 
definition of income equivalent to interest under paragraph 
(h)(1)(ii)(B) of this section, the $11 is not income equivalent to 
interest.
    (iii) During its current taxable year, CFC incurs $10 of interest 
expense with respect to the borrowing from Corporation B. That expense 
is allocated and apportioned to, and reduces, subpart F income to the 
extent provided in section 954(b)(5) and Sec. Sec. 1.861-9T through 
1.861-12T and 1.954-1(c).
    Example 3. (i) On January 1, 1994, CFC, a controlled foreign 
corporation with the United States dollar as its functional currency, 
purchases at face value a 10-year debt instrument issued by Corporation 
A having a $100 principal amount and bearing a floating rate of interest 
set at LIBOR plus one percentage point payable on December 31st of each 
year. CFC subsequently determines that it would prefer receiving a fixed 
rate of return. Accordingly, on January 1, 1995, CFC enters into a 9-
year interest rate swap agreement with Corporation B whereby Corporation 
B promises to pay CFC on December 31st of each year an amount equal to 
10 percent on a notional principal amount of $100. In exchange, CFC 
promises to pay Corporation B an amount equal to LIBOR plus one 
percentage point on the notional principal amount.
    (ii) On December 31, 1995, CFC receives $9 of interest income from 
Corporation A with respect to the debt instrument. On the same day, CFC 
receives a total of $10 from Corporation B and pays $9 to Corporation B 
with respect to the interest rate swap.
    (iii) The $9 of interest income is foreign personal holding income 
under section 954(c)(1). Pursuant to Sec. 1.446-3(d), CFC recognizes $1 
of swap income for its 1995 taxable year that is also foreign personal 
holding company income because it is income equivalent to interest under 
paragraph (h)(2)(i)(C) of this section.
    Example 4. (i) CFC, a controlled foreign corporation, purchases 
commodity X on the spot market for $100 and, contemporaneously, enter 
into a 3-month forward contract to sell commodity X for $104, a price 
set by the forward market.
    (ii) Assuming that substantially all of CFC's expected return is 
attributable to the time value of the net investment, as described in 
section 1258(c)(1), the transaction is a conversion transaction under 
section 1258(c). Accordingly, any gain treated as ordinary income under 
section 1258(a) will be foreign personal holding company income because 
it is income equivalent to interest under paragraph (h)(2)(i)(E) of this 
section.
    (i) Applicability dates--(1) Paragraphs (c)(2)(v) through (vii). 
Paragraphs (c)(2)(v) through (vii) of this section and Example 6 of 
paragraph (c)(3) of this section apply to taxable years of controlled 
foreign corporations beginning on or after May 2, 2006, and for taxable 
years of United States shareholders with or within which such taxable 
years of the controlled foreign corporations end. Taxpayers may elect to 
apply paragraphs (c)(2)(v) through (vii) to taxable years of controlled 
foreign corporations beginning after December 31, 2004, and for taxable 
years of United States shareholders with or within

[[Page 303]]

which such taxable years of the controlled foreign corporations end. If 
an election is made to apply Sec. 1.956-2(b)(1)(vi) to taxable years 
beginning after December 31, 2004, then the election must also be made 
for paragraphs (c)(2)(v) through (vii) of this section.
    (2) Paragraphs (c)(2)(iii)(B) and (c)(2)(iv)(A) of this section. 
Paragraphs (c)(2)(iii)(B) and (c)(2)(iv)(A) of this section apply for 
taxable years of controlled foreign corporations ending on or after 
November 19, 2019, and for the taxable years of United States 
shareholders in which or with which such taxable years end.
    (3) Other paragraphs. Paragraphs (c)(1)(i) and (d)(1)(i) of this 
section apply to rents or royalties, as applicable, received or accrued 
during taxable years of controlled foreign corporations ending on or 
after September 1, 2015, and to taxable years of United States 
shareholders in which or with which such taxable years end, but only 
with respect to property manufactured, produced, developed, or created, 
or in the case of acquired property, property to which substantial value 
has been added, on or after September 1, 2015. Paragraphs (c)(1)(iv), 
(c)(2)(ii), (c)(2)(iii)(E), (c)(2)(viii), (d)(1)(ii), (d)(2)(ii), 
(d)(2)(iii)(E), and (d)(2)(v) of this section apply to rents or 
royalties, as applicable, received or accrued during taxable years of 
controlled foreign corporations ending on or after September 1, 2015, 
and to taxable years of United States shareholders in which or with 
which such taxable years end, to the extent that such rents or royalties 
are received or accrued on or after September 1, 2015. See Sec. 1.954-
2(c)(1)(i), (c)(1)(iv), (c)(2)(ii), (c)(2)(iii), (d)(1)(i), (d)(1)(ii), 
(d)(2)(ii), and (d)(2)(iii), as contained in 26 CFR part 1 revised as of 
April 1, 2015, for rules applicable to rents or royalties, as 
applicable, received or accrued before September 1, 2015. Paragraph 
(h)(2)(i)(I) of this section applies to taxable years of controlled 
foreign corporations ending on or after December 16, 2019, and to 
taxable years of United States shareholders in which or with which such 
taxable years end.

[T.D. 8618, 60 FR 46517, Sept. 7, 1995]

    Editorial Note: For Federal Register citations affecting Sec. 
1.954-2, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec. 1.954-3  Foreign base company sales income.

    (a) Income included--(1) In general--(i) General rules. Foreign base 
company sales income of a controlled foreign corporation shall, except 
as provided in paragraphs (a)(2), (a)(3) and (a)(4) of this section, 
consist of gross income (whether in the form of profits, commissions, 
fees or otherwise) derived in connection with the purchase of personal 
property from a related person and its sale to any person, the sale of 
personal property to any person on behalf of a related person, the 
purchase of personal property from any person and its sale to a related 
person, or the purchase of personal property from any person on behalf 
of a related person. See section 954(d)(1). For purposes of the 
preceding sentence, except as provided in paragraphs (a)(2) and (a)(4) 
of this section, personal property sold by a controlled foreign 
corporation will be considered to be the same property that was 
purchased by the controlled foreign corporation regardless of whether 
the personal property is sold in the same form in which it was 
purchased, in a different form than the form in which it was purchased, 
or as a component part of a manufactured product. This section shall 
apply to the purchase and/or sale of personal property, whether or not 
such property was purchased and/or sold in the ordinary course of trade 
or business, except that income derived in connection with the sale of 
tangible personal property will not be considered to be foreign base 
company sales income if such property is sold to a person that is not a 
related person, as defined in Sec. 1.954-1(f), after substantial use 
has been made of the property by the controlled foreign corporation in 
its trade or business. This section shall not apply to the excess of 
gains over losses from sales or exchanges of securities or from futures 
transactions, to the extent such excess gains are includible in foreign 
personal holding company income of the controlled foreign corporation 
under Sec. 1.954-2; nor shall it apply to the sale of the controlled 
foreign corporation's property (other than its stock in trade

[[Page 304]]

or other property of a kind which would properly be included in its 
inventory if on hand at the close of the taxable year, or property held 
primarily for sale to customers in the ordinary course of its business) 
if substantially all the property of such corporation is sold pursuant 
to the discontinuation of the trade or business previously carried on by 
such corporation. The term ``any person'' as used in this paragraph 
(a)(1)(i) includes a related person as defined in Sec. 1.954-1(f).
    (ii) Special rule--(a) In general. The term ``personal property'' as 
used in section 954(d) and this section shall not include agricultural 
commodities which are not grown in the United States (within the meaning 
of section 7701(a)(9)) in commercially marketable quantities. All of the 
agricultural commodities listed in table I shall be considered grown in 
the United States in commercially marketable quantities. Bananas, black 
pepper, cocoa, coconut, coffee, crude rubber, and tea shall not be 
considered grown in the United States in commercially marketable 
quantities. All other agricultural commodities shall not be considered 
grown in the United States in commercially marketable quantities when, 
in consideration of all of the facts and circumstances of the individual 
case, such commodities are shown to be produced in the United States in 
insufficient quantity and quality to be marketed commercially. The term 
``agricultural commodities'' includes, but is not limited to, livestock, 
poultry, fish produced in fish farms, fruit, furbearing animals as well 
as the products of truck farms, ranches, nurseries, ranges, and 
orchards. A fish farm is an area where fish are grown or raised 
(artificially protected and cared for), as opposed to merely caught or 
harvested. However, the term ``agricultural commodities'' shall not 
include timber (either standing or felled), or any commodity at least 50 
percent of the fair market value of which is attributable to 
manufacturing or processing, determined in a manner consistent with the 
regulations under section 993(c) (relating to the definition of export 
property). For purposes of applying such regulations, the term 
``processing'' shall be deemed not to include handling, packing, 
packaging, grading, storing, transporting, slaughtering, and harvesting. 
Subdivision (ii) shall apply in the computation of foreign base company 
sales income for taxable years of controlled foreign corporations 
beginning after December 31, 1975, and to taxable years of U.S. 
shareholders (within the meaning of section 951(b)) within which or with 
which such taxable years of such foreign corporations end.
    (b) Table.

     Table I--Agricultural Commodities Grown in the United States in
                   Commercially Marketable Quantities
                         Livestock and Products
 
Beeswax                              Horses
Cattle and calves                    Milk
Chickens                             Mink
Chicken eggs                         Mohair
Ducks                                Rabbits
Geese                                Sheep and lambs
Goats                                Turkeys
Hogs                                 Wool
Honey
 
                                  Crops
 
Alfalfa                              Lettuce
Almonds                              Lime
Apples                               Macadamia nuts
Apricots                             Maple syrup and
Artichokes                            sugar
Asparagus                            Mint
Avocadoes                            Mushrooms
Barley                               Nectarines
Beans                                Oats
Beets                                Olives
Blackberries                         Onions
Blueberries                          Oranges
Brussel sprouts                      Papayas
Broccoli                             Pecans
Bulbs                                Peaches
Cabbage                              Peanuts
Cantaloupes                          Pears
Carrots                              Peas
Cauliflower                          Peppers
Celery                               Plums and prunes
Cherries                             Potatoes
Corn                                 Potted plants
Cotton                               Raspberries
Cranberries                          Rice
Cucumbers                            Rhubarb
Cut flowers                          Rye
Dates                                Sorghum grain
Eggplant                             Soybeans
Escarole                             Spinach
Figs                                 Strawberries
Filberts                             Sugar beets
Flaxseed                             Sugarcane
Garlic                               Sweet potatoes
Grapes                               Tangelos
Grapefruit                           Tangerines
Grass seed                           Tobacco
Hay                                  Tomatoes
Honeydew melons                      Walnuts
Hops                                 Watermelons
Lemons                               Wheat
 


[[Page 305]]

    (iii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation M. Corporation A purchases from M Corporation, a related 
person, articles manufactured in the United States and sells the 
articles to P, an unrelated person, for delivery and use in foreign 
country Y. Gross income of A Corporation derived from the purchase and 
sale of the personal property is foreign base company sales income.
    Example 2. Corporation A in Example 1 also purchases from P, an 
unrelated person, articles manufactured in country Y and sells the 
articles to foreign corporation B, a related person, for use in foreign 
country Z. Gross income of A Corporation derived from the purchase and 
sale of the personal property is foreign base company sales income.
    Example 3. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation N. By contract, N Corporation agrees to pay C Corporation, a 
related person, a commission equal to 6 percent of the gross selling 
price of all personal property shipped by N Corporation as the result of 
orders solicited by C Corporation in foreign countries Y and Z. In 
fulfillment of such orders, N Corporation ships products manufactured by 
it in the United States. Corporation C does not assume title to the 
property sold. Gross commissions received by C Corporation from N 
Corporation in connection with the sale of such property for use in 
countries Y and Z constitute foreign base company sales income.
    Example 4. Controlled foreign corporation D, incorporated under the 
laws of foreign country Y, is a wholly owned subsidiary of domestic 
corporation R. In 1964, D Corporation acquires a United States 
manufactured lathe from R Corporation. In 1972, after having made 
substantial use of the lathe in its manufacturing business, D 
Corporation sells the lathe to an unrelated person for use in foreign 
country Z. Gross income from the sale of the lathe is not foreign base 
company sales income since it is sold to an unrelated person after 
substantial use has been made of it by D Corporation in its business.
    Example 5. Controlled foreign corporation E, incorporated under the 
laws of foreign country Y, is a wholly owned subsidiary of domestic 
corporation P. Corporation E purchases from P Corporation articles 
manufactured by P Corporation outside of country Y and sells the 
articles to F Corporation, an unrelated person, for use in foreign 
country Z. Corporation E finances the purchase of the articles by F 
Corporation by agreeing to accept payment over an extended period of 
time and receives not only the purchase price but also interest and 
service fees. All gross income of E Corporation derived in connection 
with the purchase and sale of the personal property, including interest 
and service fees derived from financing the sale to F Corporation, 
constitutes foreign base company sales income.

    (2) Property manufactured, produced, constructed, grown, or 
extracted within the country in which the controlled foreign corporation 
is created or organized. Foreign base company sales income does not 
include income derived in connection with the purchase and sale of 
personal property (or purchase or sale of personal property on behalf of 
a related person) in a transaction described in paragraph (a)(1) of this 
section if the property is manufactured, produced, constructed, grown, 
or extracted in the country under the laws of which the controlled 
foreign corporation which purchases and sells the property (or acts on 
behalf of a related person) is created or organized. See section 
954(d)(1)(A). The principles set forth in paragraphs (a)(4)(ii) and 
(a)(4)(iii) of this section apply under this paragraph (a)(2) in 
determining what constitutes the manufacture, production, or 
construction of personal property, excluding the requirement set forth 
in paragraph (a)(4)(i) of this section that the provisions of paragraphs 
(a)(4)(ii) and (a)(4)(iii) of this section may only be satisfied through 
the activities of employees of the corporation manufacturing, producing, 
or constructing the personal property. The principles of paragraph 
(a)(4)(iv) of this section apply under this paragraph (a)(2) in 
determining what constitutes the manufacture, production, or 
construction of personal property but only when the personal property is 
manufactured, produced, or constructed by a person related to the 
controlled foreign corporation within the meaning of Sec. 1.954-1(f). 
The application of this paragraph (a)(2) may be illustrated by the 
following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation M. Corporation A purchases coffee beans grown in country X 
from foreign corporation P, a related person, and sells the beans to M 
Corporation, a related person, for use in the United States. Income

[[Page 306]]

from the purchase and sale of the coffee beans by A Corporation is not 
foreign base company sales income since the beans were grown in country 
X.
    Example 2. Controlled foreign corporation B, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of controlled 
foreign corporation C, also incorporated under the laws of country X. 
Corporation B purchases and imports into country X rough diamonds mined 
in foreign country Y; in country X it cuts, polishes, and shapes the 
diamonds in a process which constitutes manufacturing within the meaning 
of subparagraph (4) of this paragraph. Corporation B sells the finished 
diamonds to C Corporation, a related person, which in turn sells them 
for use in foreign country Z. Since for purposes of this subparagraph 
the finished diamonds are manufactured in country X, gross income 
derived by C Corporation from their sale is not foreign base company 
sales income.

    (3) Property sold for use, consumption, or disposition within the 
country in which the controlled foreign corporation is created or 
organized--(i) In general. Foreign base company sales income does not 
include income derived in connection with the purchase and sale of 
personal property (or purchase or sale of personal property on behalf of 
a related person) in a transaction described in subparagraph (1) of this 
paragraph, (a) if the property is sold for use, consumption, or 
disposition in the country under the laws of which the controlled 
foreign corporation which purchases and sells the property (or sells on 
behalf of a related person) is created or organized or (b), where the 
property is purchased by the controlled foreign corporation on behalf of 
a related person, if such property is purchased for use, consumption, or 
disposition in the country under the laws of which such controlled 
foreign corporation is created or organized. See section 954(d)(1)(B).
    (ii) Rules for determining country of use, consumption, or 
disposition. As a general rule, personal property which is sold to an 
unrelated person will be presumed for purposes of this subparagraph to 
have been sold for use, consumption, or disposition in the country of 
destination of the property sold; for such purpose, the occurrence in a 
country of a temporary interruption in shipment of goods shall not 
constitute such country the country of destination. However, if at the 
time of a sale of personal property to an unrelated person the 
controlled foreign corporation knew, or should have known from the facts 
and circumstances surrounding the transaction, that the property 
probably would not be used, consumed, or disposed of in the country of 
destination, the controlled foreign corporation must determine the 
country of ultimate use, consumption, or disposition of the property or 
the property will be presumed to have been used, consumed, or disposed 
of outside the country under the laws of which the controlled foreign 
corporation is created or organized. A controlled foreign corporation 
which sells personal property to a related person is presumed to sell 
such property for use, consumption, or disposition outside the country 
under the laws of which the controlled foreign corporation is created or 
organized unless such corporation establishes the use made of the 
property by the related person; once it has established that the related 
person has disposed of the property, the rules in the two preceding 
sentences relating to sales by a controlled foreign corporation to an 
unrelated person will apply at the first stage in the chain of 
distribution at which a sale is made by a related person to an unrelated 
person. Notwithstanding the preceding provisions of this subdivision, a 
controlled foreign corporation which sells personal property to any 
person all of whose business except for an insubstantial part consists 
of selling from inventory to retail customers at retail outlets all 
within one country may assume at the time of such sale to such person 
that such property will be used, consumed, or disposed of within such 
country.
    (iii) Fungible goods. For purposes of this subparagraph, a 
controlled foreign corporation which sells to a purchaser personal 
property which because of its fungible nature cannot reasonable be 
specifically traced to other purchasers and to the countries of ultimate 
use, consumption, or disposition shall, unless such corporation 
establishes a different disposition as being proper, treat such property 
as being sold, for ultimate use, consumption, or disposition in those 
countries, and to those

[[Page 307]]

other purchasers, in the same proportions in which property from the 
fungible mass of the first purchaser is sold in the regular course of 
business by such first purchaser. No apportionment need be made, 
however, on the basis of sporadic sales by the first purchaser. This 
subdivision shall apply only in a case where the controlled foreign 
corporation knew, or should have known from the facts and circumstances 
surrounding the transaction, the manner in which the first purchaser 
disposes of goods from the fungible mass.
    (iv) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, and controlled foreign corporation B, 
incorporated under the laws of foreign country Y, are related persons. 
Corporation A purchases from B Corporation electric transformers 
produced by B Corporation in country Y and sells the transformers to D 
Corporation, an unrelated person, for installation in a factory building 
being constructed in country X. Since the personal property purchased 
and sold by A Corporation is to be used within the country in which A 
Corporation is incorporated, income of A Corporation derived from the 
purchase and sale of the electric transformers is not foreign base 
company sales income.
    Example 2. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation N. Corporation C purchases from N Corporation sewing 
machines manufactured in the United States by N Corporation and sells 
the sewing machines to retail department stores, unrelated persons, 
located in foreign country X. The entire activities of the department 
stores to which C Corporation sells the machines consist of selling 
goods from inventory to retail customers at retail outlets in country X. 
Under these circumstances, at the time of sale C Corporation may assume 
the sewing machines will be used, consumed, or disposed of in country X, 
and no attempt need be made by C Corporation to determine where the 
sewing machines will ultimately be used by the customers of the retail 
department stores. Gross income of C Corporation derived from the sales 
to the department stores located in country X is not foreign base 
company sales income.
    Example 3. Controlled foreign corporation D, incorporated under the 
laws of foreign country Y, and controlled foreign corporation E, 
incorporated under the laws of foreign country X, are related persons. 
Corporation D purchases from E Corporation sulphur extracted by E 
Corporation from deposits located in country X. Corporation D sells the 
sulphur to F Corporation, an unrelated person, for delivery to F 
Corporation's storage facilities located in country Y. At the time of 
the sale of the sulphur from D Corporation to F Corporation, D 
Corporation knows that F Corporation is actively engaged in the business 
of selling a large amount of sulphur in country Y but also that F 
Corporation sells, in the normal course of its business, 25 percent of 
its sulphur for ultimate consumption in foreign country Z. However, D 
Corporation has no knowledge at the time of sale whether any portion of 
the particular shipment it sells to F Corporation will be resold by F 
Corporation for ultimate use, consumption, or disposition outside 
country Y. Moreover, delivery of the sulphur to F Corporation's storage 
facilities constitutes more than a temporary interruption in the 
shipment of the sulphur. Under such circumstances, D Corporation may, 
but is not required to, trace the ultimate disposition by F Corporation 
of the personal property sold to F Corporation; however, if D 
Corporation does not trace the ultimate disposition and if it does not 
establish a different disposition as being proper, 25 percent of the 
sulphur sold by D Corporation to F Corporation will be treated as being 
sold for consumption in country Z and 25 percent of the gross income 
from the sale of sulphur by D Corporation to F Corporation will be 
treated as foreign base company sales income.
    Example 4. Controlled foreign corporation G, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation P. Corporation G purchases from P Corporation toys 
manufactured in the United States by P Corporation and sells the toys to 
R, an unrelated person, for delivery to a duty-free port in country X. 
Instructions for the assembly and operation of the toys are printed in a 
language which is not commonly used in country X. From the facts and 
circumstances surrounding the sales to R, G Corporation knows, or should 
know, that the toys will probably not be used, consumed, or disposed of 
within country X. Therefore, unless G Corporation determines the use to 
be made of the toys by R, such property will be presumed to have been 
sold by R for use, consumption, or disposition outside of country X, and 
the entire gross income of G Corporation derived from the sales will be 
considered foreign base company sales income.

    (4) Property manufactured, produced, or constructed by the 
controlled foreign corporation--(i) In general. Foreign base company 
sales income does not include income of a controlled foreign corporation 
derived in connection with the

[[Page 308]]

sale of personal property manufactured, produced, or constructed by such 
corporation. A controlled foreign corporation will have manufactured, 
produced, or constructed personal property which the corporation sells 
only if such corporation satisfies the provisions of paragraph 
(a)(4)(ii), (a)(4)(iii), or (a)(4)(iv) of this section through the 
activities of its employees (as defined in Sec. 31.3121(d)-1(c) of this 
chapter) with respect to such property. A controlled foreign corporation 
will not be treated as having manufactured, produced, or constructed 
personal property which the corporation sells merely because the 
property is sold in a different form than the form in which it was 
purchased. For rules of apportionment in determining foreign base 
company sales income derived from the sale of personal property 
purchased and used as a component part of property which is not 
manufactured, produced, or constructed, see paragraph (a)(5) of this 
section.
    (ii) Substantial transformation of property. If personal property 
purchased by a foreign corporation is substantially transformed by such 
foreign corporation prior to sale, the property sold by the selling 
corporation is manufactured, produced, or constructed by such selling 
corporation. The application of this paragraph (a)(4)(ii) may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, operates a paper factory in foreign country 
Y. Corporation A purchases from a related person wood pulp grown in 
country Y. Corporation A, by a series of processes, converts the wood 
pulp to paper which it sells for use in foreign country Z. The 
transformation of wood pulp to paper constitutes the manufacture or 
production of property for purposes of this subparagraph.
    Example 2. Controlled foreign corporation B, incorporated under the 
laws of foreign country X, purchases steel rods from a related person 
which produces the steel in foreign country Y. Corporation B operates a 
machining plant in country X in which it utilizes the purchased steel 
rods to make screws and bolts. The transformation of steel rods to 
screws and bolts constitutes the manufacture or production of property 
for purposes of this subparagraph.
    Example 3. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, purchases tuna fish from unrelated persons 
who own fishing boats which catch such fish on the high seas. 
Corporation C receives such fish in country X in the condition in which 
taken from the fishing boats and in such country processes, cans, and 
sells the fish to related person D, incorporated under the laws of 
foreign country Y, for consumption in foreign country Z. The 
transformation of such fish into canned fish constitutes the manufacture 
or production of property for purposes of this subparagraph.

    (iii) Manufacture of a product when purchased components constitute 
part of the property sold. If purchased property is used as a component 
part of personal property which is sold, the sale of the property will 
be treated as the sale of a manufactured product, rather than the sale 
of component parts, if the assembly or conversion of the component parts 
into the final product by the selling corporation involves activities 
that are substantial in nature and generally considered to constitute 
the manufacture, production, or construction of property. Without 
limiting this substantive test, which is dependent on the facts and 
circumstances of each case, the operations of the selling corporation in 
connection with the use of the purchased property as a component part of 
the personal property which is sold will be considered to constitute the 
manufacture of a product if in connection with such property conversion 
costs (direct labor and factory burden) of such corporation account for 
20 percent or more of the total cost of goods sold. In no event, 
however, will packaging, repackaging, labeling, or minor assembly 
operations constitute the manufacture, production, or construction of 
property for purposes of section 954(d)(1). The application of this 
paragraph (a)(4)(iii) may be illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, sells industrial engines for use, 
consumption, and disposition outside country X. Corporation A, in 
connection with the assembly of such engines, performs machining and 
assembly operations. In addition, A Corporation purchases, from related 
and unrelated persons, components manufactured in foreign country Y. On 
a per unit basis, A Corporation's selling price and costs of such 
engines are as follows:

Selling price...................................  ......  ......    $400
Cost of goods sold:
  Material--
    Acquired from related persons...............    $100

[[Page 309]]

 
    Acquired from others........................      40
                                                 --------
     Total material.............................  ......    $140
Conversion costs (direct labor and factory burden)......      70
                                                 --------
Total cost of goods sold........................  ......     210
                                                         ---------
Gross profit....................................  ......     190
Administrative and selling expenses.............  ......      50
                                                         =========
Taxable income..................................  ......     140
 


The conversion costs incurred by A Corporation are more than 20 percent 
of total costs of goods sold ($70/$210 or 33 percent). Although the 
product sold, an engine, is not sufficiently distinguishable from the 
components to constitute a substantial transformation of the purchased 
parts within the meaning of subdivision (ii) of this subparagraph, A 
Corporation will be considered under this subdivision to have 
manufactured the product it sells.
    Example 2. Controlled foreign corporation B, incorporated under the 
laws of foreign country X, operates an automobile assembly plant. In 
connection with such activity, B Corporation purchases from related 
persons assembled engines, transmissions, and certain other components, 
all of which are manufactured outside of country X; purchases additional 
components from unrelated persons; conducts stamping, machining, and 
subassembly operations; and has a substantial investment in tools, jigs, 
welding equipment, and other machinery and equipment used in the 
assembly of an automobile. On a per unit basis, B Corporation's selling 
price and costs of such automobiles are as follows:

Selling price..........................  .........  .........     $2,500
Cost of goods sold:
  Material--
    Acquired from related persons......     $1,200
    Acquired from others...............        275
                                        -----------
     Total material....................  .........     $1,475
Conversion costs (direct labor and factory burden)         25
                                        -----------
     Total cost of goods sold.....................  .........      1,800
                                                   ------------
Gross profit......................................  .........        700
Administrative and selling expenses...............  .........        300
                                                   ------------
     Taxable income...............................  .........        400
                                                   ============
 


The product sold, an automobile, is not sufficiently distinguishable 
from the components purchased (the engine, transmission, etc.) to 
constitute a substantial transformation of purchased parts within the 
meaning of subdivision (ii) of this subparagraph. Although conversion 
costs of B Corporation are less than 20 percent of total cost of goods 
sold ($325/$1800 or 18 percent), the operations conducted by B 
Corporation in connection with the property purchased and sold are 
substantial in nature and are generally considered to constitute the 
manufacture of a product. Corporation B will be considered under this 
subdivision to have manufactured the product it sells.
    Example 3. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, purchases from related persons radio parts 
manufactured in foreign country Y. Corporation C designs radio kits, 
packages component parts required for assembly of such kits, and sells 
the parts in a knocked-down condition to unrelated persons for use 
outside country X. These packaging operations of C Corporation do not 
constitute the manufacture, production, or construction of personal 
property for purposes of section 954(d)(1).

    (iv) Substantial contribution to manufacturing of personal 
property--(a) In general. If an item of personal property would be 
considered manufactured, produced, or constructed (under the principles 
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) prior to sale by 
the controlled foreign corporation had all of the manufacturing, 
producing, and constructing activities undertaken with respect to that 
property prior to sale been undertaken by the controlled foreign 
corporation through the activities of its employees, then this paragraph 
(a)(4)(iv) applies. If this paragraph (a)(4)(iv) applies and if the 
facts and circumstances evince that the controlled foreign corporation 
makes a substantial contribution through the activities of its employees 
to the manufacture, production, or construction of the personal property 
sold, then the personal property sold by the controlled foreign 
corporation is manufactured, produced, or constructed by such controlled 
foreign corporation.
    (b) Activities. The determination of whether a controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture, production, or construction of the 
personal property sold involves, but will not necessarily be limited to, 
consideration of the following activities:
    (1) Oversight and direction of the activities or process pursuant to 
which the property is manufactured, produced, or constructed (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section).

[[Page 310]]

    (2) Activities that are considered in, but that are insufficient to 
satisfy, the tests provided in paragraphs (a)(4)(ii) and (a)(4)(iii) of 
this section.
    (3) Material selection, vendor selection, or control of the raw 
materials, work-in-process or finished goods.
    (4) Management of manufacturing costs or capacities (for example, 
managing the risk of loss, cost reduction or efficiency initiatives 
associated with the manufacturing process, demand planning, production 
scheduling, or hedging raw material costs).
    (5) Control of manufacturing related logistics.
    (6) Quality control (for example, sample testing or establishment of 
quality control standards).
    (7) Developing, or directing the use or development of, product 
design and design specifications, as well as trade secrets, technology, 
or other intellectual property for the purpose of manufacturing, 
producing, or constructing the personal property.
    (c) Application of substantial contribution test. When considering 
whether a controlled foreign corporation makes a substantial 
contribution to the manufacture, production, or construction of the 
personal property, the performance of any activity in paragraph 
(a)(4)(iv)(b) of this section will be taken into account. The 
performance or lack of performance of any particular activity in 
paragraph (a)(4)(iv)(b) of this section, or of a particular number of 
activities in (a)(4)(iv)(b) of this section, is not determinative. The 
weight accorded to the performance of any quantum of any activity 
(whether or not specified in paragraph (a)(4)(iv)(b) of this section) 
will vary with the facts and circumstances of the particular business. 
See paragraph (a)(4)(iv)(d) Examples 8, 10 and 11 of this section. In 
determining whether the activities of the controlled foreign corporation 
constitute a substantial contribution, there is no minimum performance 
threshold before an activity can be considered. The fact that other 
persons make a substantial contribution to the manufacture, production, 
or construction of the personal property prior to sale does not preclude 
the controlled foreign corporation from making a substantial 
contribution to the manufacture, construction, or production of that 
property through the activities of its employees. See paragraph 
(a)(4)(iv)(d) Example 9 of this section.
    (d) Examples. The rules of this paragraph (a)(4)(iv) are illustrated 
by the following examples:

    Example 1. No substantial contribution to manufacturing. (i) Facts. 
FS, a controlled foreign corporation, purchases raw materials from a 
related person. The raw materials are manufactured (under the principles 
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X 
by CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion outside of FS's country of organization. Product 
X is sold by FS for use outside of FS's country of organization. Under 
the terms of the contract, FS retains the right to control the raw 
materials, work-in-process, and finished goods, and the right to oversee 
and direct the activities or process pursuant to which Product X is 
manufactured by CM. FS owns the intellectual property used in the 
manufacturing process. However, FS does not exercise, through its 
employees, its powers to control the raw materials, work-in-process, or 
finished goods, and FS does not exercise its powers of oversight and 
direction. Likewise, FS does not, through its employees, develop or 
direct the use or development of the intellectual property for the 
purpose of manufacturing Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. FS does not satisfy the test under this paragraph (a)(4)(iv) 
because it does not make a substantial contribution through the 
activities of its employees to the manufacture of Product X. Mere 
contractual rights to control materials, contractual rights to oversee 
and direct the manufacturing activities or process pursuant to which the 
property is manufactured, and ownership of intellectual property are not 
sufficient to satisfy this paragraph (a)(4)(iv). Therefore, under the 
facts and circumstances of the business, FS is not considered to have 
manufactured Product X under paragraph (a)(4)(i) of this section.
    Example 2. Substantial contribution to manufacturing. (i) Facts. 
Assume the same facts as in Example 1, except for the following. FS, 
through its employees, engages in product design and quality control and 
controls manufacturing related logistics. Employees of

[[Page 311]]

FS exercise the right to oversee and direct the activities of CM in the 
manufacture of Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section. The analysis and conclusion 
would be the same if CM were related to FS because the relationship 
between CM and FS is irrelevant for purposes of applying paragraph 
(a)(4) of this section.
    Example 3. Raw materials procured by contract manufacturer. (i) 
Facts. FS, a controlled foreign corporation, enters into a contract with 
CM to manufacture (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) Product X. CM physically performs the 
substantial transformation, assembly, or conversion required to 
manufacture Product X outside of FS's country of organization. Product X 
is sold by FS to a related person for use outside of FS's country of 
organization. Employees of FS select the materials that will be used to 
manufacture Product X. FS does not own the materials or work-in-process 
during the manufacturing process. FS, through its employees, exercises 
oversight and direction of the manufacturing process and provides 
quality control. FS manages the manufacturing costs and capacities with 
respect to Product X by managing the risk of loss and engaging in demand 
planning and production scheduling.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section.
    Example 4. Physical conversion by employees of a person other than 
the contract manufacturer. (i) Facts. FS, a controlled foreign 
corporation organized in Country M, purchases raw materials from a 
related person. The raw materials are manufactured (under the principles 
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X 
by CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion required to manufacture Product X outside of 
FS's country of organization. Product X is sold by FS for use outside of 
FS's country of organization. CM contracts with another corporation for 
its employees in order to operate CM's manufacturing plant and 
transform, assemble, or convert the raw materials into Product X. Apart 
from the physical performance of the substantial transformation, 
assembly, or conversion of the raw materials into Product X, employees 
of FS perform all of the other manufacturing activities required in 
connection with the manufacture of Product X (for example, oversight and 
direction of the manufacturing process; vendor selection; control of raw 
materials, work-in-process, and finished goods; control of manufacturing 
related logistics; and quality control).
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section.
    Example 5. Automated manufacturing supervised by another person. (i) 
Facts. FS, a controlled foreign corporation, purchases raw materials 
from a related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into 
Product X by CM, an unrelated corporation selected by FS, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion outside of FS's 
country of organization. Product X is sold by FS to related and 
unrelated persons for use outside of FS's country of organization. At 
all times, FS retains ownership of the raw materials, work-in-process, 
and finished goods. FS retains the right to oversee and direct the 
activities or process pursuant to which Product X is manufactured by CM, 
but does not exercise, through its employees, its powers of oversight 
and direction. FS is the owner of sophisticated software and network 
systems that remotely and automatically (without human involvement) take 
orders, route them to CM, order raw materials, and perform quality 
control.

[[Page 312]]

FS has a small number of computer technicians who monitor the software 
and network systems to ensure that they are running smoothly and apply 
any necessary patches or fixes. The software and network systems were 
developed by employees of DP, the U.S. corporate parent of FS. DP's 
employees supervise the computer technicians, evaluate the results of 
the automated manufacturing business, and make ongoing operational 
decisions, including decisions related to acceptable performance of the 
manufacturing process, stoppages of that process, and decisions related 
to product and manufacturing process design. DP's employees develop and 
provide to FS all of the upgrades to the software and network systems. 
DP also has employees who direct and control other aspects of the 
manufacturing process such as vendor and material selection, management 
of the manufacturing costs and capacities, and the selection of CM. The 
need for DP's employees to direct the activities of the FS employees and 
otherwise contribute to the manufacturing process evinces that 
substantial operational responsibilities and decision making are 
required to be exercised by parties other than CM in order to 
manufacture Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstance of the business, FS does not 
satisfy the test under this paragraph (a)(4)(iv) because it does not 
make a substantial contribution through the activities of its employees 
to the manufacture of Product X. Mere ownership of materials and 
intellectual property along with contractual rights to exercise powers 
of direction and control are not sufficient to satisfy this paragraph 
(a)(4)(iv). The employees of FS do not perform the amount of activity 
necessary to constitute a substantial contribution. FS is not considered 
to have manufactured Product X under paragraph (a)(4)(i) of this 
section.
    Example 6. Automated manufacturing supervised by FS. (i) Facts. 
Assume the same facts as in Example 5, except for the following. FS, 
through its employees, engages in the activities undertaken by DP's 
employees in Example 5. DP's employees also contribute to product and 
manufacturing process design, and provide support and oversight to FS in 
connection with functions performed by FS through its employees.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. This determination does not require a comparison between 
the activities of FS and the activities of DP. Selection of the contract 
manufacturer, even though not specifically identified in paragraph 
(a)(4)(iv)(b) of this section, is considered under paragraph 
(a)(4)(iv)(c) of this section in determining whether FS makes a 
substantial contribution to the manufacture of Product X through its 
employees. FS is considered to have manufactured Product X under 
paragraph (a)(4)(i) of this section.
    Example 7. Automated manufacturing supervised by FS with purchased 
intellectual property. (i) Facts. Assume the same facts as in Example 6, 
except for the following. The software and network systems, and the 
upgrades to those systems, were purchased by FS rather than developed by 
employees of FS.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. The lack of performance of software and network system 
development activities is not determinative under the facts and 
circumstances of the business. Therefore, FS satisfies the test under 
this paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
This determination does not require a comparison between the activities 
of FS and the activities of DP. FS is considered to have manufactured 
Product X under paragraph (a)(4)(i) of this section.
    Example 8. Manufacture without intellectual property. (i) Facts. FS, 
a controlled foreign corporation, purchases raw materials from a related 
person. The raw materials are manufactured (under the principles of 
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X by 
CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion outside of FS's country of organization. Product 
X is sold by FS for use outside of FS's country of organization. At all 
times, FS controls the raw materials, work-in-process, and finished 
goods. FS controls the manufacturing related logistics, manages the 
manufacturing costs and capacities, and provides quality control with 
respect to CM's

[[Page 313]]

manufacturing process and product. No intellectual property of 
significant value is required to manufacture Product X. FS does not own 
any intellectual property underlying Product X, or hold an exclusive or 
non-exclusive right to manufacture Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Because use of intellectual property plays little or no role in 
the manufacture of Product X, it is not important to the substantial 
contribution analysis under paragraph (a)(4)(iv) of this section. Under 
the facts and circumstances of the business, FS satisfies the test under 
this paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
Therefore, FS is considered to have manufactured Product X under 
paragraph (a)(4)(i) of this section.
    Example 9. Substantial contribution by more than one CFC. (i) Facts. 
FS1 and FS2, unrelated controlled foreign corporations, contract with 
CM, an unrelated corporation, to manufacture (under the principles of 
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) Product X. CM 
physically performs the substantial transformation, assembly, or 
conversion required to manufacture Product X outside of FS1's and FS2's 
respective countries of organization. Neither FS1 nor FS2 owns the 
materials or work-in-process during the manufacturing process. Product X 
is sold by FS1 and FS2 to persons related to FS1 and FS2, respectively, 
for disposition outside of FS1's and FS2's respective countries of 
organization. FS1, through its employees, designs Product X. FS1 directs 
the use of the product design and design specifications, and other 
intellectual property, for the purpose of manufacturing Product X. 
Employees of FS1 also select the materials that will be used to 
manufacture Product X, and the vendors that provide those materials. 
FS2, through its employees, designs the process for manufacturing 
Product X. FS2, through its employees, manages the manufacturing costs 
and capacities with respect to Product X. FS1 and FS2 each provide 
quality control and oversight and direction of CM's manufacturing 
activities with respect to different aspects of the manufacture of 
Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS1 or FS2 through the 
activities of their employees, FS1 or FS2 would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) 
of this section with respect to Product X. Therefore, this paragraph 
(a)(4)(iv) applies. The fact that other persons make a substantial 
contribution to the manufacture of personal property does not preclude a 
controlled foreign corporation from making a substantial contribution to 
the manufacture of personal property through the activities of its 
employees. In the analysis of whether FS1 or FS2 make a substantial 
contribution to the manufacture of Product X, each company takes into 
account its individual activities, including those of providing quality 
control and oversight and direction of the manufacture of Product X. In 
addition, no threshold level of activity is required, including with 
respect to providing quality control or oversight and direction of the 
activities or process pursuant to which Product X is manufactured, 
before FS1 and FS2 can take into account their respective activities. 
Under the facts and circumstances of the business, both FS1 and FS2 
satisfy the test under this paragraph (a)(4)(iv) because each 
independently makes a substantial contribution through the activities of 
its employees to the manufacture of Product X. Therefore, FS1 and FS2 
are each considered to have manufactured Product X under paragraph 
(a)(4)(i) of this section.
    Example 10. Manufacture of products designed by CFC. (i) Facts. FS, 
a controlled foreign corporation, purchases raw materials from a related 
person. The raw materials are manufactured (under the principles of 
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X by 
CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion outside of FS's country of organization. Product 
X is sold by FS for use outside of FS's country of organization. 
Products in the X industry are distinguished (and vary widely in value) 
based on the raw materials used to make the product and the product 
design. FS designs the product and selects the materials that CM will 
use to manufacture Product X. FS also manages the manufacturing costs 
and capacities. Product X can be manufactured from the raw materials to 
FS's design specifications without significant oversight and direction, 
quality control, or control of manufacturing related logistics. The 
activities most relevant to the substantial contribution analysis under 
these facts are material selection, product design and management of the 
manufacturing costs and capacities.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the

[[Page 314]]

business, FS makes a substantial contribution through the activities of 
its employees to the manufacture of Product X. FS satisfies the test 
under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section.
    Example 11. Direction and oversight of manufacturing and quality 
control through periodic visits. (i) Facts. FS, a controlled foreign 
corporation, purchases raw materials from a related person. The raw 
materials are manufactured (under the principles of paragraph (a)(4)(ii) 
or (a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation, pursuant to a contract manufacturing arrangement. CM 
physically performs the substantial transformation, assembly, or 
conversion outside of FS's country of organization. Product X is sold by 
FS for use outside of FS's country of organization. FS controls the raw 
material, work-in-process, and finished goods, manages the manufacturing 
costs and capacities, and provides oversight and direction of the 
manufacture of Product X. Employees of FS visit CM's manufacturing 
facility for one week each quarter and perform quality control tests on 
a random sample of the units of Product X produced during the week. In 
the X industry, quarterly visits to a manufacturing facility by 
qualified persons are sufficient to control the quality of 
manufacturing.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) with respect to Product X 
because it makes a substantial contribution through the activities of 
its employees to the manufacture of Product X. Therefore, FS is 
considered to have manufactured Product X under paragraph (a)(4)(i) of 
this section.

    (5) Rules for apportionment of income derived from the sale of 
purchased components used in property not manufactured, produced, or 
constructed. The foreign base company sales income derived by a 
controlled foreign corporation for the taxable year from sales of 
personal property purchased and used as a component part of property 
which is not manufactured, produced, or constructed by such corporation 
within the meaning of subparagraph (4) of this paragraph shall, unless 
the records of the controlled foreign corporation show that a different 
apportionment of income is proper or unless all the income from such 
sales is treated as foreign base company sales income, be determined by 
first making for such year the following separate classifications and 
subclassifications with respect to the property which is sold and then 
by apportioning the income for such year from such sales in accordance 
with the rules of this subparagraph:
    (i) A classification of the cost of components used in the property 
which is sold into two classes consisting of the cost of components 
manufactured, produced, constructed, grown, or extracted--
    (a) Within the country under the laws of which the controlled 
foreign corporation is created or organized, and
    (b) Outside such country;
    (ii) A subclassification of the class described in subdivision (i) 
(b) of this subparagraph into--
    (a) The cost of such components purchased from unrelated persons, 
and
    (b) The cost of such components purchased from related persons;
    (iii) A classification of the income derived from such sales into 
two classes consisting of income derived from sales for use, 
consumption, or disposition--
    (a) Within the country under the laws of which the controlled 
foreign corporation is created or organized, and
    (b) Outside such country; and
    (iv) A subclassification of the class described in subdivision (iii) 
(b) of this subparagraph into income from--
    (a) Sales to unrelated persons, and
    (b) Sales to related persons.


The foreign base company sales income for the taxable year from 
purchases of the property from related persons and sales to unrelated 
persons shall be the amount which bears to the amount described in 
subdivision (iv) (a) of this subparagraph the same ratio that the amount 
described in subdivision (ii) (b) of this subparagraph bears to the 
total cost of components used in the product which is sold. The foreign 
base company sales income for the taxable year

[[Page 315]]

from purchases of the property from related persons and sales to related 
persons is the amount which bears to the amount described in subdivision 
(iv) (b) of this subparagraph the same ratio that the amount described 
in subdivision (ii) (b) of this subparagraph bears to the total cost of 
components used in the product which is sold.


The foreign base company sales income for the taxable year from 
purchases of the property from unrelated persons and sales to related 
persons is the amount which bears to the amount described in subdivision 
(iv) (b) of this subparagraph the same ratio that the amount described 
in subdivision (ii) (a) of this subparagraph bears to the total cost of 
components used in the product which is sold. The application of this 
subparagraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporation C, which is incorporated 
under the laws of foreign country X, uses the calendar year as the 
taxable year. For 1964, C Corporation purchases radio parts of which 
some are manufactured in foreign country Y; and others, in country X. 
Some of the parts manufactured in country Y are purchased from related 
persons. Corporation C uses the purchased parts in radio kits which it 
designs and sells for assembly by its customers, unrelated persons, some 
of whom use the kits outside country X. Unless the records of C 
Corporation show that a different apportionment of income is proper, the 
foreign base company sales income for 1964 is determined in the 
following manner upon the basis of the following factual classifications 
for such year:

Cost of components purchased from all persons:
  Manufactured within country X..................................    $20
  Manufactured outside country X.................................     40
                                                           --------
   Total cost....................................................     60
                                                           ========
Cost of components manufactured outside country X:
  Purchased from unrelated persons...............................     10
  Purchased from related persons.................................     30
                                                           --------
   Total cost....................................................     40
                                                           ========
Gross income from sales:
  Gross receipts from sales......................................    120
  Cost of goods sold:
    Components............................................    $60
    Direct labor and factory burden.......................     10     70
                                                           -------------
     Gross income................................................     50
                                                           ========
Gross income from sales:
  For use within country X.......................................     26
  For use outside country X......................................     24
                                                           --------
   Gross income..................................................     50
                                                           ========
Foreign base company sales income from purchases from related         12
 persons and sales to unrelated persons ($24 x $30/$60)..........
                                                           ========
 

    Example 2. The facts are the same as in example 1 except that none 
of the purchases are from related persons and some of the sales for use 
outside country X are to related persons. Unless the records of C 
Corporation show that a different apportionment of income is proper, the 
foreign base company sales income for 1964 is determined in the 
following manner upon the basis of the following additional factual 
classification for such year:

Gross income from sales for use outside country X--
  To unrelated persons........................................        $8
  To related persons..........................................        16
                                                               ---------
   Total gross income.........................................        24
                                                               =========
Foreign base company sales income from purchases from              10.67
 unrelated persons and sales to related persons ($16 x $40/
 $60).........................................................
                                                               =========
 

    Example 3. The facts are the same as in example 1 except that some 
of the sales for use outside country X are to related persons as in 
example 2. Unless the records of C Corporation show that a different 
apportionment of income is proper, the foreign base company sales income 
for 1964 is determined in the following manner:

Foreign base company sales income from purchases from related      $4.00
 persons and sales to unrelated persons ($8 x $30/$60)........
Foreign base company sales income from purchases from related       8.00
 persons and sales to related persons ($16 x $30/$60).........
Foreign base company sales income from purchases from               2.67
 unrelated persons and sales to related persons ($16 x $10/
 $60).........................................................
                                                               ---------
  Total foreign base company sales income.....................     14.67
                                                               =========
 


    (6) Special rule applicable to distributive share of partnership 
income--(i) In general. To determine the extent to which a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership would have been foreign base company sales income if 
received by it directly, under Sec. 1.952-1(g), the property sold will 
be considered to be manufactured, produced, or constructed by the 
controlled foreign corporation, within the meaning of paragraph 
(a)(4)(i) of this section, only if the manufacturing exception of 
paragraph (a)(4)(i) of this section would have applied to exclude the 
income from foreign base company sales income if the controlled foreign 
corporation had earned the income directly,

[[Page 316]]

determined by taking into account only the activities of the employees 
of, and property owned by, the partnership.
    (ii) Example. The application of paragraph (a)(6)(i) of this section 
is illustrated by the following example:

    Example. CFC, a controlled foreign corporation organized under the 
laws of Country A, is an 80 percent partner in Partnership X, a 
partnership organized under the laws of Country B. Partnership X 
performs activities in Country B that would constitute the manufacture 
of Product O, within the meaning of paragraph (a)(4) of this section, if 
performed directly by CFC. Partnership X, through its sales offices in 
Country B, then sells Product O to Corp D, a corporation that is a 
related person with respect to CFC, within the meaning of section 
954(d)(3), for use within Country B. CFC's distributive share of 
Partnership X's sales income is not foreign base company sales income 
because the manufacturing exception of paragraph (a)(4) of this section 
would have applied to exclude the income from foreign base company sales 
income if CFC had earned the income directly.

    (iii) Effective date. This paragraph (a)(6) applies to taxable years 
of a controlled foreign corporation beginning on or after July 23, 2002.
    (b) Branches of controlled foreign corporation treated as separate 
corporations--(1) General rules for determining when to apply separate 
treatment--(i) Sales or purchase branch--(a) In general. If a controlled 
foreign corporation carries on purchasing or selling activities by or 
through a branch or similar establishment located outside the country 
under the laws of which such corporation is created or organized and the 
use of the branch or similar establishment for such activities has 
substantially the same tax effect as if the branch or similar 
establishment were a wholly owned subsidiary corporation of such 
controlled foreign corporation, the branch or similar establishment and 
the remainder of the controlled foreign corporation will be treated as 
separate corporations for purposes of determining foreign base company 
sales income of such corporation. See section 954(d)(2).
    (b) Allocation of income and comparison of effective rates of tax. 
The determination as to whether such use of the branch or similar 
establishment has the same tax effect as if it were a wholly owned 
subsidiary corporation of the controlled foreign corporation shall be 
made by allocating to such branch or similar establishment only that 
income derived by the branch or establishment which, when the special 
rules of subparagraph (2)(i) of this paragraph are applied, is described 
in paragraph (a) of this section (but determined without applying 
subparagraphs (2), (3), and (4) of such paragraph). The use of the 
branch or similar establishment for such activities will be considered 
to have substantially the same tax effect as if it were a wholly owned 
subsidiary corporation of the controlled foreign corporation if the 
income allocated to the branch or similar establishment under the 
immediately preceding sentence is, by statute, treaty obligation, or 
otherwise, taxed in the year when earned at an effective rate of tax 
that is less than 90 percent of, and at least 5 percentage points less 
than, the effective rate of tax which would apply to such income under 
the laws of the country in which the controlled foreign corporation is 
created or organized, if, under the laws of such country, the entire 
income of the controlled foreign corporation were considered derived by 
the corporation from sources within such country from doing business 
through a permanent establishment therein, received in such country, and 
allocable to such permanent establishment, and the corporation were 
managed and controlled in such country.
    (c) Use of more than one branch. If a controlled foreign corporation 
carries on purchasing or selling activities by or through more than one 
branch or similar establishment located outside the country under the 
laws of which such corporation is created or organized, then paragraph 
(b)(1)(i)(b) of this section shall be applied separately to the income 
derived by each such branch or similar establishment (by treating such 
purchasing or selling branch or similar establishment as if it were the 
only branch or similar establishment of the controlled foreign 
corporation and as if any such other branches or similar establishments 
were separate corporations) in determining whether the use of such 
branch or similar establishment has substantially the same tax effect as 
if such

[[Page 317]]

branch or similar establishment were a wholly owned subsidiary 
corporation of the controlled foreign corporation. See paragraph 
(b)(1)(ii)(c)(1) of this section for rules applicable to a controlled 
foreign corporation that carries on purchase or sales activities by or 
through one or more branches or similar establishments in addition to 
carrying on manufacturing activities by or through one or more branches 
or similar establishments.
    (ii) Manufacturing branch--(a) In general. If a controlled foreign 
corporation carries on manufacturing, producing, constructing, growing, 
or extracting activities by or through a branch or similar establishment 
located outside the country under the laws of which such corporation is 
created or organized and the use of the branch or similar establishment 
for such activities with respect to personal property purchased or sold 
by or through the remainder of the controlled foreign corporation has 
substantially the same tax effect as if the branch or similar 
establishment were a wholly owned subsidiary corporation of such 
controlled foreign corporation, the branch or similar establishment and 
the remainder of the controlled foreign corporation will be treated as 
separate corporations for purposes of determining the foreign base 
company sales income of such corporation. See section 954(d)(2). The 
provisions of this paragraph (b)(1)(ii) will apply only if the 
controlled foreign corporation (including any branches or similar 
establishments of such controlled foreign corporation) manufactures, 
produces, or constructs such personal property within the meaning of 
paragraph (a)(4)(i) of this section, or carries on growing or extracting 
activities with respect to such personal property.
    (b) Allocation of income and comparison of effective rates of tax. 
The determination as to whether such use of the branch or similar 
establishment has substantially the same tax effect as if the branch or 
similar establishment were a wholly owned subsidiary corporation of the 
controlled foreign corporation shall be made by allocating to the 
remainder of such controlled foreign corporation only that income 
derived by the remainder of such corporation, which, when the special 
rules of subparagraph (2)(i) of this paragraph are applied, is described 
in paragraph (a) of this section (but determined without applying 
subparagraphs (2), (3), and (4) of such paragraph). The use of the 
branch or similar establishment for such activities will be considered 
to have substantially the same tax effect as if it were a wholly owned 
subsidiary corporation of the controlled foreign corporation if income 
allocated to the remainder of the controlled foreign corporation under 
the immediately preceding sentence is, by statute, treaty obligation, or 
otherwise, taxed in the year when earned at an effective rate of tax 
that is less than 90 percent of, and at least 5 percentage points less 
than, the effective rate of tax which would apply to such income under 
the laws of the country in which the branch or similar establishment is 
located, if, under the laws of such country, the entire income of the 
controlled foreign corporation were considered derived by such 
corporation from sources within such country from doing business through 
a permanent establishment therein, received in such country, and 
allocable to such permanent establishment, and the corporation were 
created or organized under the laws of, and managed and controlled in, 
such country.
    (c) Use of more than one branch--(1) Use of one or more sales or 
purchase branches in addition to a manufacturing branch. If, with 
respect to personal property manufactured, produced, constructed, grown, 
or extracted by or through a branch or similar establishment located 
outside the country under the laws of which the controlled foreign 
corporation is created or organized, purchasing or selling activities 
are carried on by or through more than one branch or similar 
establishment, or by or through one or more branches or similar 
establishments located outside such country, of such corporation, then 
paragraph (b)(1)(ii)(b) of this section shall be applied separately to 
the income derived by each such purchasing or selling branch or similar 
establishment (by treating such purchasing or selling branch or similar 
establishment as though it alone were the remainder of the controlled 
foreign corporation)

[[Page 318]]

for purposes of determining whether the use of such manufacturing, 
producing, constructing, growing, or extracting branch or similar 
establishment has substantially the same tax effect as if such branch or 
similar establishment were a wholly owned subsidiary corporation of the 
controlled foreign corporation. If this rule applies, the sales or 
purchase branch rules contained in paragraph (b)(1)(i) of this section 
do not apply. The application of this paragraph (b)(1)(ii)(c)(1) is 
illustrated by the following example:

    Example. All activities of controlled foreign corporation conducted 
through sales branches and manufacturing branch. (i) Facts. FS, a 
controlled foreign corporation organized under the laws of country M, 
operates three branches. Branch A, located in country A, manufactures 
Product X under the principles of paragraph (a)(4)(i) of this section. 
Branch B, located in Country B, sells Product X manufactured by Branch A 
to customers for use outside of Country B. Branch C, located in Country 
C sells Product X manufactured by Branch A to customers for use outside 
of Country C. FS does not conduct any manufacturing or selling 
activities apart from the activities of Branches A, B and C. Country M 
imposes an effective rate of tax on sales income of 0%. Country A 
imposes an effective rate of tax on sales income of 20%. Country B 
imposes an effective rate of tax on sales income of 20%. Country C 
imposes an effective rate of tax on sales income of 18%.
    (ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(1), paragraph 
(b)(1)(ii)(b) of this section is applied to the sales income derived by 
Branch B by treating Branch B as though it alone were the remainder of 
the controlled foreign corporation. The use of Branch B does not have 
the same tax effect as if Branch B were a wholly owned subsidiary of FS 
because the tax rate applicable to the income allocated to Branch B 
under paragraph (b)(1)(ii)(b) of this section (20%) is not less than 90% 
of, and at least 5 percentage points less than, the effective rate of 
tax which would apply to such income under the laws of Country A (20%), 
the country in which Branch A is located. In addition, paragraph 
(b)(1)(ii)(b) of this section is applied separately to the sales income 
derived by Branch C by treating Branch C as though it alone were the 
remainder of the controlled foreign corporation. The use of Branch C 
does not have the same tax effect as if Branch C were a wholly owned 
subsidiary of FS because the tax rate applicable to the income allocated 
to Branch C under paragraph (b)(1)(ii)(b) of this section (18%) is not 
less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax which would apply to such income under the laws of 
Country A (20%), the country in which Branch A is located. Pursuant to 
this paragraph (b)(1)(ii)(c)(1), the rules under paragraph (b)(1)(i) of 
this section for determining whether a sales or purchase branch is 
treated as a separate corporation from the remainder of the controlled 
foreign corporation do not apply.

    (2) Use of more than one branch to manufacture, produce, construct, 
grow, or extract separate items of personal property. If a controlled 
foreign corporation carries on manufacturing, producing, constructing, 
growing, or extracting activities with respect to separate items of 
personal property by or through more than one branch or similar 
establishment located outside the country under the laws of which such 
corporation is created or organized, then paragraphs (b)(1)(ii)(b) and 
(c) of this section will be applied separately to each such branch or 
similar establishment (by treating such manufacturing branch or similar 
establishment as if it were the only such branch or similar 
establishment of the controlled foreign corporation and as if any other 
such branches or similar establishments were separate corporations) for 
purposes of determining whether the use of such branch or similar 
establishment has substantially the same tax effect as if such branch or 
similar establishment were a wholly owned subsidiary corporation of the 
controlled foreign corporation. The application of this paragraph 
(b)(1)(ii)(c)(2) is illustrated by the following example:

    Example. Multiple branches that satisfy paragraph (a)(4)(i). (i) 
Facts. FS is a controlled foreign corporation organized in Country M. FS 
operates two branches, Branch A and Branch B located in Country A and 
Country B, respectively. Branch A and Branch B each manufacture separate 
items of personal property (Product X and Product Y, respectively) 
within the meaning of paragraph (a)(4)(ii) or (iii) of this section. Raw 
materials used in the manufacture of Product X and Product Y are 
purchased by FS from an unrelated person. FS engages in activities in 
Country M to sell Product X and Product Y to a related person for use, 
disposition or consumption outside of Country M. Employees of FS located 
in Country M perform only sales functions. The effective rate of tax 
imposed in Country M on the income from the sales of Product X and 
Product Y is 10%. Country A imposes an effective rate of tax on sales 
income of 20%. Country B imposes

[[Page 319]]

an effective rate of tax on sales income of 12%.
    (ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(2), paragraph 
(b)(1)(ii)(b) of this section is applied separately to Branch A and 
Branch B with respect to the sales income of FS attributable to Product 
X (manufactured by Branch A) and Product Y (manufactured by Branch B). 
Because the effective rate of tax on FS's sales income from the sale of 
Product X in Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in the country in which Branch A is located (20%), the 
use of Branch A to manufacture Product X has substantially the same tax 
effect as if Branch A were a wholly owned subsidiary corporation of FS. 
Because the effective rate of tax on FS's sales income from the sale of 
Product Y in Country M (10%) is not less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in the country in which Branch B is located (12%), the 
use of Branch B to manufacture Product Y does not have substantially the 
same tax effect as if Branch B were a wholly owned subsidiary 
corporation of FS. Consequently, only Branch A is treated as a separate 
corporation apart from the remainder of FS for purposes of determining 
foreign base company sales income from the sales of Product X.

    (3) Use of more than one manufacturing branch, or one or more 
manufacturing branches and the remainder of the controlled foreign 
corporation, to manufacture, produce, or construct the same item of 
personal property--(i) In general. This paragraph (b)(1)(ii)(c)(3) 
applies to determine the location of manufacture, production, or 
construction of personal property for purposes of applying paragraph 
(b)(1)(i)(b) or (b)(1)(ii)(b) of this section where more than one branch 
or similar establishment of a controlled foreign corporation, or one or 
more branches or similar establishments of a controlled foreign 
corporation and the remainder of the controlled foreign corporation, 
each engage in manufacturing, producing, or constructing activities with 
respect to the same item of personal property which is then sold by the 
controlled foreign corporation. This paragraph (b)(1)(ii)(c)(3) is 
applied separately with respect to the income derived by each purchasing 
or selling branch or similar establishment or purchasing or selling 
remainder of the controlled foreign corporation as provided under 
paragraphs (b)(1)(i) and (b)(1)(ii) of this section. The location of 
manufacture, production, or construction is determined under paragraph 
(b)(1)(ii)(c)(3)(ii) of this section if one or more branches or similar 
establishments or the remainder of the controlled foreign corporation 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to an item of personal property. The location of manufacture, 
production, or construction is determined under paragraph 
(b)(1)(ii)(c)(3)(iii) of this section if none of the branches or similar 
establishments or the remainder of the controlled foreign corporation 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to an item of personal property, but the controlled foreign corporation 
as a whole makes a substantial contribution to the manufacture, 
production or construction of that property within the meaning of 
paragraph (a)(4)(iv) of this section. For purposes of this paragraph 
(b)(1)(ii)(c)(3), the location of any activity with respect to the 
manufacture, production, or construction of an item of personal property 
is determined under paragraph (b)(1)(ii)(c)(3)(iv) of this section. For 
purposes of this paragraph (b)(1)(ii)(c)(3), if multiple branches or 
similar establishments are located in a single jurisdiction, then the 
activities of those branches will be aggregated for purposes of 
determining whether a branch or remainder of the controlled foreign 
corporation satisfies paragraph (a)(4)(i) of this section.
    (ii) Manufacture, production, or construction in one or more 
locations. If only one branch or similar establishment or only the 
remainder of a controlled foreign corporation independently satisfies 
paragraph (a)(4)(i) of this section with respect to an item of personal 
property, then that branch or similar establishment or the remainder of 
the controlled foreign corporation will be the location of manufacture, 
production, or construction of that property for purposes of applying 
paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section to the income 
from the sale of that property. See paragraph (b)(1)(ii)(c)(3)(v) 
Example 1 of this section. If more than one branch or similar 
establishment or one or more branches or similar establishments and

[[Page 320]]

the remainder of the controlled foreign corporation, each independently 
satisfy paragraph (a)(4)(i) of this section with respect to an item of 
personal property, then the location of manufacture, production, or 
construction of that property for purposes of applying paragraph 
(b)(1)(i)(b) or (b)(1)(ii)(b) of this section will be the location of 
that branch or similar establishment or the jurisdiction under the laws 
of which the remainder of the controlled foreign corporation is 
organized that satisfies paragraph (a)(4)(i) of this section and that 
would, after applying paragraph (b)(1)(ii)(b) of this section to such 
branch or similar establishment or paragraph (b)(1)(i)(b) of this 
section to the remainder of the controlled foreign corporation, impose 
the lowest effective rate of tax on the income allocated to such branch 
or the remainder of the controlled foreign corporation under such 
section (that is, either paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this 
section). See paragraph (b)(1)(ii)(c)(3)(v) Example 2 of this section.
    (iii) No location independently satisfies manufacturing test. If no 
branch or similar establishment or the remainder of the controlled 
foreign corporation independently satisfies paragraph (a)(4)(i) of this 
section with respect to an item of personal property but the controlled 
foreign corporation as a whole makes a substantial contribution to the 
manufacture, production, or construction of that property within the 
meaning of paragraph (a)(4)(iv) of this section, then for purposes of 
applying paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section, the 
location of manufacture, production, or construction with respect to the 
income derived by a purchasing or selling branch or similar 
establishment or the purchasing or selling remainder of the controlled 
foreign corporation in connection with the purchase or sale of that 
property will be the ``tested manufacturing location'' unless the 
``tested sales location'' provides a greater contribution to the 
manufacture, production, or construction of the property. The tested 
manufacturing location is the location of any branch or similar 
establishment or remainder of the controlled foreign corporation that 
contributes to the manufacture, production, or construction of the 
personal property, if any, that would, after applying paragraph 
(b)(1)(ii)(b) of this section to such branch or similar establishment or 
paragraph (b)(1)(i)(b) of this section to the remainder of the 
controlled foreign corporation, be treated as a separate corporation and 
would impose the lowest effective rate of tax on the income allocated to 
such branch or similar establishment or to the remainder of the 
controlled foreign corporation under such section (that is, either 
paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section). The tested 
sales location is the location of the purchasing or selling branch or 
similar establishment or the remainder of the controlled foreign 
corporation by or through which the purchasing or selling activities are 
carried on with respect to the personal property. For purposes of this 
paragraph (b)(1)(ii)(c)(3)(iii), the contribution to the manufacture, 
production, or construction of the personal property by the tested sales 
location will be deemed to include the activities of any branch or 
similar establishment or remainder of the controlled foreign corporation 
that would not be treated as a corporation separate from the tested 
sales location after the application of paragraph (b)(1)(i)(b) or 
(b)(1)(ii)(b) of this section. For purposes of this paragraph 
(b)(1)(ii)(c)(3)(iii), the contribution of the tested manufacturing 
location to the manufacture, production, or construction of the personal 
property will be deemed to include any activities of any branch or 
similar establishment or remainder of the controlled foreign corporation 
that would be treated as a corporation separate from the tested sales 
location after the application of paragraph (b)(1)(i)(b) or 
(b)(1)(ii)(b) of this section. Whether the tested sales location 
provides a greater contribution to the manufacture, production, or 
construction of the personal property is determined by weighing the 
relative contributions to the manufacture, production, or construction 
of that property by the tested sales location and the tested 
manufacturing location under the facts and circumstances test provided 
in paragraph (a)(4)(iv) of this section. See paragraph 
(b)(1)(ii)(c)(3)(v) Examples 3, 4, 5, and 6

[[Page 321]]

of this section. If the tested sales location provides a greater 
contribution to the manufacture, production, or construction of the 
personal property than the tested manufacturing location or if there is 
no tested manufacturing location, then the tested sales location is the 
location of manufacture, production, or construction of that property 
and the rules of paragraphs (b)(1)(i)(a) and (b)(1)(ii)(a) of this 
section will not apply with respect to the income derived by the tested 
sales location in connection with the purchase or sale of that property 
and the use of that purchasing or selling branch or similar 
establishment or the purchasing or selling remainder will not result in 
a branch being treated as a separate corporation for purposes of 
paragraph (b)(2)(ii) of this section.
    (iv) Location of activity. For purposes of paragraph 
(b)(1)(ii)(c)(3) of this section, the location of any activity with 
respect to the manufacture, production, or construction of an item of 
personal property is the location where the employees of the controlled 
foreign corporation perform such activity. For example, the location of 
any activity concerning intellectual property is determined based on 
where employees of the controlled foreign corporation develop or direct 
the use or development of the intellectual property, not on the formal 
assignment of that intellectual property.
    (v) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(ii)(c)(3):

    Example 1. Multiple branches contribute to the manufacture of a 
single product only one branch satisfies paragraph (a)(4)(i). (i) Facts. 
FS is a controlled foreign corporation organized in Country M. FS 
operates three branches, Branch A, Branch B, and Branch C, located 
respectively in Country A, Country B, and Country C. Branch A, Branch B, 
and Branch C each performs different manufacturing activities with 
respect to the manufacture of Product X. Branch A, through the 
activities of employees of FS located in Country A, designs Product X. 
Branch B, through the activities of employees of FS located in Country 
B, provides quality control and oversight and direction. Branch C, 
through the activities of employees of FS located in Country C, 
manufactures Product X (within the meaning of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) using the designs developed by Branch A and 
under the oversight of the quality control personnel of Branch B. The 
activities of Branch A and Branch B do not independently satisfy 
paragraph (a)(4)(i) of this section. Employees of FS located in Country 
M purchase the raw materials used in the manufacture of Product X from a 
related person and control the work-in-process and finished goods 
throughout the manufacturing process. Employees of FS located in Country 
M also manage the manufacturing costs and capacities related to Product 
X. Further, employees of FS located in Country M oversee the 
coordination between the branches. The activities of the remainder of FS 
in Country M do not independently satisfy paragraph (a)(4)(i) of this 
section. Employees of FS located in Country M sell Product X to 
unrelated persons for use outside of Country M. The sales income from 
the sale of Product X is taxed in Country M at an effective rate of tax 
of 10%. Country C imposes an effective rate of tax of 20% on sales 
income.
    (ii) Result. Country C is the location of manufacture for purposes 
of applying paragraph (b)(1)(ii)(b) of this section because only the 
activities of Branch C independently satisfy paragraph (a)(4)(i) of this 
section. The use of Branch C has substantially the same tax effect as if 
Branch C were a wholly owned subsidiary corporation of FS because the 
effective rate of tax on the sales income (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in the country in which Branch C is located 
(20%). Therefore, sales of Product X by the remainder of FS are treated 
as sales on behalf of Branch C. In determining whether the remainder of 
FS will qualify for the manufacturing exception under paragraph 
(a)(4)(iv) of this section, the activities of FS will include the 
activities of Branch A or Branch B, respectively, if each of those 
branches would not be treated as a separate corporation under paragraph 
(b)(1)(ii)(b) of this section, if that paragraph were applied 
independently to each of Branch A and Branch B. See paragraph 
(b)(2)(ii)(a) of this section.
    Example 2. Multiple branches satisfy paragraph (a)(4)(i) with 
respect to the same product sold by the controlled foreign corporation. 
(i) Facts. Assume the same facts as in Example 1, except for the 
following. In addition to the design of Product X, Branch A also 
performs in Country A other manufacturing activities, including those 
ascribed to FS in Example 1, that are sufficient to qualify as 
manufacturing under paragraph (a)(4)(iv) of this section with respect to 
Product X. Country A imposes an effective rate of tax of 12% on sales 
income.
    (ii) Result. Branch A and Branch C through their activities each 
independently satisfy the requirements of paragraph (a)(4)(i) of this 
section. Therefore, paragraph (b)(1)(ii)(b) of this section is applied 
by comparing the

[[Page 322]]

effective rate of tax imposed on the income from the sales of Product X 
against the lowest effective rate of tax that would apply to the sales 
income in either Country A or Country C if paragraph (b)(1)(ii)(b) of 
this section were applied separately to Branch A and Branch C. Country A 
imposes the lower effective rate of tax, and therefore, Branch A is 
treated as the location of manufacture for purposes of applying 
paragraph (b)(1)(ii)(b) of this section. The effective rate of tax in 
Country B is not considered because Branch B does not satisfy paragraph 
(a)(4)(i) of this section. Neither Branch A nor Branch C is treated as a 
separate corporation because the effective rate of tax on the sales 
income of FS from the sale of Product X (10%) is not less than 90% of, 
and at least 5 percentage points less than, the effective rate of tax 
that would apply to such income in the country in which Branch A is 
located (12%). Sales of Product X by the remainder of the controlled 
foreign corporation are not treated as made on behalf of any branch.
    Example 3. Determining the location of manufacture when 
manufacturing activities performed by multiple branches and no branch 
independently satisfies paragraph (a)(4)(i). (i) Facts. FS, a controlled 
foreign corporation organized in Country M, purchases raw materials from 
a related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into 
Product X by CM, an unrelated corporation, pursuant to a contract 
manufacturing arrangement. CM physically performs the substantial 
transformation, assembly, or conversion of the raw materials in Country 
C. FS has two branches, Branch A and Branch B, located in Country A and 
Country B respectively. Branch A, through the activities of employees of 
FS located in Country A, designs Product X. Branch B, through the 
activities of employees of FS located in Country B, controls 
manufacturing related logistics, provides oversight and direction during 
the manufacturing process, and controls the raw materials and work-in-
process. FS manages the manufacturing costs and capacities related to 
the manufacture of Product X through employees located in Country M. 
Further, employees of FS located in Country M oversee the coordination 
between the branches. Employees of FS located in Country M also sell 
Product X to unrelated persons for use outside of Country M. Country M 
imposes an effective rate of tax on sales income of 10%. Country A 
imposes an effective rate of tax on sales income of 20%, and Country B 
imposes an effective rate of tax on sales income of 24%. Neither the 
remainder of FS, nor any branch of FS independently satisfies paragraph 
(a)(4)(i) of this section. However, under the facts and circumstances of 
the business, FS as a whole provides a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through the activities of its employees in Country M) nor any branch of 
FS independently satisfies paragraph (a)(4)(i) of this section with 
respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. The remainder of FS, Branch A, and Branch B each provides 
a contribution through the activities of employees to the manufacture of 
Product X. Therefore, FS must determine the location of manufacture 
under paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to 
Product X are carried on by the remainder of FS. The location of Branch 
A is the tested manufacturing location because the effective rate of tax 
imposed on FS's sales income by Country M (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country A (20%), and Country A has the 
lowest effective rate of tax among the manufacturing branches that 
would, after applying paragraph (b)(1)(ii)(b) of this section, be 
treated as a separate corporation. The activities of Branch B will be 
included in the contribution of Branch A for purposes of determining the 
location of manufacture of Product X because the effective rate of tax 
imposed on the sales income by Country M (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country B (24%). Under the facts and 
circumstances of the business, the activities of the remainder of FS 
would not provide a greater contribution to the manufacture of Product X 
than the activities of Branch A and Branch B, considered together. 
Therefore, the location of manufacture is Country A, the location of 
Branch A.
    Example 4. Manufacturing activities performed by multiple branches, 
no branch independently satisfies paragraph (a)(4)(i), selling 
activities carried on by remainder of the controlled foreign 
corporation, remainder contribution includes branch manufacturing 
activities. (i) Facts. The facts are the same as Example 3, except that 
the effective rate of tax on sales income in Country B is 12%. In 
addition, under the facts of the particular business, the activities of 
employees of FS located in Country B and Country M, if considered 
together, would provide a greater contribution to the manufacture of 
Product X than the activities of employees of FS located in Country A.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through activities of its employees in Country M) nor any branch of FS 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to Product X, but

[[Page 323]]

FS, as a whole, provides a substantial contribution through the 
activities of its employees to the manufacture of Product X. The 
remainder of FS, Branch A, and Branch B each provide a contribution 
through the activities of their employees to the manufacture of Product 
X. Therefore, FS must determine the location of manufacture under 
paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to 
Product X are carried on by the remainder of FS. The location of Branch 
A is the tested manufacturing location because the effective rate of tax 
imposed on FS's sales income by Country M (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country A (20%), and Branch A is the only 
branch that would, after applying paragraph (b)(1)(ii)(b) of this 
section, be treated as a separate corporation. The activities of Branch 
B will be included in the contribution of the remainder of FS for 
purposes of determining the location of manufacture of Product X because 
the effective rate of tax imposed on the sales income by Country M (10%) 
is not less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in Country B 
(12%). Under a facts and circumstances analysis, considered together, 
the activities of Branch B and the remainder of FS would provide a 
greater contribution to the manufacture of Product X than the activities 
of Branch A. Therefore, the rules of paragraph (b)(1)(ii)(a) of this 
section will not apply with respect to the income derived by the 
remainder of FS in connection with the sale of Product X, and neither 
Branch A nor Branch B will be treated as a separate corporation for 
purposes of paragraph (b)(2)(ii) of this section.
    Example 5. Manufacturing activities performed by multiple branches, 
no branch independently satisfies paragraph (a)(4)(i), sales carried on 
by remainder of the controlled foreign corporation and a sales branch. 
(i) Facts. The facts are the same as Example 3, except that sales of 
Product X are also carried on through Branch D in Country D, and Country 
D imposes a 16% effective rate of tax on sales income. In addition, 
under the facts and circumstances of the business, the activities of 
employees of FS located in Country A and Country M, considered together, 
would provide a greater contribution to the manufacture of Product X 
than the activities of employees of FS located in Country B.
    (ii) Result. Based on the facts, neither the remainder of FS nor any 
branch of FS independently satisfies paragraph (a)(4)(i) of this section 
with respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. The remainder of FS, Branch A, and Branch B each provide a 
contribution through the activities of their employees to the 
manufacture of Product X. Therefore, FS must determine the location of 
manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this section. 
Further, pursuant to paragraph (b)(1)(ii)(c)(1) of this section, 
paragraph (b)(1)(ii)(c)(3)(iii) of this section must be applied 
separately to the sales income derived by the remainder of FS and Branch 
D respectively. The results with respect to the income derived by the 
remainder of FS in connection with the sale of Product X in this Example 
5 are the same as in Example 3. However, paragraph (b)(1)(ii)(c)(3)(iii) 
of this section must also be applied with respect to Branch D because 
the sale of Product X is also carried on through Branch D. Thus, for 
purposes of that sales income, the location of Branch D is the tested 
sales location. The location of Branch B is the tested manufacturing 
location because the effective rate of tax imposed on Branch D's sales 
income by Country D (16%) is less than 90% of, and at least 5 percentage 
points less than, the effective rate of tax that would apply to such 
income in Country B (24%), and Branch B is the only branch that would, 
after applying paragraph (b)(1)(ii)(b) of this section, be treated as a 
separate corporation. The manufacturing activities performed in Country 
M by the remainder of FS and the manufacturing activities performed in 
Country A by Branch A will be included in Branch D's contribution to the 
manufacture of Product X for purposes of determining the location of 
manufacture of Product X with respect to Branch D's sales income because 
the effective rate of tax imposed on the sales income by Country D (16%) 
is not less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in Country M (10%) 
and Country A (20%). Under the facts and circumstances of the business, 
the activities of Branch D, Branch A, and the remainder of FS, 
considered together, would provide a greater contribution to the 
manufacture of Product X than the activities of Branch B. Therefore, the 
rules of paragraph (b)(1)(ii)(a) of this section will not apply with 
respect to the income derived by Branch D in connection with the sale of 
Product X and the use of Branch D to sell Product X will not result in a 
branch being treated as a separate corporation for purposes of paragraph 
(b)(2)(ii) of this section.
    Example 6. Determining the location of manufacture when employees of 
remainder of controlled foreign corporation travel to location of 
unrelated contract manufacturer to perform manufacturing activities. (i) 
Facts. FS, a controlled foreign corporation organized in Country M, 
purchases raw materials from a related person. The raw materials are 
manufactured (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation,

[[Page 324]]

pursuant to a contract manufacturing arrangement. CM physically performs 
the substantial transformation, assembly, or conversion of the raw 
materials in Country C. Employees of FS located in Country M sell 
Product X to unrelated persons for use outside of Country M. Employees 
of FS located in Country M engage in product design, manage the 
manufacturing costs and capacities with respect to Product X, and direct 
the use of intellectual property for the purpose of manufacturing 
Product X. Quality control and oversight and direction of the 
manufacturing process are conducted in Country C by employees of FS who 
are employed in Country M but who regularly travel to Country C. Branch 
A, located in Country A, is the only branch of FS. Product design with 
respect to Product X conducted by employees of FS located in Country A 
is supplemental to the bulk of the design work, which is done by 
employees of FS located in Country M. At all times, employees of Branch 
A control the raw materials, work-in-process and finished goods. 
Employees of FS located in Country A also control manufacturing related 
logistics with respect to Product X. Country M imposes an effective rate 
of tax on sales income of 10%. Country A imposes an effective rate of 
tax on sales income of 20%. Neither the remainder of FS nor Branch A 
independently satisfies paragraph (a)(4)(i) of this section. However, 
under the facts and circumstance of the business, FS as a whole 
(including Branch A) provides a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section.
    (ii) Result. Based on the facts, neither the remainder of FS nor 
Branch A independently satisfies paragraph (a)(4)(i) of this section 
with respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. The remainder of FS and Branch A each provide a 
contribution through the activities of employees to the manufacture of 
Product X. Therefore, FS must determine the location of manufacture 
under paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to 
Product X are carried on by the remainder of FS. The tested 
manufacturing location is the location of Branch A because the effective 
rate of tax imposed on the remainder of FS's sales income by Country M 
(10%) is less than 90% of, and at least 5 percentage points less than, 
the effective rate of tax that would apply to such income in Country A 
(20%), and Branch A is the only branch that would, after applying 
paragraph (b)(1)(ii)(b) of this section, be treated as a separate 
corporation. Although the activities of traveling employees are 
considered in determining whether FS, as a whole, makes a substantial 
contribution to the manufacture of Product X under paragraph (a)(4)(iv) 
of this section, the activities of the employees of FS that are 
performed in Country C are not taken into consideration in determining 
whether Country M, the jurisdiction under the laws of which FS is 
organized, is the location of manufacture under paragraph 
(b)(1)(ii)(c)(3)(iii) of this section. Activities of employees performed 
outside the jurisdiction in which the controlled foreign corporation is 
organized and outside a location in which the controlled foreign 
corporation maintains a branch or similar establishment, are not 
considered in determining the location of manufacture. Under the facts 
and circumstances of the business, the activities of employees of FS 
performed in Country M do not provide a greater contribution to the 
manufacture of Product X than the activities of employees of FS 
performed in Country A. Therefore, the location of manufacture is 
Country A, the location of Branch A.

    (4) Use of more than one branch to manufacture, produce, construct, 
grow, or extract separate items of personal property. For purposes of 
paragraphs (b)(1)(ii)(c)(2) and (b)(1)(ii)(c)(3) of this section, an 
item of personal property refers to an individual unit of personal 
property rather than a type or class of personal property.
    (2) Special rules--(i) Determination of treatment as a wholly owned 
subsidiary corporation. For purposes of determining under this paragraph 
whether the use of a branch or similar establishment which is treated as 
a separate corporation has substantially the same tax effect as if the 
branch or similar establishment were a wholly owned subsidiary 
corporation of a controlled foreign corporation--
    (a) Treatment as separate corporations. The branch or similar 
establishment will be treated as a wholly owned subsidiary corporation 
of the controlled foreign corporation, and such branch or similar 
establishment will be deemed to be incorporated in the country in which 
it is located.
    (b) Activities treated as performed on behalf of the remainder of 
corporation. (1) With respect to purchasing or selling activities 
performed by or through the branch or similar establishment, such 
purchasing or selling activities will, with respect to personal property 
manufactured, produced, constructed, grown, or extracted by the 
remainder of the controlled foreign corporation, be treated as performed 
on behalf of

[[Page 325]]

the remainder of the controlled foreign corporation.
    (2) With respect to purchasing or selling activities performed by or 
through the branch or similar establishment, such purchasing or selling 
activities will, with respect to personal property (other than property 
described in paragraph (b)(2)(i)(b)(1) of this section) purchased or 
sold, or purchased and sold, by the remainder of the controlled foreign 
corporation (or any branch treated as the remainder of the controlled 
foreign corporation), be treated as performed on behalf of the remainder 
of the controlled foreign corporation.
    (c) Activities treated as performed on behalf of branch. With 
respect to manufacturing, producing, constructing, growing, or 
extracting activities performed by or through the branch or similar 
establishment, purchasing or selling activities performed by or through 
the remainder of the controlled foreign corporation with respect to the 
personal property manufactured, produced, constructed, grown, or 
extracted by or through the branch or similar establishment shall be 
treated as performed on behalf of the branch or similar establishment.
    (d) [Reserved] For further guidance, see Sec. 1.954-3T(b)(2)(i)(d).
    (e) Tax laws to be taken into account. Tax determinations shall be 
made by taking into account only the income, war profits, excess 
profits, or similar tax laws (or the absence of such laws) of the 
countries involved.
    (ii) Determination of foreign base company sales income. Once it has 
been determined under subparagraph (1) of this paragraph that a branch 
or similar establishment and the remainder of the controlled foreign 
corporation are to be treated as separate corporations, the 
determination of whether such branch or similar establishment, or the 
remainder of the controlled foreign corporation, as the case may be, has 
foreign base company sales income shall be made by applying the 
following rules:
    (a) Treatment as separate corporations. The branch or similar 
establishment will be treated as a wholly owned subsidiary corporation 
of the controlled foreign corporation, and such branch or similar 
establishment will be deemed to be incorporated in the country in which 
it is located. For purposes of applying the rules of this paragraph 
(b)(2)(ii), a branch or similar establishment of a controlled foreign 
corporation treated as a separate corporation purchasing or selling on 
behalf of the remainder of the controlled foreign corporation under 
paragraph (b)(2)(ii)(b) of this section, or the remainder of the 
controlled foreign corporation treated as a separate corporation 
purchasing or selling on behalf of a branch or similar establishment of 
the controlled foreign corporation under paragraph (b)(2)(ii)(c) of this 
section, will include the activities of any other branch or similar 
establishment or remainder of the controlled foreign corporation that 
would not be treated as a separate corporation (apart from the branch or 
similar establishment of a controlled foreign corporation that is 
treated as performing purchasing or selling activities on behalf of the 
remainder of the controlled foreign corporation under paragraph 
(b)(2)(ii)(b) of this section or the remainder of the controlled foreign 
corporation that is treated as performing purchasing or selling 
activities on behalf of the branch or similar establishment under 
paragraph (b)(2)(ii)(c) of this section) if the effective rate of tax 
imposed on the income of the purchasing or selling branch or similar 
establishment, or purchasing or selling remainder of the controlled 
foreign corporation, were tested under the principles of paragraph 
(b)(1)(i)(b) or (b)(1)(ii)(b) of this section against the effective rate 
of tax that would apply to such income if it were considered derived by 
such other branch or similar establishment or the remainder of the 
controlled foreign corporation.
    (b) Activities treated as performed on behalf of the remainder of 
corporation. (1) With respect to purchasing or selling activities 
performed by or through the branch or similar establishment, such 
purchasing or selling activities will, with respect to personal property 
manufactured, produced, constructed, grown, or extracted by the 
remainder of the controlled foreign corporation, be treated as performed 
on behalf of the remainder of the controlled foreign corporation.

[[Page 326]]

    (2) With respect to purchasing or selling activities performed by or 
through the branch or similar establishment, such purchasing or selling 
activities will, with respect to personal property (other than property 
described in paragraph (b)(2)(ii)(b)(1) of this section) purchased or 
sold, or purchased and sold, by the remainder of the controlled foreign 
corporation (or any branch treated as the remainder of the controlled 
foreign corporation), be treated as performed on behalf of the remainder 
of the controlled foreign corporation.
    (c) Activities treated as performed on behalf of branch. With 
respect to manufacturing, producing, constructing, growing, or 
extracting activities performed by or through the branch or similar 
establishment, purchasing or selling activities performed by or through 
the remainder of the controlled foreign corporation with respect to the 
personal property manufactured, produced, constructed, grown, or 
extracted by or through the branch or similar establishment shall be 
treated as performed on behalf of the branch or similar establishment.
    (d) [Reserved]
    (e) Comparison with ordinary treatment. Income derived by a branch 
or similar establishment, or by the remainder of the controlled foreign 
corporation, will not be foreign base company sales income under 
paragraph (b) of this section if the income would not be foreign base 
company sales income if it were derived by a separate controlled foreign 
corporation under like circumstances.
    (f) Priority of application. If income derived by the branch or 
similar establishment, or by the remainder of the controlled foreign 
corporation, from a transaction would be classified as foreign base 
company sales income of such controlled foreign corporation under 
section 954(d)(1) and paragraph (a) of this section, the income shall, 
notwithstanding this paragraph, be treated as foreign base company sales 
income under paragraph (a) of this section and the branch or similar 
establishment shall not be treated as a separate corporation with 
respect to such income.
    (3) Inclusion of amounts in gross income of United States 
shareholders. A branch or similar establishment of a controlled foreign 
corporation and the remainder of such corporation shall be treated as 
separate corporations under this paragraph solely for purposes of 
determining the foreign base company sales income of each such 
corporation and for purposes of including an amount in subpart F income 
of the controlled foreign corporation under section 953(a). See section 
954(b)(3) and paragraph (d)(4) of Sec. 1.954-1 for rules relating to 
the treatment of a branch or similar establishment of a controlled 
foreign corporation and the remainder of such corporation as separate 
corporations for purposes of independently determining if the foreign 
base company income of each such corporation is less than 10 percent, or 
more than 70 percent, of its gross income. For all other purposes, 
however, a branch or similar establishment of a controlled foreign 
corporation and the remainder of such corporation shall not be treated 
as separate corporations. For example, if the controlled foreign 
corporation has a deficit in earnings and profits to which section 
952(c) applies, the limitation of such section on the amount includable 
in the subpart F income of such corporation will apply. Moreover, 
income, war profits, or excess profits taxes paid by a branch or similar 
establishment to a foreign country will be treated as having been paid 
by the controlled foreign corporation for purposes of section 960 
(relating to special rules for foreign tax credit) and the regulations 
thereunder. Also, income of a branch or similar establishment, treated 
as a separate corporation under this paragraph, will not be treated as 
dividend income of the controlled foreign corporation of which it is a 
branch or similar establishment.
    (4) Illustrations. The application of this paragraph (b) may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is engaged in the manufacturing business in 
such country. Corporation A negotiates sales of its products for use 
outside of country X through a sales office, branch B, maintained in 
foreign country Y. These activities constitute the only activities of A 
Corporation. Country X levies an income tax

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at an effective rate of 50 percent on the income of A Corporation 
derived by the manufacturing plant in country X but does not tax the 
sales income of A Corporation derived by branch B in country Y. Country 
Y levies an income tax at an effective rate of 10 percent on the sales 
income derived by branch B but does not tax the income of A Corporation 
derived by the manufacturing plant in country X. If the sales income 
derived by branch B were, under the laws of country X, derived from 
sources within country X by A Corporation, such income would be taxed by 
such country at an effective rate of 50 percent. In determining foreign 
base company sales income of A Corporation, branch B is treated as a 
separate wholly owned subsidiary corporation of A Corporation, the 10 
percent rate of tax on branch B's income being less than 90 percent of, 
and at least 5 percentage points less than, the 50 percent rate. Income 
derived by branch B, treated as a separate corporation, from the sale by 
or through it for use, consumption, or disposition outside country Y of 
the personal property produced in country X is treated as income from 
the sale of personal property on behalf of A Corporation, a related 
person, and constitutes foreign base company sales income. The remainder 
of A Corporation, treated as a separate corporation, derives no foreign 
base company sales income since it produces the product which is sold.
    Example 2. Controlled foreign corporation C is incorporated under 
the laws of foreign country X. Corporation C maintains branch B in 
foreign country Y. Branch B manufactures articles in country Y which are 
sold through the sales offices of C Corporation located in country X. 
These activities constitute the only activities of C Corporation. 
Country Y levies an income tax at an effective rate of 30 percent on the 
manufacturing profit of C Corporation derived by branch B but does not 
tax the sales income of C Corporation derived by the sales offices in 
country X. Country X does not impose an income, war profits, excess 
profits, or similar tax, and no tax is paid to any foreign country with 
respect to income of C Corporation which is not derived by branch B. If 
C Corporation were incorporated under the laws of country Y, the sales 
income of the sales offices in country X would be taxed by country Y at 
an effective rate of 30 percent. In determining foreign base company 
sales income of C Corporation, branch B is treated as a separate wholly 
owned subsidiary corporation of C Corporation, the zero rate of tax on 
the income derived by the remainder of C Corporation being less than 90 
percent of, and at least 5 percentage points less than, the 30 percent 
rate. Branch B, treated as a separate corporation, derives no foreign 
base company sales income since it produces the product which is sold. 
Income derived by the remainder of C Corporation, treated as a separate 
corporation, from the sale by or through it for use, consumption, or 
disposition outside country X of the personal property produced in 
country Y is treated as income from the sale of personal property on 
behalf of branch B, a related person, and constitutes foreign base 
company sales income.
    Example 3. (i) Facts. Corporation E, a controlled foreign 
corporation incorporated under the laws of foreign Country X, is a 
wholly owned subsidiary of Corporation D, also a controlled foreign 
corporation incorporated under the laws of Country X. Corporation E 
maintains Branch B in foreign Country Y. Both corporations use the 
calendar year as the taxable year. In 1964, Corporation E's sole 
activity, carried on through Branch B, consists of the purchase of 
articles manufactured in Country X by Corporation D, a related person, 
and the sale of the articles through Branch B to unrelated persons. One 
hundred percent of the articles sold through Branch B are sold for use 
outside Country X and 90% are also sold for use outside of Country Y. 
The income of Corporation E derived by Branch B from such transactions 
is taxed to Corporation E by Country X only at the time Corporation E 
distributes such income to Corporation D and is taxed on the basis of 
what the tax (a 40% effective rate) would have been if the income had 
been derived in 1964 by Corporation E from sources within Country X from 
doing business through a permanent establishment therein. Country Y 
levies an income tax at an effective rate of 50% on income derived from 
sources within such country, but the income of Branch B for 1964 is 
effectively taxed by Country Y at a 5% rate since under the laws of such 
country, only 10% of Branch B's income is derived from sources within 
such country. Corporation E makes no distributions to Corporation D in 
1964.
    (ii) Result. In determining foreign base company sales income of 
Corporation E for 1964, Branch B is treated as a separate wholly owned 
subsidiary corporation of Corporation E, the 5% rate of tax being less 
than 90% of, and at least 5 percentage points less than the 40% rate. 
Income derived by Branch B, treated as a separate corporation, from the 
purchase from a related person (Corporation D), of personal property 
manufactured outside of Country Y and sold for use, disposition, or 
consumption outside of Country Y constitutes foreign base company sales 
income. If, instead, Corporation D were unrelated to Corporation E, none 
of the income would be foreign base company sales income because 
Corporation E would be purchasing from and selling to unrelated persons 
and if Branch B were treated as a separate corporation it would likewise 
be purchasing from and selling to unrelated persons. Alternatively, if 
Corporation D were related to Corporation E, but Branch B manufactured 
the articles prior to sale under the principles

[[Page 328]]

of paragraph (a)(4)(iv) of this section, the income would not be foreign 
base company sales income because Branch B, treated as a separate 
corporation, would qualify for the manufacturing exception under 
paragraph (a)(4) of this section.
    Example 4. Controlled foreign corporation F, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation M. Corporation F, through its branch B in foreign country Y, 
purchases from controlled foreign corporation G, a wholly owned 
subsidiary of M Corporation incorporated under the laws of foreign 
country Z, personal property which G Corporation manufactures in country 
Z. Corporation F sells such property for use in foreign country W. Since 
the income of F Corporation from such purchases and sales is classified 
as foreign base company sales income under section 954(d)(1) and 
paragraph (a) of this section, branch B will not be treated as a 
separate corporation with respect to such income even if the tax 
differential between countries X and Y would otherwise justify such 
treatment.
    Example 5. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is engaged in manufacturing articles through 
its home office, located in country X, and selling such articles through 
branch B, located in foreign country Y, and through branch C, located in 
foreign country Z, for use outside country X. These activities 
constitute the only activities of A Corporation for its taxable year 
1963. Each such country levies an income tax on only the income derived 
from sources within such country, and all income derived in 1963 by the 
home office, branch B, and branch C, respectively, is derived from 
sources within countries X, Y, and Z, respectively. The income and 
income taxes of A Corporation for 1963 are as follows:

------------------------------------------------------------------------
                                    X Country    Y Country    Z Country
------------------------------------------------------------------------
Income of:
  Home office....................     $200,000
  Branch B.......................  ...........     $100,000
  Branch C.......................  ...........  ...........     $100,000
Income tax.......................     $100,000      $20,000      $20,000
Effective rate of tax............          50%          20%          20%
------------------------------------------------------------------------


By applying subparagraph (1)(i) of this paragraph and by treating branch 
B as though it were the only branch of A Corporation, branch B is 
treated as a separate wholly owned subsidiary corporation of A 
Corporation in determining foreign base company sales income of A 
Corporation for 1963, the 20 percent rate of tax on the income of such 
branch being less than 90 percent of, and at least 5 percentage points 
less than, the 50 percent rate of tax which would apply to the income of 
branch B under the laws of country X if, under the laws of such country, 
all the income of A Corporation for 1963 derived through the home office 
and branch B were derived from sources within country X. Moreover, by 
applying subparagraph (1)(i) of this paragraph and by treating branch C 
as though it were the only branch of A Corporation, branch C is treated 
as a separate wholly owned subsidiary corporation of A Corporation, the 
20 percent rate of tax on the income of such branch being less than 90 
percent of, and at least 5 percentage points less than, the 50 percent 
rate of tax which would apply to the income of branch C under the laws 
of country X if, under the laws of such country, all the income of A 
Corporation for 1963 derived through the home office and branch C were 
derived from sources within country X. The income derived by branch B 
and branch C, respectively, each treated as a separate corporation, from 
the sale by or through each of them for use, consumption, or disposition 
outside country Y and country Z, respectively, is treated as income from 
the sale of personal property on behalf of A Corporation, a related 
person, and constitutes foreign base company sales income for 1963. The 
home office of A Corporation, treated as a separate corporation, derives 
no foreign base company sales income for 1963 since it produces the 
articles which are sold.
    Examples 6-7 [Reserved]
    Example 8. Uniformly applicable incentive tax rate in one country. 
(i) Facts. FS is a controlled foreign corporation organized in Country 
M. FS operates one branch, Branch A, located in Country A. Branch A 
manufactures Product X within the meaning of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section. Raw materials used in the manufacture of 
Product X are purchased by FS from an unrelated person. FS engages in 
activities in Country M to sell Product X to a related person for use 
outside of Country M. Employees of FS located in Country M carry on only 
sales functions. The effective rate imposed in Country M on the income 
from the sale of Product X is 10%. Country A generally imposes an 
effective rate of tax on income of 20%, but imposes a uniformly 
applicable incentive rate of tax of 10% on manufacturing income and 
related sales income.
    (ii) Result. The use of Branch A to manufacture Product X does not 
have substantially the same tax effect as if Branch A were a wholly 
owned subsidiary corporation of FS because the effective rate of tax on 
FS's sales income from the sale of Product X in Country M (10%) is not 
less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in the country in 
which Branch A is located (10%). Consequently, pursuant to paragraph 
(b)(1)(ii)(b) of this section, Branch A is not treated as a separate 
corporation apart from the remainder of FS for purposes of determining 
foreign base company sales income.

[[Page 329]]

    Example 9. Manufacturing activities performed by multiple branches, 
no branch independently satisfies paragraph (a)(4)(i), selling 
activities carried on by remainder of the controlled foreign 
corporation, some branch manufacturing activities included in remainder 
contribution. (i) Facts. FS, a controlled foreign corporation organized 
in Country M, has three branches, Branch A, Branch B, and Branch C, 
located in Country A, Country B, and Country C respectively. FS 
purchases raw materials from a related person. The raw materials are 
manufactured (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation, pursuant to a contract manufacturing arrangement. CM 
physically performs the substantial transformation, assembly, or 
conversion required to manufacture Product X outside of FS's country of 
organization. FS manages the manufacturing costs and capacities with 
respect to the manufacture of Product X through employees located in 
Country M. Further, employees of FS located in Country M oversee the 
coordination between the branches. Branch A, through the activities of 
employees of FS located in Country A, designs Product X, controls 
manufacturing related logistics, and controls the raw materials and 
work-in-process during the manufacturing process. Branch B, through the 
activities of employees of FS located in Country B, provides quality 
control. Branch C, through the activities of employees of FS located in 
Country C, provides oversight and direction during the manufacturing 
process. Employees of FS located in Country M sell Product X to 
unrelated persons for use outside of Country M. Country M imposes an 
effective rate of tax on sales income of 10%. Country A imposes an 
effective rate of tax on sales income of 12%, Country B imposes an 
effective rate of tax on sales income of 24%, and Country C imposes an 
effective rate of tax on sales income of 25%. None of the remainder of 
FS, Branch A, Branch B, or Branch C independently satisfies paragraph 
(a)(4)(i) of this section. However, under the facts and circumstances of 
the business, FS, as a whole, provides a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section. Under the facts and circumstances of the business, the 
activities of the remainder of FS and Branch A, if considered together, 
would not provide a greater contribution to the manufacture of Product X 
than the activities of Branch B and Branch C, if considered together. 
Under the facts and circumstances of the business, however, the 
activities of the employees of the remainder of FS and Branch A, if 
considered together, would constitute a substantial contribution to the 
manufacture of Product X.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through activities of its employees in Country M) nor any branch of FS 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to Product X, but FS, as a whole, provides a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
The remainder of FS, Branch A, Branch B, and Branch C each provide a 
contribution through the activities of employees to the manufacture of 
Product X. Therefore, FS must determine the location of manufacture 
under paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to 
Product X are carried on by the remainder of FS. The location of Branch 
B is the tested manufacturing location because the effective rate of tax 
imposed on FS's sales income by Country M (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country B (24%), and Country B has the 
lowest effective rate of tax among the manufacturing branches that 
would, after applying paragraph (b)(1)(ii)(b) of this section, be 
treated as a separate corporation. The manufacturing activities 
performed in Country A by Branch A will be included in the contribution 
of the remainder of FS for purposes of determining the location of 
manufacture of Product X because the effective rate of tax imposed on 
the sales income by Country M (10%) is not less than 90% of, and at 
least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country A (12%). The manufacturing 
activities performed in Country C by Branch C will be included in the 
contribution of Branch B for purposes of determining the location of 
manufacture of Product X because the effective rate of tax imposed on 
the sales income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in Country C (25%). Under the facts and circumstances of 
the business, the manufacturing activities of the remainder of FS and 
Branch A, considered together, would not provide a greater contribution 
to the manufacture of Product X than the activities of Branch B and 
Branch C, considered together. Therefore, the location of manufacture is 
Country B, the location of Branch B. In determining that Country B is 
the location of manufacture, it was determined that after applying 
paragraph (b)(1)(ii)(b) of this section Branch B would be treated as a 
separate corporation under paragraph (b)(1)(ii)(a) of this section for 
purposes of determining foreign base company sales income. To determine 
whether income from the sale of Product X is foreign base company sales 
income, the remainder of FS takes into account the activities of Branch 
A because, under paragraph (b)(2)(ii)(a) of this section, Branch A would 
not be treated as a

[[Page 330]]

separate corporation apart from FS. The remainder of FS is considered to 
have manufactured Product X under paragraph (a)(4)(i) of this section 
because the manufacturing activities of the remainder of FS and Branch 
A, considered together, would make a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section. Therefore, income derived from the sale of Product X by 
the remainder of FS does not constitute foreign base company sales 
income.

    (c) Effective/applicability date. Paragraphs (a)(1)(i), (a)(1)(iii) 
Example 1, (a)(1)(iii) Example 2, (a)(2), (a)(4)(i), (a)(4)(ii), 
(a)(4)(iii), (a)(4)(iv), (a)(6)(i), (b)(1)(i)(c), (b)(1)(ii)(a), 
(b)(1)(ii)(c), (b)(2)(i)(b), (b)(2)(ii)(a), (b)(2)(ii)(b), 
(b)(2)(ii)(e), and (b)(4) Example 3, (b)(4) Example 8, and (b)(4) 
Example 9 of this section shall apply to taxable years of controlled 
foreign corporations beginning after June 30, 2009, and for taxable 
years of United States shareholders in which or with which such taxable 
years of the controlled foreign corporations end.
    (d) Application of regulations to earlier taxable years. A taxpayer 
may choose to apply these regulations retroactively with respect to its 
open taxable years that began prior to July 1, 2009. The taxpayer may so 
choose if and only if the taxpayer and all members of the taxpayer's 
affiliated group (within the meaning of section 1504(a)) apply these 
regulations, in their entirety, to the earliest taxable year of each 
controlled foreign corporation that ends with or within an open taxable 
year of the taxpayer and to all subsequent taxable years.

[T.D. 6734, 29 FR 6392, May 15, 1964, as amended by T.D. 7545, 43 FR 
32754, May 8, 1978; T.D. 7893, 48 FR 22508, May 19, 1983; T.D. 7894, 48 
FR 22523, May 19, 1983; T.D. 9008, 67 FR 48025, July 23, 2002; T.D. 
9438, 73 FR 79344, T.D. 9438, Dec. 29, 2008; 74 FR 11844, Mar. 20, 2009; 
T.D. 9563, 76 FR 78546, Dec. 19, 2011]



Sec. 1.954-4  Foreign base company services income.

    (a) Items included. Except as provided in paragraph (d) of this 
section, foreign base company services income means income of a 
controlled foreign corporation, whether in the form of compensation, 
commissions, fees, or otherwise, derived in connection with the 
performance of technical, managerial, engineering, architectural, 
scientific, skilled, industrial, commercial, or like services which--
    (1) Are performed for, or on behalf of a related person, as defined 
in paragraph (e)(1) of Sec. 1.954-1, and
    (2) Are performed outside the country under the laws of which the 
controlled foreign corporation is created or organized.
    (b) Services performed for, or on behalf of, a related person--(1) 
Specific cases. For purposes of paragraph (a)(1) of this section, 
``services which are performed for, or on behalf of, a related person'' 
include (but are not limited to) services performed by a controlled 
foreign corporation in a case where--
    (i) The controlled foreign corporation is paid or reimbursed by, is 
released from an obligation to, or otherwise receives substantial 
financial benefit from, a related person for performing such services;
    (ii) The controlled foreign corporation performs services (whether 
or not with respect to property sold by a related person) which a 
related person is, or has been, obligated to perform;
    (iii) The controlled foreign corporation performs services with 
respect to property sold by a related person and the performance of such 
services constitutes a condition or a material term of such sale; or
    (iv) Substantial assistance contributing to the performance of such 
services has been furnished by a related person or persons.
    (2) Special rules--(i) Guaranty of performance. Subparagraph (1)(ii) 
of this paragraph shall not apply with respect to services performed by 
a controlled foreign corporation pursuant to a contract the performance 
of which is guaranteed by a related person, if (a) the related person's 
sole obligation with respect to the contract is to guarantee performance 
of such services, (b) the controlled foreign corporation is fully 
obligated to perform the services under the contract, and (c) the 
related person (or any other person related to the controlled foreign 
corporation) does not in fact (1) pay for performance of, or perform, 
any of such services the performance of which is so guaranteed or (2) 
pay for performance of, or perform, any significant services related to 
such

[[Page 331]]

services. If the related person (or any other person related to the 
controlled foreign corporation) does in fact pay for performance of, or 
perform, any of such services or any significant services related to 
such services, subparagraph (1)(ii) of this paragraph shall apply with 
respect to the services performed by the controlled foreign corporation 
pursuant to the contract the performance of which is guaranteed by the 
related person, even though such payment or performance is not 
considered to be substantial assistance for purposes of subparagraph 
(1)(iv) of this paragraph. For purposes of this subdivision, a related 
person shall be considered to guarantee performance of the services by 
the controlled foreign corporation whether it guarantees performance of 
such services by a separate contract of guaranty or enters into a 
service contract solely for purposes of guaranteeing performance of such 
services and immediately thereafter assigns the entire contract to the 
controlled foreign corporation for execution.
    (ii) Application of substantial assistance test. For purposes of 
subparagraph (1)(iv) of this paragraph--
    (a) Assistance furnished by a related person or persons to the 
controlled foreign corporation shall include, but shall not be limited 
to, direction, supervision, services, know-how, financial assistance 
(other than contributions to capital), and equipment, material, or 
supplies.
    (b) Assistance furnished by a related person or persons to a 
controlled foreign corporation in the form of direction, supervision, 
services, or know-how shall not be considered substantial unless either 
(1) the assistance so furnished provides the controlled foreign 
corporation with skills which are a principal element in producing the 
income from the performance of such services by such corporation or (2) 
the cost to the controlled foreign corporation of the assistance so 
furnished equals 50 percent or more of the total cost to the controlled 
foreign corporation of performing the services performed by such 
corporation. The term ``cost'', as used in this subdivision (b), shall 
be determined after taking into account adjustments, if any, made under 
section 482.
    (c) Financial assistance (other than contributions to capital), 
equipment, material, or supplies furnished by a related person to a 
controlled foreign corporation shall be considered assistance only in 
that amount by which the consideration actually paid by the controlled 
foreign corporation for the purchase or use of such item is less than 
the arm's length charge for such purchase or use. The total of such 
amounts so considered to be assistance in the case of financial 
assistance, equipment, material, and supplies furnished by all related 
persons shall be compared with the profits derived by the controlled 
foreign corporation from the performance of the services to determine 
whether the financial assistance, equipment, material, and supplies 
furnished by a related person or persons are by themselves substantial 
assistance contributing to the performance of such services. For 
purposes of this subdivision (c), determinations shall be made after 
taking into account adjustments, if any, made under section 482 and the 
term ``consideration actually paid'' shall include any amount which is 
deemed paid by the controlled foreign corporation pursuant to such an 
adjustment.
    (d) Even though assistance furnished by a related person or persons 
to a controlled foreign corporation in the form of direction, 
supervision, services, or know-how is not considered to be substantial 
under (b) of this subdivision and assistance furnished by a related 
person or persons in the form of financial assistance (other than 
contributions to capital), equipment, material, or supplies is not 
considered to be substantial under (c) of this subdivision, such 
assistance may nevertheless constitute substantial assistance when taken 
together or in combination with other assistance furnished by a related 
person or persons which in itself is not considered to be substantial.
    (e) Assistance furnished by a related person or persons to a 
controlled foreign corporation in the form of direction, supervision, 
services, or know-how shall not be taken into account under (b) or (d) 
of this subdivision unless the assistance so furnished assists

[[Page 332]]

the controlled foreign corporation directly in the performance of the 
services performed by such corporation.
    (iii) Special rule applicable to distributive share of partnership 
income. A controlled foreign corporation's distributive share of a 
partnership's services income will be deemed to be derived from services 
performed for or on behalf of a related person, within the meaning of 
section 954(e)(1)(A), if the partnership is a related person with 
respect to the controlled foreign corporation, under section 954(d)(3), 
and, in connection with the services performed by the partnership, the 
controlled foreign corporation, or a person that is a related person 
with respect to the controlled foreign corporation, provided assistance 
that would have constituted substantial assistance contributing to the 
performance of such services, under paragraph (b)(2)(ii) of this 
section, if furnished to the controlled foreign corporation by a related 
person. This paragraph (b)(2)(iii) applies to taxable years of a 
controlled foreign corporation beginning on or after July 23, 2002.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A is paid by related 
corporation M for the installation and maintenance of industrial 
machines which M Corporation manufactures and sells to B Corporation. 
Such installation and maintenance services by A Corporation are 
performed for, or on behalf of, M Corporation for purposes of section 
954(e).
    Example 2. Controlled foreign corporation B enters into a contract 
with an unrelated person to drill an oil well in a foreign country. 
Domestic corporation M owns all the outstanding stock of B Corporation. 
Corporation B employs a relatively small clerical and administrative 
staff and owns the necessary well-drilling equipment. Most of the 
technical and supervisory personnel who oversee the drilling of the oil 
well by B Corporation are regular employees of M Corporation who are 
temporarily employed by B Corporation. In addition, B Corporation hires 
on the open market unskilled and semiskilled laborers to work on the 
drilling project. The services performed by B Corporation under the 
well-drilling contract are performed for, or on behalf of, a related 
person for purposes of section 954(e) because the services of the 
technical and supervisory personnel which are provided by M Corporation 
are of substantial assistance in the performance of such contract in 
that they assist B Corporation directly in the execution of the contract 
and provide B Corporation with skills which are a principal element in 
producing the income from the performance of such contract.
    Example 3. Controlled foreign corporation F enters into a contract 
with an unrelated person to construct a dam in a foreign country. 
Domestic corporation M owns all the outstanding stock of F Corporation. 
Corporation F leases or buys from M Corporation, on an arm's length 
basis, the equipment and material necessary for the construction of the 
dam. The technical and supervisory personnel who design and oversee the 
construction of the dam are regular full-time employees of F Corporation 
who are not on loan from any related person. The principal clerical 
work, and the financial accounting, required in connection with the 
construction of the dam by F Corporation are performed, on a remunerated 
basis, by full-time employees of M Corporation. All other assistance F 
Corporation requires in completing the construction of the dam is paid 
for by that corporation and furnished by unrelated persons. The services 
performed by F Corporation under the contract for the construction of 
the dam are not performed for, or on behalf of, a related person for 
purposes of section 954(e) because the clerical and accounting services 
furnished by M Corporation do not assist F Corporation directly in the 
performance of the contract.
    Example 4. Controlled foreign corporation D, a wholly owned 
subsidiary of domestic corporation M, procures and enters a contract 
with an unrelated person to construct a superhighway in a foreign 
country, but such person enters the contract only on the condition that 
M Corporation agrees to perform, or to pay for the performance by some 
person other than D Corporation of, the services called for by the 
contract if D Corporation should fail to complete their performance. 
Corporation D is capable of performing such contract. No related person 
as to D Corporation pays for, or performs, any services called for by 
the contract, or pays for, or performs, any significant services related 
to such services. The construction of the superhighway by D Corporation 
is not considered for purposes of section 954(e) to be the performance 
of services for, or on behalf of M Corporation.
    Example 5. Domestic corporation M is obligated under a contract with 
an unrelated person to construct a superhighway in a foreign country. At 
a later date M Corporation assigns the entire contract to its wholly 
owned subsidiary, controlled foreign corporation C, and the unrelated 
person releases M Corporation from any obligation under the contract. 
The construction of such highway by C Corporation is considered for 
purposes of section 954(e) to be the performance of services for, or on 
behalf of, M Corporation.

[[Page 333]]

    Example 6. Domestic corporation M enters a contract with an 
unrelated person to construct a superhighway in a foreign country. 
Corporation M immediately assigns the entire contract to its wholly 
owned subsidiary, controlled foreign corporation C. The unrelated person 
does not release M Corporation of its obligation under the contract, the 
sole purpose of these arrangements being to have M Corporation guarantee 
performance of the contract by C Corporation. Corporation C is capable 
of performing the construction contract. Neither M Corporation nor any 
other person related to C Corporation pays for, or performs, any 
services called for by the construction contract or at any time pays 
for, or performs, any significant services related to the services 
performed under such contract. The construction of the superhighway by C 
Corporation is not considered for purposes of section 954(e) to be the 
performance of services for, or on behalf of, M Corporation.
    Example 7. The facts are the same as in example 6 except that M 
Corporation, preparatory to entering the construction contract, prepares 
plans and specifications which enable the submission of bids for the 
contract. Since M Corporation has performed significant services related 
to the services the performance of which it has guaranteed, the 
construction of such highway by C Corporation is considered for purposes 
of section 954(e) to be the performance of services for, or on behalf 
of, M Corporation.
    Example 8. Domestic corporation M manufactures an industrial machine 
which requires specialized installation. Corporation M sells the 
machines for a basic price if the contract of sale contains no provision 
for installation. If, however, the customer agrees to employ controlled 
foreign corporation E, a wholly owned subsidiary of M Corporation, to 
install the machine and to pay E Corporation a specified installation 
charge, M Corporation sells the machine at a price which is less than 
the basic price. The installation services performed by E Corporation 
for customers of M Corporation purchasing the machine at the reduced 
price are considered for purposes of section 954(e) to be performed for, 
or on behalf of, M Corporation.
    Example 9. Domestic corporation M manufactures and sells industrial 
machines with a warranty as to their performance conditional upon their 
installation and maintenance by a factory-authorized service agency. 
Controlled foreign corporation F, a wholly owned subsidiary of M 
Corporation, is the only authorized service agency. Any installation or 
maintenance services performed by F Corporation on such machines are 
considered for purposes of section 954(e) to be performed for, or on 
behalf of, M Corporation.
    Example 10. Domestic corporation M manufactures electric office 
machines which it sells at a basic price without any provision for, or 
understanding as to, adjustment or maintenance of the machines. The 
machines require constant adjustment and maintenance services which M 
Corporation, certain wholly owned subsidiaries of M Corporation, and 
certain unrelated persons throughout the world are qualified to perform. 
From among the numerous persons qualified and available to perform 
adjustment and maintenance services with respect to such office 
machines, foreign corporation B, a customer of M Corporation, employs 
controlled foreign corporation G, a wholly owned subsidiary of M 
Corporation, to adjust and maintain the office machines which B 
Corporation purchases from M Corporation. The adjustment and maintenance 
services performed by G Corporation for B Corporation are not considered 
for purposes of section 954(e) to be performed for, or on behalf of, M 
Corporation.

    (c) Place where services are performed. The place where services 
will be considered to have been performed for purposes of paragraph 
(a)(2) of this section will depend on the facts and circumstances of 
each case. As a general rule, services will be considered performed 
where the persons performing services for the controlled foreign 
corporation which derives income in connection with the performance of 
technical, managerial, architectural, engineering, scientific, skilled, 
industrial, commercial, or like services are physically located when 
they perform their duties in the execution of the service activity 
resulting in such income. Therefore, in many cases, total gross income 
of a controlled foreign corporation derived in connection with each 
service contract or arrangement performed for or on behalf of a related 
person must be apportioned, between income which is not foreign base 
company services income and that which is foreign base company services 
income, on a basis of employee-time spent within the foreign country 
under the laws of which the controlled foreign corporation is created or 
organized and employee-time spent without the foreign country under the 
laws of which such corporation is created or organized. In allocating 
time spent within and without the foreign country under the laws of 
which the controlled foreign corporation is created or organized, 
relative weight must also be

[[Page 334]]

given to the value of the various functions performed by persons in 
fulfillment of the service contract or arrangement. For example, 
clerical work will ordinarily be assigned little value, while services 
performed by technical, highly skilled, and managerial personnel will be 
assigned greater values in relation to the type of function performed by 
each individual.
    (d) Items excluded. Foreign base company services income does not 
include--
    (1) Income derived in connection with the performance of services by 
a controlled foreign corporation if--
    (i) The services directly relate to the sale or exchange of personal 
property by the controlled foreign corporation,
    (ii) The property sold or exchanged was manufactured, produced, 
grown, or extracted by such controlled foreign corporation, and
    (iii) The services were performed before the sale or exchange of 
such property by the controlled foreign corporation;
    (2) Income derived in connection with the performance of services by 
a controlled foreign corporation if the services directly relate to an 
offer or effort to sell or exchange personal property which was, or 
would have been, manufactured, produced, grown, or extracted by such 
controlled foreign corporation whether or not a sale or exchange of such 
property was in fact consummated; or
    (3) For taxable years beginning after December 31, 1975, foreign 
base company shipping income (as determined under Sec. 1.954-6).

[T.D. 6734, 29 FR 6399, May 15, 1964, as amended by T.D. 6981, 33 FR 
16497, Nov. 13, 1968; T.D. 7893, 48 FR 22523, May 19, 1983; T.D. 9008, 
67 FR 48025, July 23, 2002]



Sec. 1.954-5  Increase in qualified investments in less developed
countries; taxable years of controlled foreign corporations beginning
before January 1, 1976.

    For rules applicable to taxable years of controlled foreign 
corporations beginning before January 1, 1976, see section 954(b)(1) (as 
in effect before the enactment of the Tax Reduction Act of 1975) and 26 
CFR 1.954-5 (Revised as of April 1, 1975).

[T.D. 7893, 48 FR 22508, May 19, 1983]



Sec. 1.954-6  Foreign base company shipping income.

    (a) Scope--(1) In general. This section prescribes rules for 
determining foreign base company shipping income under the provisions of 
section 954(f), as amended by the Tax Reduction Act of 1975.
    (2) Effective date. (i) The rules prescribed in this section apply 
to taxable years of foreign corporations beginning after December 31, 
1975, and to taxable years of United States shareholders (as defined in 
section 951 (b)) within which or with which such taxable years of such 
foreign corporations end.
    (ii) Except as described in paragraph (b)(1)(viii) of this section, 
foreign base company shipping income does not include amounts earned by 
a foreign corporation in a taxable year of such corporation beginning 
before January 1, 1976. See example 1 of paragraph (g)(2) of this 
section for an illustration of the effect of this subparagraph on 
partnership income. See example 3 of paragraph (f)(4)(ii) of this 
section for an illustration of the effect of this subparagraph on 
certain dividend income. See paragraph (f)(5)(iii) of this section for 
the effect of this subparagraph on certain interest and gains.
    (b) Definitions--(1) Foreign base company shipping income. The term 
``foreign base company shipping income'' means--
    (i) Gross income derived from, or in connection with, the use (or 
hiring or leasing for use) of any aircraft or vessel in foreign commerce 
(see paragraph (c) of this section),
    (ii) Gross income derived from, or in connection with, the 
performance of services directly related to the use of any aircraft or 
vessel in foreign commerce (see paragraph (d) of this section),
    (iii) Gross income incidental to income described in subdivisions 
(i) and (ii) of this subparagraph, as provided in paragraph (e) of this 
section,
    (iv) Gross income derived from the sale, exchange, or other 
disposition of any aircraft or vessel used or held for

[[Page 335]]

use (by the seller or by a person related to the seller) in foreign 
commerce,
    (v) In the case of a controlled foreign corporation, dividends, 
interest, and gains described in paragraph (f) of this section,
    (vi) Income described in paragraph (g) of this section (relating to 
partnerships, trusts, etc.),
    (vii) Exchange gain, to the extent allocable to foreign base company 
shipping income (see Sec. 1.952-2(c)(2)(v)(b), and
    (viii) In the case of a controlled foreign corporation and at its 
option, dividends, interest, and gains attributable to income derived 
from aircraft and vessels (as defined in 26 CFR 1.954-1(b)(2) (Revised 
as of April 1, 1975)) by a less developed country shipping company 
(described in Sec. 1.955-5(b)) in taxable years beginning after 
December 31, 1962, and before January 1, 1976. The portion of a 
dividend, interest, or gain attributable to such income shall be 
determined by the same method as that for determining the portion of a 
dividend, interest, or gain attributable to foreign base company 
shipping income under paragraphs (f)(4), (5), and (6) of this section, 
but without regard to paragraphs (f)(6)(ii) and (iv)(B).
    (2) Foreign base company shipping operations. For purposes of 
sections 951 through 964, the term ``foreign base company shipping 
operations'' means the trade or business from which gross income 
described in subparagraph (1)(i) and (ii) of this paragraph is derived.
    (3) Foreign commerce. For purposes of sections 951 through 964--
    (i) An aircraft or vessel is used in foreign commerce to the extent 
it is used in transportation of property or passengers--
    (A) Between a port (or airport) in the United States or possession 
of the United States and a port (or airport) in a foreign country, or
    (B) Between a port (or airport) in a foreign country and another in 
the same country or between a port (or airport) in a foreign country and 
one in another foreign country.


Thus, for example, a trawler, a factory ship, and an oil drilling ship 
are not considered to be used in foreign commerce. On the other hand, a 
cruise ship which visits one or more foreign ports is considered to be 
so used. Notwithstanding subdivision (i)(B) of this paragraph (b)(3), 
foreign base company income does not include income derived from, or in 
connection with, the use of an aircraft or vessel in transportation of 
property or passengers between a port (or airport) in a foreign country 
and another port (or airport) in the same country if both the foreign 
corporation is created or organized and the aircraft or vessel is 
registered in that country.
    (ii) The term vessel includes all water craft and other artificial 
contrivances of whatever description and at whatever stage of 
construction, whether on the stocks or launched, which are used or are 
capable of being used or are intended to be used as a means of 
transportation on water. This definition does not apply for purposes of 
section 956(b)(2)(G) and Sec. 1.956-2(b)(1)(ix).
    (iii) The term port means any place (whether on or off shore) where 
aircraft or vessels are accustomed to load or unload goods or to take on 
or let off passengers.
    (iv) Any vessel (such as a lighter or beacon lightship) which serves 
other vessels used in foreign commerce (within the meaning of 
subdivision (i) of this subparagraph) shall, to the extent so used, also 
be considered to be used in foreign commerce.
    (v) For the meaning of the term ``foreign country'', see section 
638(2).
    (4) Use in foreign commerce. For purposes of sections 951 through 
964, the use of an aircraft or vessel in foreign commerce includes the 
hiring or leasing (or subleasing) of an aircraft or vessel to another 
for use in foreign commerce. Thus, for example, an aircraft or vessel is 
``used in foreign commerce'' within the meaning of section 955(b)(1)(A) 
if such aircraft or vessel is chartered (whether pursuant to a bareboat 
charter, time charter, or otherwise) to another for use in foreign 
commerce.
    (5) Related person. With respect to a controlled foreign 
corporation, the term ``related person'' means a related person as 
defined in Sec. 1.954-1(e)(1), and the term ``unrelated person'' means 
an unrelated person as defined in Sec. 1.954-1(e)(2).

[[Page 336]]

    (c) Aircraft or vessel income--(1) In general. The term ``income 
derived from, or in connection with, the use (or hiring or leasing for 
use) of any aircraft or vessel in foreign commerce'' as used in 
paragraph (b)(1)(i) of this section means--
    (i) Income derived from transporting passengers or property by 
aircraft or vessel in foreign commerce and
    (ii) Income derived from hiring or leasing an aircraft or vessel to 
another for use in foreign commerce.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation C owns a foreign flag vessel which it 
charters under a long-term charter to foreign corporation D. The vessel 
is used by D as a tramp which has no fixed or regular schedule. The 
vessel carries bulk and packaged cargoes, as well as occasional 
passengers, under charter parties, contracts of affreightment, or other 
contracts of carriage. The carriage of cargoes and passengers is between 
a port in the United States and a port in a foreign country or between a 
port in one foreign country and another port in the same or a different 
foreign country. The charter hire paid to C by D constitutes income 
derived from the use of the vessel in foreign commerce, but is not 
foreign base company income to the extent the charter hire is allocable 
to income derived from the use of the vessel between ports in the same 
foreign country in which both C is incorporated and the vessel is 
registered. The charter hire and freight and passenger revenue 
(including demurrage and dead freight) derived by D also constitute 
income derived from the use of the vessel in foreign commerce, but is 
not foreign base company income to the extent the charter hire and 
freight and passenger revenue are allocable to the use of the vessel 
between ports in the same foreign country in which both D is 
incorporated and the vessel is registered.
    Example 2. (a) Foreign corporation E owns a foreign flag tanker 
which it charters under a long-term bareboat charter to foreign 
corporation F for use in foreign commerce. F produces oil in a foreign 
country and ships the oil to other foreign countries and to the United 
States. The vessel, when not engaged in carrying F's oil, is used to 
carry bulk cargoes for unrelated persons in foreign commerce as 
opportunity offers. The charger hire received by E constitutes income 
derived from the use of the vessel in foreign commerce. The income 
derived by F from carrying bulk cargoes for unrelated persons also 
constitutes income derived from the use of the vessel in foreign 
commerce.
    (b) F is forced to lay up the vessel as a result of adverse market 
developments. Pursuant to the terms of the charter, F continues to pay 
charter hire to E during the period of lay-up. The charter hire received 
by E during the period of lay-up constitutes income derived from the use 
of the vessel in foreign commerce.
    Example 3. (a) A shipment of cheese is loaded into a container owned 
by controlled foreign corporation S at the consignor's place of business 
in Hamar, Norway. The cheese is transported to Milan, Italy, by the 
following routings:
    (1) Overland by road from Hamar, Norway, to Gothenburg, Sweden, by 
unrelated motor carriers via Oslo, Norway,
    (2) By sea from Gothenburg to Rotterdam, Netherlands, by feeder 
vessel under foreign flag, time chartered to S by unrelated owner,
    (3) By sea from Rotterdam to Algeciras, Spain, by feeder vessel 
under foreign flag, time chartered to S by unrelated owner.
    (4) By sea from Algeciras to Genoa, Italy, by line-haul vessel under 
U.S. flag, chartered by S from related company, and
    (5) Overland from Genoa to Milan, Italy, by unrelated motor carrier.
    (b) The consignor pays S total charges of $1,710, and S pays $676 to 
unrelated third parties, which amounts may be broken down as follows:

------------------------------------------------------------------------
                                                     Revenue     Costs
                                           Amount   collected   paid to
                                         billed to   by S on   unrelated
         Description of charges           customer  behalf of   3d party
                                            and         an        and
                                         collected  unrelated   absorbed
                                            by S      party       by S
------------------------------------------------------------------------
Ocean freight..........................     $1,420
Trucking charge of empty equipment to           50        $50
 shipper's facility....................
Trucking charges Hamar to Oslo.........         60         60
Trucking charges Oslo to Gothenburg....  .........  .........       $315
Trucking charges Genoa to Milan........        180        180
Brokerage Commission in Europe.........  .........  .........         71
                                        --------------------------------
    Total..............................      1,710        290        386
------------------------------------------------------------------------

    (c) Of the $1,710 amount billed to the consignor and collected by S, 
$290 is collected by S on behalf of unrelated third parties. This $290 
amount is not includable in S's gross income, and is therefore not 
includable in S's foreign base company shipping income. The remaining 
$1,420 amount (i.e., $1,710-$290) is includable in S's foreign base 
company shipping income. The $386 amount paid by S to unrelated third 
parties and absorbed by S is deductible from foreign base company 
shipping income under Sec. 1.954-1(c).


[[Page 337]]


    (d) Services directly related--(1) In general. The term ``income 
derived from, or in connection with, the performance of services 
directly related to the use of an aircraft or vessel in foreign 
commerce'', as used in paragraph (b)(1)(ii) of this section, means--
    (i) Income derived from, or in connection with, the performance of 
services described in subparagraph (2) or (3) of this paragraph, and
    (ii) Income treated as foreign base company shipping income under 
subparagraph (4) of this paragraph.
    (2) Intragroup services. The services described in this subparagraph 
are services performed for a person who is the owner, lessor, lessee or 
operator of an aircraft or vessel used in foreign commerce, by such 
person or by a person related to such person, and which fall into one or 
more of the following categories:
    (i) Terminal services, such as dockage, wharfage, storage, lights, 
water, refrigeration, and similar services;
    (ii) Stevedoring and other cargo handling services;
    (iii) Container related services (including the rental of containers 
and related equipment) performed either in connection with the local 
drayage or inland haulage of cargo or in the course of transportation in 
foreign commerce;
    (iv) Services performed by tugs, lighters, barges, scows, launches, 
floating cranes, and other similar equipment;
    (v) Maintenance and repairs;
    (vi) Training of pilots and crews;
    (vii) Licensing of patents, know-how, and similar intangible 
property developed and used in the course of foreign base company 
shipping operations;
    (viii) Services performed by a booking, operating, or managing 
agent; and
    (ix) Any service performed in the course of the actual 
transportation of passengers or property.
    (3) Services for passenger, consignor, or consignee. The services 
described in this subparagraph are services provided by the operator (or 
person related to the operator) of an aircraft or vessel in foreign 
commerce for the passenger, consignor, or consignee, such as--
    (i) Services described in one or more of the categories set out in 
subparagraphs (2)(i) through (iv) and (ix) of this paragraph,
    (ii) The rental of staterooms, berths, or living accommodations and 
the furnishing of meals,
    (iii) Barber shop and other services to passengers aboard vessels,
    (iv) Excess baggage, and
    (v) Demurrage, dispatch, and dead freight.
    (4) The 70-percent test. At the option of the foreign corporation 
all the gross income for a taxable year derived by a foreign corporation 
from any facility used in connection with the performance of services 
described in one or more of the categories set out in subparagraph 
(2)(i) through (ix) of this paragraph is foreign base company shipping 
income if more than 70 percent of such gross income for either--
    (i) Such taxable year, or
    (ii) Such taxable year and the two preceding taxable years,


is foreign base company shipping income (determined without regard to 
this subparagraph). Thus, for example, if 80 percent of the gross income 
derived by a controlled foreign corporation at a stevedoring facility is 
treated as foreign base company shipping income under subparagraph (2) 
of this paragraph, then the remaining 20 percent is treated as foreign 
base company shipping income under this subparagraph.
    (5) Rules for applying subparagraph (4). (i) Solely for purposes of 
applying subparagraphs (4) of this paragraph, foreign base company 
shipping income and gross income shall be deemed to include an arm's 
length charge (see paragraph (h)(5) of this section) for services 
performed by the foreign corporation for itself.
    (ii) In determining whether services performed by a foreign 
corporation are performed at a single facility or at two or more 
different facilities, all of the facts and circumstances involved will 
be taken into account. Ordinarily, all services performed by a foreign 
corporation within a single port area will be considered performed at a 
single facility.
    (iii) The application of this subparagraph and subparagraph (4) of 
this paragraph may be illustrated by the

[[Page 338]]

following example in which it is assumed that the foreign corporation 
has chosen to apply the 70-percent test of subparagraph (4):

    Example. (a) Controlled foreign corporation X uses the calendar year 
as the taxable year. For 1976, X is divided into two operating 
divisions, A and B. Division A operates a number of vessels in foreign 
commerce. Division B operates a terminal facility at which it performs 
services described in subparagraph (2)(i) of this paragraph for vessels 
some of which are operated by division A, some of which are operated by 
persons related to X, and some of which are operated by persons 
unrelated to X. For 1976, X includes under subparagraph (5) as foreign 
base company shipping income and gross income, for purposes of 
subparagraph (4), an arm's length charge for services performed for 
itself. For 1976, the gross income derived by division B is 
reconstructed for purposes of subparagraph (4) of this paragraph as 
follows, based on the facts shown in the following table:

(1) Gross income derived from persons unrelated to X...........      $20
(2) Gross income derived from persons related to X.............       10
                                                                --------
(3) Actual gross income (line (1) plus line (2))...............       30
(4) Hypothetical gross income derived from division A                 70
 (determined by the application of subdivision (i) of this
 subparagraph).................................................
                                                                --------
(5) Total reconstructed gross income (line (3) plus line (4))..      100
                                                                ========
 

    (b) Since 80 percent of the reconstructed gross income derived by 
division B would be treated as foreign base company shipping income 
under subparagraph (2) of this paragraph, the entire $30 amount of the 
gross income actually derived by division B is treated as foreign base 
company shipping income under subparagraph (4) of this paragraph.

    (6) Arm's length charge. For purposes of this section, the arm's 
length charge for services performed by a foreign corporation for itself 
shall be determined by applying the principles of section 482 and the 
regulations thereunder as if the party for whom the services are 
performed and the party by whom the services are performed were not the 
same person, but were controlled taxpayers within the meaning of Sec. 
1.482-1(a)(4).
    (7) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A acts as a managing agent 
for foreign corporation B, a related person which contracts to construct 
and charter a foreign flag vessel for use in foreign commerce. As 
managing agent for B, A performs a broad range of services relating to 
the use of the vessel, including arranging for, and supervising of, 
construction and chartering of the vessel, and handling of operating 
services after construction is completed. The income derived by A from 
its management and operating services constitutes income derived in 
connection with the performance of services directly related to the use 
of the vessel in foreign commerce.
    Example 2. Controlled foreign corporation C uses the calendar year 
as the taxable year. During 1976, C is engaged in the trade or business 
of acting as a steamship agent solely for unrelated persons. C's 
activities as steamship agent range from ``husbanding'' (i.e., arranging 
for fuel, supplies and port services, and attending to crew and customs 
matters) to the solicitation and booking of cargo at a number of foreign 
ports. None of C's other gross income for 1976 is foreign base company 
shipping income. Under these circumstances, C's gross income derived 
from its steamship agency does not constitute foreign base company 
shipping income.

    (e) Incidental income--(1) In general. Foreign base company shipping 
income includes all incidental income derived by a foreign corporation 
in the course of its active conduct of foreign base company shipping 
operations.
    (2) Examples. Examples of incidental income derived in the course of 
the active conduct of foreign base company shipping operations include--
    (i) Gain from the sale, exchange or other disposition of assets 
which are related shipping assets within the meaning of Sec. 1.955A-
2(b),
    (ii) Income derived from temporary investments described in Sec. 
1.955A-2(b)(2)(i) and (iii),
    (iii) Interest on accounts receivable and evidences of indebtedness 
described in Sec. 1.955A-2(b)(2)(ii),
    (iv) Income derived from granting concessions to others aboard 
aircraft or vessels used in foreign commerce,
    (v) Income derived from stock and currency futures described in 
Sec. 1.955A-2(b)(2)(vii) and (viii),
    (vi) Income derived by the lessor of an aircraft or vessel used in 
foreign commerce from additional rentals for the use of related 
equipment (such as a complement of containers), and
    (vii) Interest derived by the seller from a purchase money mortgage 
loan in respect of the sale of an aircraft or vessel described in Sec. 
1.955A-2(a)(1)(i).

[[Page 339]]

    (f) Certain dividends, interest, and gain--(1) In general. (i) The 
foreign base company shipping income of a controlled foreign corporation 
(referred to in subdivision (ii)(A) of this paragraph (f)(1) as ``first 
corporation'') includes--
    (A) Dividends and interest received from foreign corporations listed 
in subdivision (ii) of this paragraph (f)(1), and
    (B) Gain recognized from the sale, exchange, or other disposition of 
stock or obligations of foreign corporations listed in subdivision (ii) 
of this paragraph (f)(1),


but only to the extent that such dividends, interest, and gains are 
attributable to foreign base company shipping income of the foreign 
corporations listed in subdivision (ii) of this paragraph (f)(1).
    (ii) The foreign corporations referred to in subdivision (i) of this 
paragraph (f)(1) are--
    (A) Foreign corporations with respect to which the first corporation 
(see subdivision (i) of this paragraph (f)(1)) would be deemed under 
section 902(b) to pay taxes,
    (B) Controlled foreign corporations which are related persons 
(within the meaning of section 954(d)(3)), and
    (C) Less developed country shipping companies described in Sec. 
1.955-5(b).
    (2) Corporation deemed to pay taxes. (i) For purposes of this 
paragraph, a controlled foreign corporation would be deemed under 
section 902(b) to pay taxes in respect of any other foreign corporation 
if such controlled foreign corporation would be deemed, for purposes of 
applying section 902(a) to any United States shareholder of such 
controlled foreign corporation, to pay taxes in respect of dividends 
which were received from such other foreign corporation (whether or not 
such other foreign corporation actually pays any taxes or dividends). 
Solely for purposes of this subdivision, each United States shareholder 
(within the meaning of section 951(b)) shall be deemed to be a domestic 
corporation.
    (ii) The application of subdivision (i) of this subparagraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M owns 100 percent of the one class 
of stock of controlled foreign corporation X, which in turn owns 40 
percent of the one class of stock of foreign corporation Y. Y is not a 
controlled foreign corporation. For purposes of subdivision (1) of this 
subparagraph, X is deemed to pay taxes in respect of Y.
    Example 2. The facts are the same as in example 1, except that 
United States shareholder A, an individual, owns 80 percent of the stock 
of corporation X, and United States shareholders B and C, parent and 
child, own the other 20 percent in equal shares. For purposes of 
applying this paragraph to all three United States shareholders (A, B, 
and C), X is deemed to pay taxes in respect of Y.

    (3) Obligation defined. For purposes of this section, the term 
``obligation'' means any bond, note, debenture, certificate, or other 
evidence of indebtedness, and a debt recorded in the books of account of 
both the creditor and the debtor. In the absence of legal, governmental, 
or business reasons to the contrary, the indebtedness must bear interest 
or be issued at a discount.
    (4) Dividends. (i) For purposes of this paragraph and Sec. 1.954-
1(b)(2), the portion of a dividend which is attributable to foreign base 
company shipping income is that amount which bears the same ratio to the 
total dividend received as the earnings and profits out of which such 
dividend is paid that are attributable to foreign base company shipping 
income bears to the total earnings and profits out of which such 
dividend is paid. For purposes of this subdivision, the source of the 
earnings and profits out of which a distribution is made shall be 
determined under section 316(a), except that the source of the earnings 
and profits out of which a distribution is made by a controlled foreign 
corporation with respect to stock owned (within the meaning of section 
958(a)) by a United States shareholder of such controlled foreign 
corporation shall be determined under Sec. 1.959-3.
    (ii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. Domestic corporation M owns 100 percent of the one class 
of stock of controlled foreign corporation X, which in turn owns 40 
percent of the one class of stock of foreign corporation Y. Y, which is 
not (and has not been) either a controlled foreign corporation or a less 
developed country shipping company, makes a distribution of $100 to X. 
Under section 316(a), such distribution is made out of Y's earnings and 
profits for 1978.

[[Page 340]]

Sixty percent of Y's earnings and profits for 1978 are attributable to 
foreign base company shipping income. As a result, $60 of the $100 
distribution constitutes foreign base company shipping income to X under 
subdivision (i) of this subparagraph.
    Example 2. The facts are the same as in example 1, except that under 
section 316(a) $20 of the $100 dividend is paid out of Y's earnings and 
profits for 1979, and the other $80 is paid out of Y's earnings and 
profits for 1978. Thirty percent of Y's earnings and profits for 1979 
are attributable to foreign base company shipping income. Since 60 
percent of Y's earnings and profits for 1978 are also attributable to 
foreign base company shipping income, $54, i.e. (.60 x $80) + (.30 x 
$20), of the $100 distribution constitutes foreign base company shipping 
income to X under subdivision (i) of this subparagraph.
    Example 3. The facts are the same as in example 1 except that under 
section 316(a) the $100 dividend is made out of Y's earnings and profits 
for 1972. Since under paragraph (a)(2)(ii) of this section foreign base 
company shipping income does not include amounts earned by a foreign 
corporation (not a less developed country shipping company) in a taxable 
year beginning before January 1, 1978, no amount of such $100 
distribution constitutes foreign base company shipping income to X under 
subdivision (i) of this subparagraph.
    Example 4. Domestic corporation N owns 100 percent of the one class 
of stock of controlled foreign corporation S, which in turn owns 100 
percent of the one class of stock of controlled foreign corporation T. T 
makes a distribution of $100 to S, of which $80 is allocable under Sec. 
1.959-3 to earnings and profits for 1977 which are described in Sec. 
1.959-3(b)(2), and $20 is allocable to earnings and profits for 1978 
which are described in Sec. 1.959-3(b)(3). The $80 amount is excluded 
from S's gross income under section 959(b) and therefore is not included 
in S's foreign base company shipping income. One hundred percent of T's 
earnings and profits for 1978 described in Sec. 1.959-3(b)(3) were 
attributable to reinvested foreign base company shipping income. As a 
result, the entire $20 amount is included in S's foreign base company 
shipping income under this paragraph. See Sec. 1.954-1(b)(2) for the 
rule that such $20 amount may be excluded from the foreign base company 
income of S.

    (5) Interest and gain. (i) Except as provided in subdivisions (ii) 
and (iii) of this subparagraph, the portion of any interest paid by a 
foreign corporation, or gain recognized from the sale, exchange, or 
other disposition of stock or obligations of a foreign corporation, 
which is attributable to the foreign base company shipping income of 
such foreign corporation is that amount which bears the same ratio to 
such interest or gain as the foreign base company shipping income of 
such corporation for the period described in subparagraph (6) of this 
paragraph bears to its gross income for such period.
    (ii) Interest which is paid by a controlled foreign corporation is 
attributable to such corporation's foreign base company shipping income 
to the same extent that such interest is allocable (under the principles 
of Sec. 1.954-1(c)) to its foreign base company shipping income.
    (iii) If interest is paid by a foreign corporation, or if stock 
obligations of a foreign corporation are sold, exchanged, or otherwise 
disposed of, during a taxable year of such foreign corporation beginning 
before January 1, 1976, then no portion of such interest or gain is 
attributable to foreign base company shipping income.
    (iv) Solely for purposes of subdivision (i) of this subparagraph, if 
a controlled foreign corporation (the ``first corporation'') owns more 
than 10 percent of the stock of another controlled foreign corporation 
(the ``second corporation''), then
    (A) The gross income of the first corporation for any taxable year 
shall be--
    (1) Increased by its pro rata share of the gross income of the 
second corporation for the taxable year which ends with or within such 
taxable year of the first corporation, and
    (2) Decreased by the amount of any dividends received from the 
second corporation; and
    (B) The foreign base company shipping income of the first 
corporation for any taxable year shall be--
    (1) Increased by its pro rata share of the foreign base company 
shipping income of the second corporation for the taxable year which 
ends with or within such taxable year of the first corporation, and
    (2) Decreased by the amount of any dividends received from the 
second corporation which constitute foreign base company income.
    (v) Solely for purposes of applying subdivision (i) of this 
subparagraph, the district director shall make such other adjustments to 
the gross income and the foreign base company shipping

[[Page 341]]

income of any foreign corporation as are necessary to properly determine 
the extent to which any interest or gain is attributable to foreign base 
company shipping income, including proper adjustments to reflect any 
transaction during the test period described in subparagraph (6) of this 
paragraph to which section 332, 351, 354, 355, 356, or 361 applies.
    (6) Test period. (i) Except as provided in subdivisions (ii) and 
(iii) of this subparagraph the period described in this subparagraph 
with respect to any foreign corporation is the 3-year period ending with 
the close of such corporation's taxable year preceding the year during 
which interest was paid or stock or obligations were sold, exchanged, or 
otherwise disposed of, or such part of such period as such corporation 
was in existence.
    (ii) The period described in this paragraph shall not include any 
part of a taxable year beginning before January 1, 1976.
    (iii) If interest is paid by a foreign corporation, or if stock or 
obligations of a foreign corporation are sold, exchanged, or otherwise 
disposed of during its first taxable year, then the period described in 
this paragraph shall be such first taxable year.
    (iv) For purposes of subdivision (iii) of this subparagraph, the 
first taxable year of a foreign corporation is the later of--
    (A) The first taxable year of its existence, or
    (B) Its first taxable year beginning after December 31, 1975.
    (g) Income from partnerships, trusts, etc--(1) In general. The 
foreign base company shipping income of any foreign corporation 
includes--
    (i) Its distributive share of the gross income of any partnership, 
and
    (ii) Any amounts includible in its gross income under section 
652(a), 662(a), 671, or 691(a),


to the extent that such items would have been includible in its foreign 
base company shipping income had they been realized by it directly.
    (2) Illustrations. The application of subparagraph (1) of this 
paragraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporations X and Y are equal 
partners in partnership P. The taxable years end on December 31 for X, 
June 30 for Y, and March 31 for P. In the fiscal year ending March 31, 
1976, P's sole business activity is the use of a vessel in foreign 
commerce. P derives gross income of $200 from the use of the vessel, and 
incurs expenses, taxes, and other deductions of $160. Assume X's 
distributive share of such

$200 of P's gross income is $100, all of which is includible in X's 
gross income. If X had realized its distributive share of $100 directly, 
then the amount which would have been includible in X's foreign base 
company shipping income under this paragraph is the portion allocable to 
the months of January, February, and March of 1976. Such amount, $25 
(i.e., \1/2\ x $200 x 3 months/12 months), is included in X's foreign 
base company shipping income for its taxable year ending December 31, 
1976. Similarly, X is entitled under this paragraph to a deduction from 
foreign base company shipping income of $20 (i.e., \1/2\ x $160 x 3 
months/12 months). Since foreign base company shipping income does not 
include amounts earned by a foreign corporation (not a less developed 
country shipping corporation) in a taxable year beginning before January 
1, 1976, Y has no foreign base company shipping income (under this 
paragraph or otherwise) for its taxable year beginning on July 1, 1975.
    Example 2. The facts are the same as in example 1, except that P 
incurs expenses, taxes, and deductions of $240 in its taxable year 
ending on March 31, 1976. Accordingly, $25 is includible in X's foreign 
base company shipping income, and the amount deductible therefrom under 
this paragraph is $30 (i.e., \1/2\ x $240 x 3 months/12 months).

    (3) Other income. Except as expressly provided in subparagraph (1) 
of this paragraph, foreign base company shipping income does not include 
any amount includible in the gross income of a controlled foreign 
corporation under part I of subchapter J (section 641 and following, 
relating to estates, trusts, and beneficiaries), and gains from the sale 
or other disposition of any interest in an estate or trust.
    (h) Additional rules--(1) Gross income. For purposes of this section 
and Sec. 1.955A-2, the gross income of a foreign corporation (whether 
or not a controlled foreign corporation) shall be determined in 
accordance with the provisions of section 952 and Sec. 1.952-2. Thus, 
for example, section 883 (relating to exclusions from gross income of 
foreign corporations) is inapplicable under Sec. 1.952-2 (a)(1) and 
(c)(1). In addition,

[[Page 342]]

the gross income of a controlled foreign corporation shall be 
determined, with respect to a United States shareholder of such 
controlled foreign corporation, by excluding distributions received by 
such corporation which are excluded from gross income under section 
959(b) with respect to such shareholder.
    (2) Earnings and profits. For purposes of this section, the earnings 
and profits of a foreign corporation (whether or not a controlled 
foreign corporation) shall be determined in accordance with the 
provisions of section 964 and the regulations thereunder.
    (3) No double counting. No item of gross income shall be counted as 
foreign base company shipping income under more than one provision of 
this section. For example, If $200 of gross income derived from the use 
of a lighter is treated as foreign base company shipping income under 
both paragraphs (b)(1)(i) and (ii) of this section, then such $200 is 
counted only once as foreign base company shipping income. A taxpayer 
may choose under which provision to include an item of income.
    (4) Losses. (i) Generally, if a controlled foreign corporation has 
losses which are properly allocable to foreign base company shipping 
income, the extent to which such losses are deductible from such income 
shall be determined by treating such foreign corporation as a domestic 
corporation and applying the principles of section 63. See Sec. Sec. 
1.954-1(c) and 1.952-2(b). Thus for example, losses from sales or 
exchanges of capital assets are allowable only to the extent of gains 
from such sales or exchanges.
    (ii) If gain from the sale, exchange, or other disposition of any 
stock or obligation would be treated (to any extent) as foreign base 
company shipping income, then loss from such sale, exchange, or other 
disposition is properly allocable to foreign base company shipping 
income (to the same extent).
    (iii) In determining the extent to which any loss on the disposition 
of a qualified investment in foreign base company shipping operations is 
deductible from foreign base company shipping income, it is immaterial 
that such loss is taken into account under Sec. 1.955A-1(b)(1)(ii) as a 
reduction in the amount of the decrease in (withdrawal from) qualified 
investments in foreign base company shipping operations.
    (5) Hypothetical charges. Under paragraph (d)(5)(i) of this section 
and Sec. 1.955A-2(a)(4)(ii)(A), gross income may be deemed to include 
hypothetical arm's length charges for services performed by a controlled 
foreign corporation for itself. Under paragraph (d)(2) of this section, 
certain of these hypothetical charges may be treated as foreign based 
company shipping income. Such hypothetical charges are deemed to be 
income solely for purposes of applying the ``extent of use'' tests 
prescribed by paragraph (d)(4) of this section and Sec. 1.955A-2(a)(4). 
Charges for services performed by a controlled foreign corporation for 
itself shall in no event be included in income for any other purposes.

[T.D. 7894, 48 FR 22523, May 19, 1983]



Sec. 1.954-7  Increase in qualified investments in foreign base 
company shipping operations.

    (a) Determination of investments at close of taxable year--(1) In 
general. Under section 954(g), the increase in qualified investments in 
foreign base company shipping operations, for purposes of section 
954(b)(2) and paragraph (b)(1) of Sec. 1.954-1, of any controlled 
foreign corporation for any taxable year is, except as provided in 
paragraph (b) of this section, the amount by which--
    (i) The controlled foreign corporation's qualified investments in 
foreign base company shipping operations at the close of the taxable 
year, exceed
    (ii) Its qualified investments in foreign base company shipping 
operations at the close of the preceding taxable year.
    (2) Preceding taxable year. For purposes of this section, a taxable 
year which begins before January 1, 1976, may be a preceding taxable 
year.
    (3) Cross-reference. See section 955 (b) and Sec. 1.955A-2 for the 
definition of the term ``qualified investments in foreign base company 
shipping operations''.
    (b) Election to determine investments at close of following taxable 
year--(1) General rule. In lieu of determining an increase in qualified 
investments in foreign base company shipping operations

[[Page 343]]

for a taxable year in the manner provided in paragraph (a) of this 
section, a United States shareholder of a controlled foreign corporation 
may make an election under section 955(b)(3) to determine the increase 
for the corporation's taxable year by ascertaining the amount by which--
    (i) Such corporation's qualified investments in foreign base company 
shipping operations at the close of the taxable year immediately 
following such taxable year, exceed
    (ii) Its qualified investments in foreign base company shipping 
operations at the close of the taxable year immediately preceding such 
following taxable year.
    (2) Election with respect to first taxable year. Notwithstanding 
subparagraph (1) of this paragraph, if an election is made without 
consent by a United States shareholder under Sec. 1.955A-4 (b)(1) with 
respect to a controlled foreign corporation, the increase in such 
controlled foreign corporation's qualified investments in foreign base 
company shipping operations for the first taxable year to which such 
election applies shall be the amount by which--
    (i) Such corporation's qualified investments in foreign base company 
shipping operations at the close of the taxable year immediately 
following such first taxable year, exceed
    (ii) Its qualified investments in foreign base company shipping 
operations at the close of the taxable year immediately preceding such 
first taxable year.
    (3) Manner of making election. For the manner of making an election 
under section 955(b)(3), and for rules pertaining to the revocation of 
such an election, see Sec. 1.955A-4.
    (4) Coordination with prior law. If a United States shareholder 
makes an election without consent under Sec. 1.955A-4(b)(1) with 
respect to a controlled foreign corporation, then such corporation's 
increase in qualified investments in foreign base company shipping 
operations for the first taxable year to which such election applies 
shall be determined by disregarding any change which occurs during such 
taxable year in the amount of such corporation's investments in stock or 
obligations of a less developed country shipping company described in 
Sec. 1.955-5 (b) if both of the following conditions exist:
    (i) Such taxable year is the first taxable year of such corporation 
which begins after December 31, 1975, and
    (ii) Such United States shareholder has elected to determine the 
change in such corporation's qualified investments in less developed 
countries for its last taxable year beginning before January 1, 1976, 
under Sec. 1.954-5(b) or Sec. 1.955-3.
    (5) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) Controlled foreign corporation X is a wholly owned 
subsidiary of domestic corporation M. X uses the calendar year as the 
taxable year. The amounts of X's qualified investments in foreign base 
company shipping operations at the close of 1975 through 1979 are as 
follows:

Qualified investments at December 31, 1975.................      $16,000
Qualified investments at December 31, 1976.................       17,000
Qualified investments at December 31, 1977.................       23,000
Qualified investments at December 31, 1978.................       28,000
Qualified investments at December 31, 1979.................       30,000
 

    (b) Assume that M properly files without consent a timely election 
under Sec. 1.955A-4(b)(1) to determine X's increase for 1976 in 
qualified investments in foreign base company shipping operations 
pursuant to this paragraph, and that the election remains in force 
through 1978. Then X's increases for 1976 through 1978 in qualified 
investments in foreign base company shipping operations are as follows:

Increase for 1976 ($23,000 minus $16,000).....................    $7,000
Increase for 1977 ($28,000 minus $23,000).....................     5,000
Increase for 1978 ($30,000 minus $28,000).....................     2,000
 

    Example 2. Assume the same facts as in example 1, except that M 
never files an election under Sec. 1.955A-4(b)(1). X's increases for 
1976 through 1978 in qualified investments in foreign base company 
shipping operations are as follows:

Increase for 1976 ($17,000 minus $16,000).....................    $1,000
Increase for 1977 ($23,000 minus $17,000).....................     6,000
Increase for 1978 ($28,000 minus $23,000).....................     5,000
 

    Example 3. The facts are the same as in example 1, except that X's 
qualified investments in foreign base company shipping operations 
include an investment in less developed country shipping companies 
described in Sec. 1.955-5(b) of $500 on December 31, 1975, and $750 on 
December 31, 1976. Assume further that M has made an election under 
section 955(b)(3) (as in effect before the enactment of the Tax 
Reduction Act of 1975) with respect to X's taxable year 1975. Then X's 
increase in qualified investments in foreign

[[Page 344]]

base company shipping operations for 1976 is $6,750 (i.e., $7,000-$250).

    (c) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) Controlled foreign corporation X uses the calendar year 
as the taxable year. On December 31, 1975, X's qualified investments in 
foreign base company shipping operations (determined as provided in 
Sec. 1.955A-2(g)) consist of the following amounts:

Cash.........................................................     $6,000
Readily marketable securities................................      1,000
Stock of related controlled foreign corporations.............      4,000
Traffic and other receivables................................     14,000
Marine insurance claims receivables..........................      1,000
Foreign income tax refunds receivable........................      1,000
Prepaid shipping expenses and shipping inventories ashore....      1,000
Vessel construction funds....................................          0
Vessels......................................................    123,000
Vessel plans and construction in progress....................      3,000
Containers and chassis.......................................          0
Terminal property and equipment..............................      2,000
Shipping office (land and building)..........................      1,000
Vessel spare parts ashore....................................      1,000
Performance deposits.........................................      2,000
Deferred charges.............................................      2,000
Stock of less developed country shipping company described in     10,000
 Sec. 1-955-5(b)...........................................
                                                              ----------
                                                                 172,000
                                                              ==========
 

    (b) On December 31, 1976, X's qualified investments in foreign base 
company shipping operations (determined as provided in Sec. 1.955A-
2(g)) consists of the following amounts:

Cash.........................................................     $5,000
Readily marketable securities................................      2,000
Stock of related controlled foreign corporations.............      4,000
Traffic and other receivables................................     16,000
Foreign income tax refunds receivable........................      3,000
Prepaid shipping expenses and shipping inventories ashore....      2,000
Vessel construction funds....................................      1,000
Vessels......................................................    117,000
Vessel plans and construction in progress....................     12,000
Containers and chassis.......................................      4,000
Terminal property and equipment..............................      2,000
Shipping office (land and building)..........................      1,000
Vessel spare parts ashore....................................      1,000
Performance deposits.........................................      2,000
Deferred charges.............................................      2,000
Stock of less developed country shipping company described in          0
 Sec. 1.955-5(b)...........................................
                                                              ----------
                                                                 174,000
                                                              ==========
 

    (c) For 1976, X's increase in qualified investments in foreign base 
company shipping operations is $2,000, which amount is determined as 
follows:

Qualified investments at Dec. 31, 1976.......................   $174,000
Qualified investments at Dec. 31, 1975.......................    172,000
                                                              ----------
    Increase for 1976........................................      2,000
 


[T.D. 7894, 48 FR 22528, May 19, 1983]



Sec. 1.954-8  Foreign base company oil related income.

    (a) Foreign base company oil related income--(1) In general. Under 
section 954(g), the foreign base company oil related income of a 
controlled foreign corporation (except as provided under paragraph (b) 
of this section) consists of the items of foreign oil related income 
(``FORI'') described in section 907(c)(2) and (3), other than such 
income derived from a source within a foreign country in connection 
with--
    (i) Oil or gas which was extracted from an oil or gas well located 
in that foreign country (``extraction exception''), or
    (ii) Oil, gas, or a primary product of oil or gas which is sold by 
the controlled foreign corporation or a related person for use or 
consumption within that country or is loaded in that country on a vessel 
or aircraft as fuel for the vessel or aircraft (``use or consumption 
exception'').


A taxpayer claiming the use or consumption exception must establish its 
applicability on the basis of facts and circumstances. For special rules 
for applying the extraction exception, see paragraph (c) of this 
section.
    (2) Source of income. The source of foreign base company oil related 
income is determined generally under the principles of Sec. Sec. 1.861-
1 to 1.863-5. See Sec. 1.863-6. Thus, income from the performance of a 
service generally is sourced in the country where the service is 
performed. See Sec. 1.861-4. Underwriting income from insuring a 
foreign oil related activity is sourced at the location of the risk. See 
section 861(a)(7) and Sec. 1.953-2.
    (3) Primary product. The term ``primary product'' of oil or gas has 
the meaning given this term by Sec. 1.907(c)-1(d)(5) and (6).
    (4) Vessel. For the definition of the term ``vessel'', see Sec. 
1.954-6(b)(3)(ii).
    (5) Foreign country. For purposes of this section, the term 
``foreign country'' has the same meaning as in section 638 (relating to 
continental shelf areas). Thus, for example, oil or gas extracted from a 
sea area will be deemed to be extracted in the country which has 
exclusive rights of exploitation of natural resources with respect to 
that

[[Page 345]]

area if the other conditions of section 638 are met.
    (6) Country of use or consumption. For rules for determining the 
country of use or consumption, see Sec. 1.954-3(a)(3)(ii).
    (7) Insurance income. For purposes of this section, income derived 
from or attributable to insurance of section 907(c)(2) activities means 
taxable income as defined in section 832(a) and as modified by the 
principles of Sec. 1.953-4 (other than as the section is applied to 
life insurance).
    (8) Fuel product. For purposes of this section, the term ``fuel 
product'' means oil, gas or a primary product of oil or gas.
    (9) Effective date. The provisions of section 954(g) and this 
section are applicable to taxable years of foreign corporations 
beginning on or after January 1, 1983, and to taxable years of United 
States shareholders in which or with which those taxable years of 
foreign corporations end.
    (b) Exemption for small oil producers--(1) In general. Foreign base 
company oil related income does not include any income of a foreign 
corporation which is not a large oil producer.
    (2) Large oil producer. A corporation is a large oil producer 
(within the meaning of section 954(g)(2)) if the average daily 
production (extraction) of foreign crude oil and natural gas by the 
related group which includes the corporation and related persons (within 
the meaning of section 954(d)(3)) for the taxable year or immediately 
preceding taxable year is 1,000 or more barrels. The average daily 
production of foreign crude oil or natural gas for any taxable year (and 
the conversion of cubic feet of natural gas into barrels) is determined 
under rules similar to the rules of section 613A, except that only crude 
oil or natural gas from a well located outside the United States is 
taken into account.
    (c) Special rules for applying the extraction exception of paragraph 
(a)(1)(i) of this section--(1) Refining income described in section 
907(c)(2)(A). With regard to a controlled foreign corporation's refining 
income from the processing of minerals extracted (by the taxpayer or by 
any other person) from oil or gas wells into their primary products, as 
described in section 907(c)(2)(A), a pro rata method will be applied for 
purposes of determining the part of the refining income that qualifies 
for the extraction exception of paragraph (a)(1)(i) of this section. The 
pro rata method will be based on the proportion that the barrels of the 
fuel product extracted in the country of processing bears to the total 
barrels of the fuel product processed in that country and will apply 
regardless of the country of sale of the primary product.
    (2) Marketing income described in section 907(c)(2)(C). With regard 
to a controlled foreign corporation's marketing income from the 
distribution or sale of minerals extracted from oil or gas wells or of 
primary products, as described in section 907(c)(2)(C), a pro rata 
method will be applied for purposes of determining the part of the 
marketing income that qualifies for the extraction exception of 
paragraph (a)(1)(i) of this section. When applying the pro rata method 
to the sale of a fuel product other than a primary product, the pro rata 
method will be based on the proportion that the barrels of the fuel 
product extracted in the country of sale bears to the total barrels of 
the fuel product sold in that country. When applying the pro rata method 
to the sale of primary products, the method will be based on the 
proportion that the barrels of the fuel product extracted in the country 
of sale bears to the total barrels of the fuel product processed. For 
purposes of applying the pro rata method, data of the controlled foreign 
corporation's related group (as defined in section 954(g)(2)(C)) will be 
taken into account. The pro rata method will not apply, however, if the 
mineral or primary product is purchased by the controlled foreign 
corporation from a person not within the controlled foreign 
corporation's related group. In that situation, the marketing income 
will be presumed to qualify for the extraction exception if the country 
of the source of the marketing income is a net exporter of crude oil or 
gas, whichever is relevant. If the country of the source of the 
marketing income is not a net exporter of crude oil or gas, whichever is 
relevant, the marketing income will be

[[Page 346]]

presumed not to qualify for the extraction exception. The controlled 
foreign corporation may, however, rebut this latter presumption by 
demonstrating on the basis of all the facts and circumstances that its 
marketing income does qualify for the extraction exception. If a primary 
product that is acquired from a person within the controlled foreign 
corporation's related group is commingled with like products acquired 
from persons not within that related group, the pro rata method based on 
the proportion that the barrels of the fuel product extracted in the 
country of sale bears to the total barrels of the fuel product processed 
will be applied to that portion of the total products sold that was 
purchased from persons within the related group, to the extent that that 
person did not sell product purchased from an unrelated person, and 
either the presumption or facts and circumstances will determine the 
characterization of the remainder.
    (3) Transportation income described in section 907(c)(2)(B). With 
regard to a controlled foreign corporation's income from the 
transportation of minerals from oil and gas wells or of primary 
products, as described in section 907(c)(2)(B), the rules set forth in 
paragraph (c)(2) of this section will apply for purposes of determining 
the part of the transportation income that qualifies for the extraction 
exception of paragraph (a)(1)(i) of this section.
    (4) Illustrations. The following examples illustrate the application 
of this paragraph.

    Example 1. Controlled foreign corporation M has a refinery in 
foreign country A that refines 250x barrels of oil during its taxable 
year beginning in 1984. It is determined that 125x barrels of its 250x 
barrels were extracted in country A. M sold 150x barrels of its 250x 
barrels in country A for consumption in country A which resulted in 
$225x of income from refining and $225x of marketing income, as 
described in section 907(c)(2)(C). M also sold within foreign country B, 
for consumption in country B, 100x barrels of its 250x barrels which 
resulted in an additional $150x of income from refining for M and $170x 
of marketing income for M. The 100x barrels sold by M within country B, 
a contiguous country, were transported from M's refinery in country A to 
country B by a pipeline which is owned by M, and M recognized a total of 
$10x of income from the transportation of the 100x barrels. Of this 
$10x, $8x was recognized in country A and $2x was recognized in country 
B. Under the source of income rules of paragraph (a)(2) of this section, 
income from refining is considered derived from the country in which the 
refining occurs and not from the country where the sale of the refined 
product occurs.
    (i) M's refining income. M has $75x of foreign base company oil 
related income with respect to its refining of the 250x barrels, 
determined as follows:
(A) Total amount of income from refining attributable to oil refined in 
country A by M.....................................................$375x
(B) Amount of income from refining with respect to oil sold for 
consumption ($225x) in country A (use or consumption exception under 
paragraph (a)(1)(ii) of this section..............................(225x)
(C) Pro rate amount of income from refining attributable to sales in 
country B considered extracted from country A ($150x times 125x barrels/
250x barrels) (extraction exception under paragraph (a)(1)(i) of this 
section..........................................................(75x)..
(D) Foreign base company oil related income.......................$75x..
    (ii) M's marketing income. M does not have foreign base company oil 
related income with respect to its sale of the 100x barrels in country B 
and 150x barrels in country A because the $170x and $225x, respectively, 
of marketing income was derived from the country in which the oil was 
sold for consumption (an exception under paragraph (a)(1)(ii) of this 
section).
    (iii) M's transportation income. M does not have foreign base 
company oil related income with respect to its $2x of pipeline 
transportation income recognized in country B because the income was 
derived from the country in which the 100x barrels were sold for 
consumption, an exception under paragraph (a)(1)(ii) of this section. 
With regard to the $8x of pipeline transportation income recognized in 
country A, however, M has $4x of foreign base company oil related income 
since of the total barrels refined in country A (250x) only one-half 
were extracted in that country. Therefore, only one-half of the 
transportation income qualifies for the extraction exception of 
paragraph (a)(1)(i) of this section.
    (iv) M's extraction income. M does not have foreign base company oil 
related income for its extraction activity because extraction income is 
excluded in all events. See section 954(g)(1)(A).
    Example 2. Assume the same facts as in Example 1 except that M sold 
all of the 250x barrels of refined oil in country A. In addition, assume 
that country A is a net exporter of crude oil. As in Example 1, M sold 
150x barrels for consumption in country A with the same

[[Page 347]]

resulting income. M sold in country A the remaining 100x barrels to 
unrelated controlled foreign corporation N which resulted in an 
additional $150x of income from refining for M and $170x of marketing 
income for M. N immediately resold in country A for export those 100x 
barrels. N did not commingle the 100x barrels with any other refined 
oil. N earned $10x of marketing income on that sale.
    (i) M's refining income. M has $75x foreign base company oil related 
income with respect to its refining of the 250x barrels determined as 
follows:
(A) Total amount of income from refining attributable to oil refined in 
country A by M.....................................................$375x
(B) Amount of income from refining with respect to oil sold for 
consumption ($225x) in country A (use or consumption exception under 
paragraph (a)(1)(ii) of this section).............................(225x)
(C) Pro rata amount of income from refining attributable to sales in 
country A (for consumption outside of country A) considered extracted 
from country A ($150x times 125x barrels/250x barrels) (extraction 
exception under paragraph (a)(1)(i) of this section).............(75x)..
(D) Foreign base company oil related income.......................$75x..
    (ii) M's marketing income. M does not have foreign base company oil 
related income with respect to its marketing income from the sale of the 
150x barrels in country A because the $225x of marketing income was 
derived from the country in which the oil was sold for consumption (an 
exception under paragraph (a)(1)(ii) of this section). M has $85x of 
foreign base company oil related income with respect to its marketing 
income from sale to N of the 100x barrels, determined as follows:
(A) Total amount of marketing income from the sale.................$170x
(B) Pro rata amount of marketing income attributable to oil product 
considered extracted in country A ($170x times 125x barrels/250x 
barrels) (extraction exception under paragraph (a)(1)(i) of this 
section).........................................................(85x)..
(C) Foreign base company oil related income.......................$85x..
    (iii) N's marketing income. N is not related to M. Therefore, since 
N sold the 100x barrels in country A, a net exporter of crude oil, and 
since N did not commingle the 100x barrels with other refined products, 
it is presumed that all of the 100x barrels were extracted in country A. 
Accordingly, all of N's $10x of marketing income is excepted under 
paragraph (a)(1)(i) of this section.
    Example 3. Assume the same facts as in Example 2 except that N is 
related to M. Characterization of M's income remains the same as in 
Example 2. N will have, however, $5x of foreign base company oil related 
income with regard to its marketing income, determined as follows:
(i) Total amount of marketing income from the sale..................$10x
(ii) Pro rata amount of marketing income considered extracted from 
country A ($10x times 125x barrels/250x barrels) (extraction exception 
under paragraph (a)(1)(i) of this section)..........................5x..
(iii) Foreign base company oil related income......................$5x..
    Example 4. Assume that controlled foreign corporation M has a 
refinery in foreign country A that refines 200x barrels of oil during 
its taxable year beginning in 1984. It is determined that 100x barrels 
of that oil were extracted in country A and that the other 100x barrels 
were extracted in country B. Neither country A nor country B is a net 
exporter of crude oil. In addition, M purchased from an unrelated 
country A refiner 100x barrels of already refined oil. M does not know 
where this oil was extracted. These 100x barrels of purchased refined 
oil were commingled with the 200x barrels of refined oil from M's 
refinery. M sold 225x barrels of refined oil in country A for 
consumption in country A which resulted in $250x of income from refining 
and $225x of marketing income. M sold within foreign country B for 
consumption outside of country B 75x barrels of refined oil which 
resulted in $100x of income from refining and $75x of marketing income. 
The refined product was transported between country A and country B by 
an unrelated person.
    (i) M's refining income. With regard to the sales in country A, M 
has $50x of foreign base company oil related income with respect to its 
refining of the 100x barrels, determined as follows:
(A) Total amount of income from refining attributable to oil refined in 
country A by M.....................................................$350x
(B) Amount of income from refining with respect to oil sold for 
consumption in country A ($250x) (use or consumption exception under 
paragraph (a)(1)(ii) of this section).............................(250x)
(C) Pro rata amount of income from refining attributable to sales in 
country B considered extracted from country A ($100x times 100x barrels/
200x barrels) (extraction exception under paragraph (a)(1)(i) of this 
section).........................................................(50x)..
(D) Foreign base company oil related income.......................$50x..
    (ii) M's marketing income. Since the barrels from M's refinery and 
those that M purchased were commingled, a portion, as follows, of the 
marketing income is deemed to

[[Page 348]]

derive from both purchased and refined products. Since M refined 200x 
barrels and purchased 100x barrels, its marketing income of $225x from 
the sale of the 225x barrels in country A for consumption in country A 
will be deemed to consist of $150x (200x/300x x $225x) from the sale of 
products refined by M and $75x (100x/300x x $225x) from the sale of 
purchased products. Likewise, its marketing income of $75x from the sale 
of the 75x barrels in country B for consumption outside of country B 
will be deemed to consist of $50x (200x/300x x $75x) from the sale of 
products refined by M and $25x (100x/300x x $75x) from the sale of 
purchased products.
    (A) Purchased products. M is considered as having $75x of marketing 
income from the sale of purchased products in country A for consumption 
in country A. None of this marketing income is foreign base company oil 
related income since the marketing income is earned in country A, the 
country of consumption. See paragraph (a)(1)(ii) of this section. All of 
the $25x of M's marketing income from the sale of purchased products in 
country B will be foreign base company oil related income. The exception 
at paragraph (a)(1)(ii) of this section does not apply since the refined 
oil is not sold for use or consumption in country B. Likewise, the 
extraction exception under paragraph (a)(1)(i) of this section does not 
apply. The purchased product cannot be presumed to be extracted in 
country B since country B is not a net exporter of crude oil. In 
addition, M cannot show, on a facts and circumstances basis, that 
purchased products were refined from crude oil extracted in country B.
    (B) Products refined by M. With regard to M's marketing income 
attributable to the sale of products refined by M, M does not have any 
foreign base company oil related income with regard to its $150x of 
marketing income in country A since that income was derived from the 
country in which the oil was sold for consumption (the use or 
consumption exception under paragraph (a)(1)(ii) of this section). M has 
$25x of foreign base company oil related income with regard to its $50x 
of marketing income in country B determined as follows:
(1) Total amount of income from marketing attributable to oil refined by 
M and sold in country B.............................................$50x
(2) Pro rata amount of income from marketing attributable to sales in 
country B considered extracted from country B ($50x times 100x barrels/
200x barrels) (extraction exception under paragraph (a)(1)(i) of this 
section).........................................................(25x)..
(3) Foreign base company oil related income.......................$25x..

[T.D. 8331, 56 FR 2847, Jan. 25, 1991; 56 FR 11511, Mar. 19, 1991]



Sec. 1.954(c)(6)-1  Certain cases in which section 954(c)(6)
exception not available.

    (a) Cross-references to other rules. For a non-exclusive list of 
rules that in certain cases limit the applicability of the exception to 
foreign personal holding company income under section 954(c)(6), see--
    (1) Section 1.245A-5(d) (rules regarding the application of section 
954(c)(6) to extraordinary disposition amounts);
    (2) Section 1.245A-5(f) (rules regarding the application of section 
954(c)(6) to tiered extraordinary reduction amounts);
    (3) Section 1.245A(e)-1(c) (rules regarding tiered hybrid 
dividends);
    (4) Section 1.367(b)-4(e)(4) (rules regarding income inclusion and 
gain recognition in certain exchanges following an inversion 
transaction);
    (5) Section 964(e)(4)(A) (rules regarding certain gain from the sale 
or exchange of stock that is recharacterized as a dividend); and
    (6) Section 1.7701(l)-4(e) (rules regarding recharacterization of 
certain transactions following an inversion transaction).
    (b) Applicability date. This section applies as of August 27, 2020.

[T.D. 9909, 85 FR 53097, Aug. 27, 2020]



Sec. 1.955-0  Effective dates.

    (a) Section 955 as in effect before the enactment of the Tax 
Reduction Act of 1975--(1) In general. In general, Sec. Sec. 1.955-1 
through 1.955-6 are applicable with respect to withdrawals of previously 
excluded subpart F income from qualified investment in less developed 
countries for taxable years of foreign corporations beginning after 
December 31, 1962, and to taxable years of United States shareholders 
(as defined in section 951(b)) within which or with which such taxable 
years of such foreign corporations end. However, such sections are 
effective with respect to withdrawals of amounts invested in less 
developed country shipping companies described in section 955(c)(2) (as 
in effect before the enactment of the Tax Reduction Act of 1975) only 
for taxable years of foreign corporations beginning before January 1, 
1976, and for taxable years

[[Page 349]]

of United States shareholders (as defined in section 951(b)) within 
which or with which such taxable years of such foreign corporations end. 
For rules applicable to withdrawals of amounts invested in less 
developed country shipping companies described in section 955(c)(2) (as 
in effect before such enactment), in taxable years of foreign 
corporations beginning after December 31, 1975, see section 955(b)(5) 
(as amended by such Act) and Sec. Sec. 1.955A-1 through 1.955A-4.
    (2) References. Except as otherwise provided therein, all references 
contained in Sec. Sec. 1.955-1 through 1.955-6 to section 954 or 955 or 
to the regulations under section 954 are to those sections and 
regulations as in effect before the enactment of the Tax Reduction Act 
of 1975. For regulations under section 954 (as in effect before such 
enactment), see 26 CFR Sec. 1.954-1 through 1.954-5 (Revised as of 
April 1, 1975). For taxable years of foreign corporations beginning 
after December 31, 1975, and for taxable years of United States 
shareholders (as described in section 951(b)) within which or with which 
such taxable years of such foreign corporations end, the definitions of 
less developed countries and less developed country corporations 
contained in section 902(d) (as amended by such Act) and Sec. 1.902-2 
apply for purposes of determining the credit for corporate stockholders 
in foreign corporations under section 902.
    (b) Section 955 as amended by the Tax Reduction Act of 1975. Except 
as otherwise provided therein, Sec. Sec. 1.955A-1 through 1.955A-4 are 
applicable to taxable years of foreign corporations beginning after 
December 31, 1975, and to taxable years of United States shareholders 
(as defined in section 951(b)) within which or with which such taxable 
years of such foreign corporations end.

[T.D. 7893, 48 FR 22508, May 19, 1983, as amended by T.D. 7894, 48 FR 
22529, May 19, 1983]



Sec. 1.955-1  Shareholder's pro rata share of amount of previously 
excluded subpart F income withdrawn from investment in less developed 
countries.

    (a) In general. Pursuant to section 951(a)(1)(A)(ii) and the 
regulations thereunder, a United States shareholder of a controlled 
foreign corporation must include in its gross income its pro rata share 
(as determined in accordance with paragraph (c) of this section) of the 
amount of such controlled foreign corporation's previously excluded 
subpart F income which is withdrawn for any taxable year from investment 
in less developed countries. Section 955 provides rules for determining 
the amount of a controlled foreign corporation's previously excluded 
subpart F income for any taxable year of the corporation beginning after 
December 31, 1962, that is withdrawn from investment in less developed 
countries for any taxable year of the corporation beginning before 
January 1, 1976. Except for investment in less developed country 
shipping companies, section 955 also provides rules for determining the 
amount of a controlled foreign corporation's previously excluded subpart 
F income for any taxable year of the corporation beginning after 
December 31, 1962, which is withdrawn from investment in less developed 
countries in taxable years of the corporation beginning after December 
31, 1975. To determine the amount of a controlled foreign corporation's 
previously excluded subpart F income withdrawn from investment in less 
developed country shipping companies described in section 955(c)(2) in 
taxable years of a controlled foreign corporation beginning after 
December 31, 1975, see section 955(b)(5) (as in effect after amendment 
by the Tax Reduction Act of 1975) and Sec. Sec. 1.955A-1 through 
1.955A-4. For effective dates, see Sec. 1.955-0.
    (b) Amount withdrawn by controlled foreign corporation--(1) In 
general. For purposes of sections 951 through 964, the amount of a 
controlled foreign corporation's previously excluded subpart F income 
which is withdrawn for any taxable year from investment in less 
developed countries is an amount equal to the decrease for such year in 
such corporation's qualified investments in less developed countries. 
Such decrease is, except as provided in Sec. 1.955-3--
    (i) An amount equal to the excess of the amount of its qualified 
investments in less developed countries at the close of the preceding 
taxable year over the amount of its qualified investments in

[[Page 350]]

less developed countries at the close of the taxable year, minus
    (ii) The amount (if any) by which recognized losses on sales or 
exchanges by such corporation during the taxable year of qualified 
investments in less developed countries exceed its recognized gains on 
sales or exchanges during such year of qualified investments in less 
developed countries,


but only to the extent that the net amount so determined does not exceed 
the limitation determined under subparagraph (2) of this paragraph. See 
Sec. 1.955-2 for determining the amount of qualified investments in 
less developed countries.
    (2) Limitations applicable in determining decreases--(i) General. 
The limitation referred to in subparagraph (1) of this paragraph for any 
taxable year of a controlled foreign corporation shall be the lesser of 
the following two limitations:
    (a) The sum of the controlled foreign corporation's earnings and 
profits (or deficit in earnings and profits) for the taxable year, 
computed as of the close of the taxable year without diminution by 
reason of any distributions made during the taxable year, plus the sum 
of its earnings and profits (or deficits in earnings and profits) 
accumulated for prior taxable years beginning after December 31, 1962, 
(including prior taxable years beginning after December 31, 1975) or,
    (b) The sum of the amounts excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 from the foreign base company income 
of such corporation for all prior taxable years, minus the sum of the 
amounts (determined under this paragraph) of its previously excluded 
subpart F income withdrawn from investment in less developed countries 
for all prior taxable years.
    (ii) Treatment of earnings and profits. For purposes of determining 
earnings and profits of a controlled foreign corporation under 
subdivision (i)(a) of this subparagraph, such earnings and profits shall 
be considered not to include any amounts which are attributable to--
    (a)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a)(1)(A)(i) or (iii), or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a) and have not been distributed; 
or
    (b)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) or would be so included under 
such section but for the fact that such amounts were distributed to such 
shareholder during the taxable year, or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subdivision apply only in determining the limitation 
on a controlled foreign corporation's decrease in qualified investments 
in less developed countries. See section 959 and the regulations 
thereunder for limitations on the exclusion from gross income of 
previously taxed earnings and profits.
    (3) Taxable years beginning after December 31, 1975. (i) In the case 
of a taxable year of a controlled foreign corporation beginning after 
December 31, 1975, Sec. 1.955-2(b)(5) must be applied in determining 
the amount of its qualified investments in less developed countries on 
both of the determination dates applicable to such taxable year.
    (ii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. (a) Controlled foreign corporation M uses the calendar 
year as the taxable year. Throughout 1974 through 1976, M owns 100 
percent of the only class of stock of foreign corporation N, a less 
developed country shipping company described in Sec. 1.955-5(b), and M 
owns no other stock or obligations. The amount taken into account under 
Sec. 1.955-2(d) with respect to the stock of N is $10,000 at the close 
of 1974, 1975, and 1976. The amount of M's previously excluded subpart F 
income which is withdrawn for 1975 (a year to which Sec. 1.955-2(b)(5) 
does not apply) from investment in less developed countries is zero, 
determined as follows:

(1) Qualified investments in less developed countries at the     $10,000
 close of 1974...............................................

[[Page 351]]

 
(2) Less: qualified investments in less developed countries       10,000
 at the close of 1975........................................
                                                              ----------
(3) Balance..................................................          0
                                                              ==========
 


(Further computations similar to those set out in lines (iv) through 
(ix) of example 1 of paragraph (d) of this section are unnecessary 
because the balance in line (3) of this example is zero.)
    (b) As a result of Sec. 1.955-2(b)(5)(ii), the amount of M's 
previously excluded subpart F income which is withdrawn for 1976 from 
investment in less developed countries is zero, determined as follows:

(1) Qualified investments in less developed countries at the close    $0
 of 1975...........................................................
(2) Less: qualified investments in less developed countries at the     0
 close of 1976.....................................................
                                                                    ----
(3) Balance........................................................    0
                                                                    ====
 

    Example 2. The facts are the same as in example 1, except that 
foreign corporation N is a less developed country corporation described 
in Sec. 1.955-5(a). The amount of M's previously excluded subpart F 
income withdrawn for 1976 from investment in less developed countries is 
zero, determined as follows:

(1) Qualified investments in less developed countries at the     $10,000
 close of 1975...............................................
(2) Less: qualified investments in less developed countries       10,000
 at the close of 1976........................................
                                                              ----------
(3) Balance..................................................          0
                                                              ==========
 

    (c) Shareholder's pro rata share of amount withdrawn by controlled 
foreign corporation--(1) In general. A United States shareholder's pro 
rata share of a controlled foreign corporation's previously excluded 
subpart F income withdrawn for any taxable year from investment in less 
developed countries is his pro rata share of the amount withdrawn for 
such year by such corporation, as determined under paragraph (b) of this 
section. See section 955(a)(3).
    (2) Special rule. A United States shareholder's pro rata share of 
the net amount determined under paragraph (b)(2)(i)(b) of this section 
with respect to any stock of the controlled foreign corporation owned by 
such shareholder shall be determined without taking into account any 
amount attributable to a period prior to the date on which such 
shareholder acquired such stock. See section 1248 and the regulations 
thereunder for rules governing treatment of gain from sales or exchanges 
of stock in certain foreign corporations.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 60 percent of the 
only class of stock of M Corporation, a controlled foreign corporation 
throughout the entire period here involved. Both A and M Corporation use 
the calendar year as a taxable year. Corporation M's qualified 
investments in less developed countries at the close of 1964 amount to 
$125,000; and, at the close of 1965, to $75,000. During 1965, M 
Corporation realizes recognized gains of $5,000 and recognized losses of 
$15,000, on sales of qualified investments in less developed countries. 
Corporation M's earnings and profits for 1965 and its accumulated 
earnings and profits for 1963 and 1964 amount to $45,000, as determined 
under paragraph (b)(2) of this section. The amount excluded under 
section 954(b)(1) for 1963 from its foreign base company income is 
$75,000, and the amount of its previously excluded subpart F income 
withdrawn for 1964 from investment in less developed countries is 
$25,000. The amount of M Corporation's previously excluded subpart F 
income withdrawn for 1965 from investment in less developed countries is 
$40,000, and A's pro rata share of such amount is $24,000, determined as 
follows:

(i) Qualified investments in less developed countries at the    $125,000
 close of 1964...............................................
(ii) Less: Qualified investments in less developed countries      75,000
 at the close of 1965........................................
                                                              ----------
(iii) Balance................................................     50,000
(iv) Less: Excess of recognized losses over recognized gains      10,000
 on sales during 1965 of qualified investments in less
 developed countries ($15,000 less $5,000)...................
                                                              ----------
(v) Tentative decrease in qualified investments in less           40,000
 developed countries for 1965................................
                                                              ==========
(vi) Earnings and profits for 1963, 1964, and 1965...........     45,000
                                                              ----------
(vii) Excess of amount excluded under section 954(b)(1) from      50,000
 foreign base company income for 1963 ($75,000 over amount of
 previously excluded subpart F income withdrawn for 1964 from
 investment in less developed countries ($25,000)............
                                                              ----------
(viii) M Corporation's amount of previously excluded subpart      40,000
 F income withdrawn for 1965 from investment in less
 developed countries (item (v), but not to exceed the lesser
 of item (vi) or item (vii)).................................
                                                              ----------
(ix) A's pro rata share of M Corporation's amount of             $24,000
 previously excluded subpart F income withdrawn for 1965 from
 investment in less developed countries (60 percent of
 $40,000)....................................................
                                                              ==========
 

    Example 2. The facts are the same as in example 1, except that M 
Corporation's earnings and profits (determined under paragraph (b)(2) of 
this section) for 1963, 1964, and 1965

[[Page 352]]

(item (vi)) are $30,000 instead of $45,000. Corporation M's amount of 
previously excluded subpart F income withdrawn for 1965 from investment 
in less developed countries is $30,000. A's pro rata share of such 
amount is $18,000 (60 percent of $30,000).
    Example 3. The facts are the same as in example 1, except that the 
excess of the amount excluded under section 954(b)(1) for 1963 from M 
Corporation's foreign base company income over the amount of its 
previously excluded subpart F income withdrawn for 1964 from investment 
in less developed countries (item (vii)) is $20,000 instead of $50,000. 
Corporation M's amount of previously excluded subpart F income withdrawn 
for 1965 from investment in less developed countries is $20,000. A's pro 
rata share of such amount is $12,000 (60 percent of $20,000).

[T.D. 6683, 28 FR 11178, Oct. 18, 1963, as amended by T.D. 6795, 30 FR 
942, Jan. 29, 1965; T.D. 7893, 48 FR 22509, May 19, 1983; T.D. 7894, 48 
FR 22529, May 19, 1983]



Sec. 1.955-2  Amount of a controlled foreign corporation's qualified
investments in less developed countries.

    (a) Included property. For purposes of sections 951 through 964, a 
controlled foreign corporation's ``qualified investments in less 
developed countries'' are items of property (other than property 
excluded under paragraph (b)(1) of this section) owned directly by such 
corporation on the applicable determination date for purposes of section 
954(f) or section 955(a)(2) and consisting of one or more of the 
following:
    (1) Stock of a less developed country corporation if the controlled 
foreign corporation owns (within the meaning of paragraph (b)(2) of this 
section) on the applicable determination date 10 percent or more of the 
total combined voting power of all classes of stock of such less 
developed country corporation;
    (2) An obligation (as defined in paragraph (b)(3) of this section) 
of a less developed country corporation which, at the time of 
acquisition (as defined in paragraph (b)(4) of this section) of such 
obligation by the controlled foreign corporation, has a maturity of one 
year or more, but only if the controlled foreign corporation owns 
(within the meaning of paragraph (b)(2) of this section) on the 
applicable determination date 10 percent or more of the total combined 
voting power of all classes of stock of such less developed country 
corporation; and
    (3) An obligation (as defined in paragraph (b)(3) of this section) 
of a less developed country, including obligations issued or guaranteed 
by the government of such country or of a political subdivision thereof 
and obligations of any agency or instrumentality of such country, in 
which such country is financially committed. The application of this 
subparagraph may be illustrated by the following example:

    Example. A, a political subdivision of foreign country X, constructs 
and operates a toll bridge. Country X is a less developed country 
throughout the period here involved. A issues bonds under an indenture 
which provides for amortization of the principal and interest of such 
bonds only out of the net revenues derived from operation of the bridge. 
The bonds of A are obligations in which X country is financially 
committed and, in the hands of a controlled foreign corporation, are 
qualified investments in less developed countries.

    (b) Special rules--(1) Excluded property. For purposes of paragraph 
(a) of this section, property which is disposed of within 6 months after 
the date of its acquisition shall be excluded from a controlled foreign 
corporation's qualified investments in less developed countries. 
However, the fact that property acquired by a controlled foreign 
corporation has not been held on an applicable determination date for 
more than 6 months after the date of its acquisition shall not prevent 
such property from being included in the controlled foreign 
corporation's qualified investments in less developed countries on such 
date. Proper adjustments shall be made subsequently, however, to exclude 
any item of property so included, if the property is in fact disposed of 
within 6 months after the date of its acquisition. See section 
955(b)(4).
    (2) Determination of stock ownership. In determining for purposes of 
paragraphs (a)(1) and (2) of this section whether a controlled foreign 
corporation owns 10 percent or more of the total combined voting power 
of all classes of stock of a less developed country corporation, only 
stock owned directly by such controlled foreign corporation shall be 
taken into account and the provisions of section 958 and

[[Page 353]]

the regulations thereunder shall not apply. See section 958(a)(1).
    (3) Obligation defined. For purposes of paragraphs (a)(2) and (3) of 
this section, the term ``obligation'' means any bond, note, debenture, 
certificate, or other evidence of indebtedness. In the absence of legal, 
governmental, or business reasons to the contrary, the indebtedness must 
bear interest or be issued at a discount.
    (4) Date of acquisition. For purposes of paragraphs (a)(2) and 
(b)(5)(i) of this section, stock or an obligation shall be considered 
acquired by a foreign corporation as of the date such corporation 
acquires an adjusted basis in the stock or obligation. For this purpose, 
in a case in which a foreign corporation acquires stock or an obligation 
in a transaction (other than a reorganization of the type described in 
section 368(a)(1)(E) or (F)) in which no gain or loss would be 
recognized had the transaction been between two domestic corporations, 
such corporation will be considered to have acquired an adjusted basis 
in such stock or obligation as of the date such transaction occurs.
    (5) Taxable years beginning after December 31, 1975. For taxable 
years beginning after December 31, 1975, qualified investments in less 
developed countries do not include--
    (i) Any property acquired after the latest determination date 
applicable to a taxable year beginning before December 31, 1975,
    (ii) Stock or obligations of a less developed country shipping 
company described in Sec. 1.955-5(b), and
    (iii) Stock or obligations which were not treated as qualified 
investments in less developed countries on the later of the two 
determination dates applicable to the preceding taxable year.


See Sec. 1.955-1(b)(3) for rules relating to the application of this 
subparagraph. See Sec. 1.955A-2(h) for rules relating to the treatment 
of investments in stock or obligations described in subdivision (ii) of 
this subparagraph as qualified investments in foreign base company 
shipping operations.
    (6) Determination dates. For purposes of subparagraph (5) of this 
paragraph and Sec. 1.955-1(b)(3), the determination dates applicable to 
a taxable year of a controlled foreign corporation are--
    (i) Except as provided in subdivision (ii) of this subparagraph, the 
close of such taxable year and the close of the preceding taxable year, 
and
    (ii) With respect to a United States shareholder who has made an 
election under section 955(b)(3) to determine such corporation's 
increase in qualified investments in less developed countries at the 
close of the following taxable year, the close of such taxable year and 
the close of the taxable year immediately following such taxable year.
    (c) Termination of designation as a less developed country. For 
purposes of sections 951 through 964, property which would constitute a 
qualified investment in a less developed country but for the fact that a 
foreign country or United States possession has, after the acquisition 
of such property by the controlled foreign corporation, ceased to be a 
less developed country shall be treated as a qualified investment in a 
less developed country. The application of this paragraph may be 
illustrated by the following example:

    Example. On December 31, 1969, in accordance with the provisions of 
Sec. 1.955-4, the designation of the foreign country X as an 
economically less developed country is terminated. Corporation M, a 
controlled foreign corporation, has $50,000 of qualified investments in 
country X acquired before December 31, 1969. After 1969 such investments 
are treated as qualified investments in a less developed country 
notwithstanding the termination of the status of X Country as an 
economically less developed country. However, if such qualified 
investments of M Corporation are reduced to $40,000, each United States 
shareholder of M Corporation is required, subject to the provisions of 
Sec. 1.955-1, to include his pro rata share of the $10,000 decrease in 
his gross income under section 951(a)(1)(A)(ii) and the regulations 
thereunder.

    (d) Amount attributable to property--(1) General rule. For purposes 
of this section, the amount taken into account with respect to any 
property which constitutes a qualified investment in a less developed 
country shall be its adjusted basis as of the applicable determination 
date, reduced by any liability (other than a liability described in 
subparagraph (2) of this paragraph) to which such property is subject on 
such date. To be taken into account under this subparagraph, a liability 
must

[[Page 354]]

constitute a specific charge against the property involved. Thus, a 
liability evidenced by an open account or a liability secured only by 
the general credit of the controlled foreign corporation will not be 
taken into account. On the other hand, if a liability constitutes a 
specific charge against several items of property and cannot definitely 
be allocated to any single item of property, the liability shall be 
apportioned against each of such items of property in that ratio which 
the adjusted basis of such item on the applicable determination date 
bears to the adjusted basis of all such items at such time. A liability 
in excess of the adjusted basis of the property which is subject to such 
liability shall not be taken into account for the purpose of reducing 
the adjusted basis of other property which is not subject to such 
liability.
    (2) Excluded charges. For purposes of subparagraph (1) of this 
paragraph, a specific charge created with respect to any item of 
property principally for the purpose of artificially increasing or 
decreasing the amount of a controlled foreign corporation's qualified 
investments in less developed countries will not be recognized; whether 
a specific charge is created principally for such purpose will depend 
upon all the facts and circumstances of each case. One of the factors 
that will be considered in making such a determination with respect to a 
loan is whether the loan is from a related person, as defined in section 
954(d)(3) and paragraph (e) of Sec. 1.954-1.
    (3) Statement required. If for purposes of this section a United 
States shareholder of a controlled foreign corporation reduces the 
adjusted basis of property which constitutes a qualified investment in a 
less developed country on the ground that such property is subject to a 
liability, he shall attach to his return a statement setting forth the 
adjusted basis of the property before the reduction and the amount and 
nature of the reduction.
    (4) Taxable years beginning after December 31, 1975. For taxable 
years beginning after December 31, 1975, the amount taken into account 
under subparagraph (1) of this paragraph with respect to any property 
which constitutes a qualified investment in less developed countries 
shall not exceed the amount taken into account with respect to such 
property at the close of the preceding taxable year.

[T.D. 6683, 28 FR 11179, Oct. 18, 1963, as amended by T.D. 7894, 48 FR 
22529, May 19, 1983]



Sec. 1.955-3  Election as to date of determining qualified investments
in less developed countries.

    (a) Nature of election. In lieu of determining the increase for a 
taxable year of a foreign corporation beginning before January 1, 1976, 
under the provisions of section 954(f) and paragraph (a) of Sec. 1.954-
5, or the decrease under the provisions of section 955(a)(2) and 
paragraph (b) of Sec. 1.955-1, in a controlled foreign corporation's 
qualified investments in less developed countries for a taxable year in 
the manner provided in such provisions, a United States shareholder of 
such controlled foreign corporation may elect, under the provisions of 
section 955(b)(3) and this section, to determine such increase in 
accordance with the provisions of paragraph (b) of Sec. 1.954-5 and to 
determine such decrease by ascertaining the amount by which--
    (1) Such controlled foreign corporation's qualified investments in 
less developed countries at the close of such taxable year exceed its 
qualified investments in less developed countries at the close of the 
taxable year immediately following such taxable year, and reducing such 
excess by
    (2) The amount determined under paragraph (b)(1)(ii) of Sec. 1.955-
1 for such taxable year,


subject to the limitation provided in paragraph (b)(2) of Sec. 1.955-1 
for such taxable year. An election under this section may be made with 
respect to each controlled foreign corporation with respect to which a 
person is a United States shareholder within the meaning of section 
951(b), but the election may not be exercised separately with respect to 
the increases and the decreases of such controlled foreign corporation. 
If an election is made under this section to determine the increase of a 
controlled foreign corporation in accordance with the provisions of 
paragraph (b) of Sec. 1.954-5, subsequent decreases of such controlled 
foreign

[[Page 355]]

corporation shall be determined in accordance with this paragraph and 
not in accordance with paragraph (b) of Sec. 1.955-1.
    (b) Time and manner of making election--(1) Without consent. An 
election under this section with respect to a controlled foreign 
corporation shall be made without the consent of the Commissioner by a 
United States shareholder's filing a statement to such effect with his 
return for his taxable year in which or with which ends the first 
taxable year of such controlled foreign corporation in which--
    (i) Such shareholder owns, within the meaning of section 958(a), or 
is considered as owning by applying the rules of ownership of section 
958(b), 10 percent or more of the total combined voting power of all 
classes of stock entitled to vote of such controlled foreign 
corporation, and
    (ii) Such controlled foreign corporation realizes foreign base 
company income from which amounts are excluded under section 954(b)(1) 
and paragraph (b)(1) of Sec. 1.954-1.


The statement shall contain the name and address of the controlled 
foreign corporation and identification of such first taxable year of 
such corporation. For taxable years of a foreign corporation beginning 
after December 31, 1975, no election under this section with respect to 
a controlled foreign corporation may be made without the consent of the 
Commissioner.
    (2) With consent. An election under this section with respect to a 
controlled foreign corporation may be made by a United States 
shareholder at any time with the consent of the Commissioner. Consent 
will not be granted unless the United States shareholder and the 
Commissioner agree to the terms, conditions, and adjustments under which 
the election will be effected. Consent will not be granted if the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute an amount described in section 
954(b)(1) in accordance with the election provided in this section 
begins after December 31, 1975. The application for consent to elect 
shall be made by the United States shareholder's mailing a letter for 
such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute an amount described in section 
954(b)(1) in accordance with the election provided in this section. The 
application shall include the following information:
    (i) The name, address, and taxable year of the United States 
shareholder;
    (ii) The name and address of the controlled foreign corporation;
    (iii) The first taxable year of the controlled foreign corporation 
for which income is to be computed under the election;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in less developed countries at the close of its preceding 
taxable year; and
    (v) The sum of the amounts excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 from the foreign base company income 
of the controlled foreign corporation for all prior taxable years during 
which such shareholder was a United States shareholder of such 
corporation and the sum of the amounts of its previously excluded 
subpart F income withdrawn from investment in less developed countries 
for all prior taxable years during which such shareholder was a United 
States shareholder of such corporation.
    (c) Effect of election--(1) General. Except as provided in 
subparagraphs (3) and (4) of this paragraph, an election under this 
section with respect to a controlled foreign corporation shall be 
binding on the United States shareholder and shall apply to all 
qualified investments in less developed countries acquired, or disposed 
of, by such controlled foreign corporation during the taxable year 
following its taxable year for which income is first computed under the 
election and during all succeeding taxable years of such corporation.
    (2) Returns. Any return of a United States shareholder required to 
be filed before the completion of a period with respect to which 
determinations are to be made as to a controlled foreign corporation's 
qualified investments in less developed countries for purposes of

[[Page 356]]

computing such shareholder's taxable income shall be filed on the basis 
of an estimate of the amount of the controlled foreign corporation's 
qualified investments in less developed countries at the close of the 
period. If the actual amount of such investments is not the same as the 
amount of the estimate, the United States shareholder shall immediately 
notify the Commissioner. The Commissioner will thereupon redetermine the 
amount of tax of such United States shareholder for the year or years 
with respect to which the incorrect amount was taken into account. The 
amount of tax, if any, due upon such redetermination shall be paid by 
the United States shareholder upon notice and demand by the district 
director. The amount of tax, if any, shown by such redetermination to 
have been overpaid shall be credited or refunded to the United States 
shareholder in accordance with the provisions of sections 6402 and 6511 
and the regulations thereunder.
    (3) Revocation. Upon application by the United States shareholder, 
the election made under this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless the United 
States shareholder and the Commissioner agree to the terms, conditions, 
and adjustments under which the rev- ocation will be effected. Unless 
such agreement provides otherwise, the change in the controlled foreign 
corporation's qualified investments in less developed countries for its 
first taxable year for which income is computed without regard to the 
election previously made will be considered to be zero for purposes of 
effectuating the revocation. The application for consent to revocation 
shall be made by the United States shareholder's mailing a letter for 
such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute the amounts described in section 
954(b)(1) or 955(a) without regard to the election provided in this 
section. The application may also be filed in a taxable year beginning 
after December 31, 1975. The application shall include the following 
information:
    (i) The name, address, and taxpayer identification number of the 
United States shareholder;
    (ii) The name and address of the controlled foreign corporation;
    (iii) The taxable year of the controlled foreign corporation for 
which such amounts are to be so computed;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in less developed countries at the close of its preceding 
taxable year;
    (v) The sum of the amounts excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 from the foreign base company income 
of the controlled foreign corporation for all prior taxable years during 
which such shareholder was a United States shareholder of such 
corporation and the sum of the amounts of its previously excluded 
subpart F income withdrawn from investment in less developed countries 
for all prior taxable years during which such shareholder was a United 
States shareholder of such corporation; and
    (vi) The reasons for the request for consent to revocation.
    (4) Transfer of stock. If during any taxable year of a controlled 
foreign corporation--
    (i) A United States shareholder who has made an election under this 
section with respect to such controlled foreign corporation sells, 
exchanges, or otherwise disposes of all or part of his stock in such 
controlled foreign corporation, and
    (ii) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange, or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
controlled foreign corporation's acquisitions and dispositions of 
qualified investments in less developed countries for such taxable year 
shall be considered to be zero. If the United States shareholder's 
successor in interest is entitled to and does make an election under 
paragraph (b)(1) of this section to determine the controlled foreign 
corporation's increase in qualified investments in less developed 
countries for the taxable year in which he acquires such stock, such 
increase with

[[Page 357]]

respect to the stock so acquired shall be determined in accordance with 
the provisions of paragraph (b)(1) of Sec. 1.954-5. If the controlled 
foreign corporation realizes no foreign base company income from which 
amounts are excluded under section 954(b)(1) and paragraph (b)(1) of 
Sec. 1.954-1 for the taxable year in which the United States 
shareholder's successor in interest acquires such stock and such 
successor in interest makes an election under paragraph (b)(1) of this 
section with respect to a subsequent taxable year of such controlled 
foreign corporation, the increase in the controlled foreign 
corporation's qualified investments in less developed countries for such 
subsequent taxable year shall be determined in accordance with the 
provisions of paragraph (b)(2) of Sec. 1.954-5.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Foreign corporation A is a wholly owned subsidiary of 
domestic corporation M. Both corporations use the calendar year as a 
taxable year. In a statement filed with its return for 1963, M 
Corporation makes an election under section 955(b)(3) and the election 
remains in force for the taxable year 1964. At December 31, 1964, A 
Corporation's qualified investments in less developed countries amount 
to $100,000; and, at December 31, 1965, to $80,000. For purposes of 
paragraph (a)(1) of this section, A Corporation's decrease in qualified 
investments in less developed countries for the taxable year 1964 is 
$20,000 and is determined by ascertaining the amount by which A 
Corporation's qualified investments in less developed countries at 
December 31, 1964 ($100,000) exceed its qualified investments in less 
developed countries at December 31, 1965 ($80,000).
    Example 2. The facts are the same as in example 1 except that A 
Corporation experiences no changes in qualified investments in less 
developed countries during its taxable years 1966 and 1967. If M 
Corporation's election were to remain in force, A Corporation's 
acquisitions and dispositions of qualified investments in less developed 
countries during A Corporation's taxable year 1968 would be taken into 
account in determining whether A Corporation has experienced an increase 
or a decrease in qualified investments in less developed countries for 
its taxable year 1967. However, M Corporation duly files before the 
close of A Corporation's taxable year 1967 an application for consent to 
revocation of M Corporation's election under section 955(b)(3), and, 
pursuant to an agreement between the Commissioner and M Corporation, 
consent is granted by the Commissioner. Assuming such agreement does not 
provide otherwise, A Corporation's change in qualified investments in 
less developed countries for its taxable year 1967 is zero because the 
effect of the revocation of the election is to treat acquisitions and 
dispositions of qualified investments in less developed countries 
actually occurring in 1968 as having occurred in such year rather than 
in 1967.
    Example 3. The facts are the same as in example 2 except that A 
Corporation's qualified investments in less developed countries at 
December 31, 1968, amount to $70,000. For purposes of paragraph 
(b)(1)(i) of Sec. 1.955-1, the decrease in A Corporation's qualified 
investments in less developed countries for the taxable year 1968 is 
$10,000 and is determined by ascertaining the amount by which A 
Corporation's qualified investments in less developed countries at 
December 31, 1967 ($80,000) exceed its qualified investments in less 
developed countries at December 31, 1968 ($70,000).
    Example 4. The facts are the same as in example 1 except that on 
September 30, 1965, M Corporation sells 40 percent of the only class of 
stock of A Corporation to N Corporation, a domestic corporation. 
Corporation N uses the calendar year as a taxable year. Corporation A 
remains a controlled foreign corporation immediately after such sale of 
its stock. Corporation A's qualified investments in less developed 
countries at December 31, 1966, amount to $90,000. The changes in A 
Corporation's qualified investments in less developed countries 
occurring in its taxable year 1965 are considered to be zero with 
respect to the 40-percent stock interest acquired by N Corporation. The 
entire $20,000 reduction in A Corporation's qualified investments in 
less developed countries which occurs during the taxable year 1965 is 
taken into account by M Corporation for purposes of paragraph (a)(1) of 
this section in determining its tax liability for the taxable year 1964. 
Corporation A's increase in qualified investments in less developed 
countries for the taxable year 1965 with respect to the 60-percent stock 
interest retained by M Corporation is $6,000 and is determined by 
ascertaining M Corporation's pro rata share (60 percent) of the amount 
by which A Corporation's qualified investments in less developed 
countries at December 31, 1968 ($90,000) exceed its qualified 
investments in less developed countries at December 31, 1965 ($80,000). 
Corporation N does not make an election under section 955(b)(3) in its 
return for its taxable year 1966. Corporation A's increase in qualified 
investments in less developed countries for the taxable year 1966 with 
respect to the 40-percent stock interest acquired by N Corporation is 
$4,000.

[T.D. 6683, 28 FR 11180, Oct. 18, 1963, as amended by T.D. 7893, 48 FR 
22509, May 19, 1983; T.D. 7894, 48 FR 22530, May 19, 1983]

[[Page 358]]



Sec. 1.955-4  Definition of less developed country.

    (a) Designation by Executive order. For purposes of sections 951 
through 964, the term ``less developed country'' means any foreign 
country (other than an area within the Sino-Soviet bloc) or any 
possession of the United States with respect to which, on the first day 
of the foreign corporation's taxable year, there is in effect an 
Executive order by the President of the United States designating such 
country or possession as an economically less developed country for 
purposes of such sections. Each territory, department, province, or 
possession of any foreign country other than a country within the Sino-
Soviet bloc may be treated as a separate foreign country for purposes of 
such designation if the territory, department, province, or possession 
is overseas from the country of which it is a territory, department, 
province, or possession. Thus, for example, an overseas possession of a 
foreign country may be designated by Executive order as an economically 
less developed country even though the foreign country itself has not 
been designated as an economically less developed country; or the 
foreign country may be so designated even though the overseas 
possessions of such country have not been designated as economically 
less developed countries. The term ``possession of the United States'', 
for purposes of section 955(c)(3) and this section, shall be construed 
to have the same meaning as that contained in paragraph (b)(2) of Sec. 
1.957-3.
    (b) Countries not eligible for designation. Section 955(c)(3) 
provides that no designation by Executive order may be made under 
section 955(c)(3) and paragraph (a) of this section with respect to--

Australia
Austria
Belgium
CanadaDenmark
France
Germany (Federal Republic)
Hong Kong
Italy
Japan
Liechtenstein
Luxembourg
Monaco
Netherlands
New Zealand
Norway
Union of South Africa
San Marino
Sweden
Switzerland
United Kingdom.

    (c) Termination of designation. Section 955(c)(3) provides that, 
after the President has designated any foreign country or possession of 
the United States as an economically less developed country for purposes 
of sections 951 through 964, he may not terminate such designation 
(either by issuing an Executive order for the purpose of terminating 
such designation or by issuing an Executive order which has the effect 
of terminating such designation) unless, at least 30 days prior to such 
termination, he has notified the Senate and the House of Representatives 
of his intention to terminate such designation. If such 30-day notice is 
given, no action by the Congress of the United States is necessary to 
effectuate the termination. The requirement for giving 30-day notice to 
the Senate and House of Representatives applies also to the termination 
of a designation with respect to an overseas territory, department, 
province, or possession of a foreign country. See paragraph (c) of Sec. 
1.955-2 for the effect of a termination of a Presidential designation 
upon property which would be a qualified investment in a less developed 
country but for the fact of such termination.

[T.D. 6683, 28 FR 11182, Oct. 18, 1963]



Sec. 1.955-5  Definition of less developed country corporation.

    (a) Less developed country corporation--(1) In general. For purposes 
of sections 951 through 964, the term ``less developed country 
corporation'' means a foreign corporation described in paragraph (b) of 
this section and also any foreign corporation--
    (i) Which is engaged in the active conduct of one or more trades or 
businesses during the entire taxable year;
    (ii) Which derives 80 percent or more of its gross income, if any, 
for such taxable year from sources within less developed countries, as 
determined under the provisions of Sec. 1.955-6; and
    (iii) Which has 80 percent or more in value (within the meaning of 
paragraph (d) of this section) of its assets on each day of such taxable 
year consisting of one or more of the following items of property:

[[Page 359]]

    (a) Property (other than property described in (b) through (h) of 
this subdivision) which is used, or held for use, in such trades or 
businesses and is located in one or more less developed countries;
    (b) Money;
    (c) Deposits with persons carrying on the banking business;
    (d) Stock of any other less developed country corporation;
    (e) Obligations (within the meaning of paragraph (b)(3) of Sec. 
1.955-2) of another less developed country corporation which at the time 
of their acquisition (within the meaning of paragraph (b)(4) of Sec. 
1.955-2) by the foreign corporation have a maturity of one year or more;
    (f) Obligations (within the meaning of paragraph (b)(3) of Sec. 
1.955-2) of any less developed country;
    (g) Investments which are required to be made or held because of 
restrictions imposed by the government of any less developed country; 
and
    (h) Property described in section 956(b)(2).


For purposes of this subparagraph, if a foreign corporation is a partner 
in a foreign partnership, as defined in section 7701(a)(2) and (5) and 
the regulations thereunder, such corporation will be considered to be 
engaged in the active conduct of a trade or business to the extent and 
in the manner in which the partnership is so engaged and to own directly 
its proportionate share of each of the assets of the partnership. For 
purposes of subdivision (i) of this subparagraph, a newly-organized 
foreign corporation will be considered engaged in the active conduct of 
a trade or business from the date of its organization if such 
corporation commences business operations as soon as practicable after 
such organization. In the absence of affirmative evidence showing that 
the 80-percent requirement of subdivision (iii) of this subparagraph has 
not been satisfied on each day of the taxable year, such requirement 
will be considered satisfied if it is established to the satisfaction of 
the district director that such requirement has been satisfied on the 
last day of each quarter of the taxable year of the foreign corporation. 
For purposes of subdivision (iii) of this subparagraph, property (other 
than stock in trade or other property of a kind which would properly be 
included in inventory of the foreign corporation if on hand at the close 
of the taxable year, or property held primarily for sale to customers in 
the ordinary course of the trade or business of the foreign corporation) 
purchased for use in a trade or business and temporarily located outside 
less developed countries will be considered located in less developed 
countries if, but only if, such property is shipped to and received in 
less developed countries promptly after such purchase.
    (2) Special rules. For purposes of subparagraph (1)(iii)(a) of this 
paragraph--
    (i) Treatment of receivables. Bills receivable, accounts receivable, 
notes receivable and open accounts shall be considered to be used in the 
trade or business and located in less developed countries if, but only 
if--
    (a) Such obligations arise out of the rental of property located in 
less developed countries, the performance of services within less 
developed countries, or the sale of property manufactured, produced, 
grown, or extracted in less developed countries, but only to the extent 
that the aggregate amount of such obligations at any time during the 
taxable year does not exceed an amount which is ordinary and necessary 
to carry on the business of both parties to the transactions if such 
transactions are between unrelated persons or, if such transactions are 
between related persons, an amount which would be ordinary and necessary 
to carry on the business of both parties to the transactions if such 
transactions were between unrelated persons;
    (b) In the case of bills receivable, accounts receivable, notes 
receivable, and open accounts arising out of transactions other than 
those referred to in (a) of this subdivision--
    (1) If the obligor is an individual such individual is a resident of 
one or more less developed countries and of no other country which is 
not a less developed country;
    (2) If the obligor is a corporation which as to the foreign 
corporation is a related person as defined in section 954(d)(3) and 
paragraph (e) of Sec. 1.954-1, such obligor meets, with respect to the

[[Page 360]]

period ending with the close of its annual accounting period in which 
occurs the date on which the obligation is incurred, the 80-percent 
gross income requirement of paragraph (b)(1)(ii) of Sec. 1.955-6.
    (3) If the obligor is a corporation which as to the foreign 
corporation is not a related person as defined in section 954(d)(3) and 
paragraph (e) of Sec. 1.954-1, it is reasonable, on the basis of 
ascertainable facts, for the obligee to believe that the obligor meets, 
with respect to such period, the 80-percent gross income requirement of 
paragraph (b)(1)(ii) of Sec. 1.955-6.
    (ii) Location of interests in real estate. Interests in real estate 
such as leaseholds of land or improvements thereon, mortgages on real 
property (including interests in mortgages on leaseholds of land or 
improvements thereon), and mineral, oil, or gas interests shall be 
considered located in less developed countries if, but only if, the 
underlying real estate is located in less developed countries.
    (iii) Location of certain other intangibles. Intangible property 
(other than any such property described in subdivision (i) or (ii) of 
this subparagraph) used in the trade or business of the foreign 
corporation shall be considered to be located in less developed 
countries in the same ratio that the amount of the foreign corporation's 
tangible property and property described in subdivision (i) or (ii) of 
this subparagraph used in its trades or businesses and located or deemed 
located in less developed countries bears to the total amount of its 
tangible property and property described in subdivision (i) or (ii) of 
this subparagraph used in its trades or businesses.
    (3) Illustration. The provisions of subparagraph (1) of this 
paragraph may be illustrated by the following example:

    Example. Foreign corporation A is formed on November 1, 1963, to 
engage in the business of manufacturing and selling radios in Brazil, a 
less developed country as of November 1, 1963. Corporation A uses the 
calendar year as a taxable year. Shortly after it is formed, A 
Corporation acquires a plant site and begins construction of a plant 
which is completed on August 1, 1964. Corporation A commences business 
operations as soon as practicable and continues such operations through 
December 31, 1964, and thereafter. Corporation A will be considered for 
purposes of subparagraph (1)(i) of this paragraph to be engaged in the 
active conduct of a trade or business for its entire taxable years 
ending on December 31, 1963, and 1964. The plant site and the plant 
(while under construction and after completion) will be considered to be 
property held during such taxable years for use in A Corporation's trade 
or business.

    (b) Shipping companies. For purposes of sections 951 through 964, 
the term ``less developed country corporation'' also means any foreign 
corporation--
    (1) Which has 80 percent or more of its gross income, if any, for 
the taxable year consisting of one or more of--
    (i) Gross income derived--
    (a) From, or in connection with, the using (or hiring or leasing for 
use) in foreign commerce of aircraft or vessels registered under the 
laws of a less developed country,
    (b) From, or in connection with, the performance of services 
directly related to the use in foreign commerce of aircraft or vessels 
registered under the laws of a less developed country, or
    (c) From the sale or exchange of aircraft or vessels registered 
under the laws of a less developed country and used in foreign commerce 
by such foreign corporation;
    (ii) Dividends and interest received or accrued from other foreign 
corporations which are less developed country corporations within the 
meaning of this paragraph and 10 percent or more of the total combined 
voting power of all classes of stock of which is owned at the time such 
dividends and interest are so received or accrued by such foreign 
corporation; and
    (iii) Gain from the sale or exchange of stock or obligations of 
other foreign corporations which are less developed country corporations 
within the meaning of this paragraph and 10 percent or more of the total 
combined voting power of all classes of stock of which is owned by such 
foreign corporation immediately before such sale or exchange; and
    (2) Which has 80 percent or more in value (within the meaning of 
paragraph (d) of this section) of its assets on each day of the taxable 
year consisting of--
    (i) Assets used, or held for use, for the production of income 
described in subparagraph (1) of this paragraph, or

[[Page 361]]

in connection with the production of such income, whether or not such 
income is received during the taxable year, and
    (ii) Property described in section 956(b)(2).


In the absence of affirmative evidence showing that the 80-percent 
requirement of this subparagraph has not been satisfied on each day of 
the taxable year such requirement will be considered satisfied if it is 
established to the satisfaction of the district director that such 
requirement has been satisfied on the last day of each quarter of the 
taxable year of the foreign corporation. The provisions of this 
subparagraph may be illustrated by the following example:

    Example. Foreign corporation A is formed on November 1, 1963, for 
the purpose of constructing and operating a vessel and, on that date, 
enters a charter agreement which provides that such vessel will be 
registered under the laws of Liberia, a less developed country as of 
November 1, 1963, and operated between South American and European 
ports. Corporation A uses the calendar year as a taxable year. 
Construction of the vessel is completed on September 1, 1965, and the 
vessel is registered under the laws of Liberia and operated between 
South American and European ports through December 31, 1965, and 
thereafter. The charter and the vessel (while under construction and 
after completion), or any interest of A Corporation in such assets, will 
be considered assets which are held by A Corporation during its taxable 
years ending on December 31, 1963, 1964, and 1965, for use in the 
production of income described in subparagraph (1) of this paragraph.

    (c) Determination of stock ownership. In determining for purposes of 
paragraph (b)(1)(ii) and (iii) of this section whether a foreign 
corporation owns 10 percent or more of the total combined voting power 
of all classes of stock of a less developed country corporation, only 
stock owned directly by such foreign corporation shall be taken into 
account and the provisions of section 958 and the regulations thereunder 
shall not apply. See section 958(a)(1).
    (d) Determination of value. For purposes of paragraphs (a)(1)(iii) 
and (b)(2) of this section--
    (1) General. Except as provided in subparagraph (2) of this 
paragraph, the value at which property shall be taken into account is 
its actual value (not reduced by liabilities) which, in the absence of 
affirmative evidence to the contrary, shall be deemed to be its adjusted 
basis.
    (2) Treatment of certain receivables. The value at which receivables 
described in paragraph (a)(2)(i) of this section and held by a foreign 
corporation using the cash receipts and disbursements method of 
accounting shall be taken into account is their actual value (not 
reduced by liabilities) which, in the absence of affirmative evidence to 
the contrary, shall be deemed to be their face value.

[T.D. 6683, 28 FR 11182, Oct. 18, 1963]



Sec. 1.955-6  Gross income from sources within less developed countries.

    (a) General. For purposes of paragraph (a)(1)(ii) of Sec. 1.955.5, 
the determination whether a foreign corporation has derived 80 percent 
or more of its gross income from sources within less developed countries 
for any taxable year shall be made by the application of the provisions 
of sections 861 through 864, and Sec. Sec. 1.861-1 through 1.863-5, in 
application of which the name of a less developed country shall be 
substituted for ``the United States'', except that if income is derived 
by the foreign corporation from--
    (1) Interest (other than interest to which subparagraph (3) of this 
paragraph applies), the rules set forth in paragraph (b) of this section 
shall apply;
    (2) Dividends, the rules set forth in paragraph (c) of this section 
shall apply; or
    (3) Income (including interest) derived in connection with the sale 
of tangible personal property, the rules set forth in paragraph (d) of 
this section shall apply.


The source of income described in subparagraph (1), (2), or (3) of this 
paragraph shall be determined solely under the rules of this section and 
without regard to the rules of sections 861 through 864, and the 
regulations thereunder.
    (b) Interest--(1) In general. Except as provided in subparagraph (2) 
of this paragraph and paragraph (d) of this section, gross income 
derived by the

[[Page 362]]

foreign corporation from interest on any indebtedness--
    (i) Of an individual shall be treated as income from sources within 
a less developed country if, but only if, such individual is a resident 
of one or more less developed countries and of no other country which is 
not a less developed country.
    (ii) Of a corporation shall be treated as income from sources within 
less developed countries if, but only if, 80 percent or more of the 
gross income of the payer corporation for the 3-year period ending with 
the close of its annual accounting period in which such interest is 
paid, or for such part of such 3-year period as such corporation has 
been in existence, or for such part of such 3-year period as occurs on 
and after the beginning of such corporation's first annual accounting 
period beginning after December 31, 1962, whichever period is shortest, 
was derived from sources within less developed countries as determined 
in accordance with the principles of this section; or
    (iii) Of a less developed country, including obligations issued or 
guaranteed by the government of such country or of a political 
subdivision thereof and obligations of any agency or instrumentality of 
such country, in which such country is financially committed shall be 
treated as income from sources within such country.
    (2) Special rule. Gross income derived by the foreign corporation 
from interest on obligations of the United States shall be treated as 
income from sources within less developed countries without regard to 
the provisions of subparagraph (1) of this paragraph.
    (3) Payers other than related persons. For purposes of subparagraph 
(1)(ii) of this paragraph, a payer corporation which as to the recipient 
corporation is not a related person as defined in section 954(d)(3) and 
paragraph (e) of Sec. 1.954-1 shall be deemed to have satisfied the 80-
percent gross income requirement if, on the basis of ascertainable 
facts, it is reasonable for the recipient corporation to believe that 
such requirement is satisfied.
    (c) Dividends--(1) In general. Gross income derived by the foreign 
corporation from dividends, as defined in section 316 and the 
regulations thereunder, shall be treated as income from sources within 
less developed countries if, but only if, 80 percent or more of the 
gross income of the payer corporation for the 3-year period ending with 
the close of its annual accounting period in which such dividends are 
distributed, or for such part of such 3-year period as such corporation 
has been in existence, or for such part of such 3-year period as occurs 
on and after the beginning of such corporation's first annual accounting 
period beginning after December 31, 1962, whichever period is shortest, 
was derived from sources within less developed countries as determined 
in accordance with the principles of this section.
    (2) Payers other than related persons. See paragraph (b)(3) of this 
section for rule governing satisfaction of the 80-percent gross income 
requirement by payers other than related persons.
    (d) Sale of tangible personal property--(1) In general. Income 
(whether in the form of profits, commissions, fees, interest, or 
otherwise) derived by the foreign corporation in connection with the 
sale of tangible personal property shall be treated as income from 
sources within less developed countries if, but only if--
    (i) Such property is produced (within the meaning of subparagraph 
(2) of this paragraph) within less developed countries; or
    (ii) Such property is sold for use, consumption, or disposition 
within less developed countries even though produced outside less 
developed countries and the selling corporation is engaged within less 
developed countries, in connection with sales of such property, in 
continuous operational activities which are substantial in relation to 
such sales, as evidenced, for example, by the maintenance within less 
developed countries of a substantial sales or service organization or 
substantial facilities for the storage, handling, transportation, 
assembly, packaging, or servicing of such property.
    (2) Production defined. For purposes of this paragraph, the term 
``produced'' means manufactured, grown, extracted, or constructed and 
includes a substantial transformation of property purchased for resale 
or the manufacture of a product when purchased components

[[Page 363]]

constitute part of the property which is sold. See paragraph (a)(4)(ii) 
and (iii) of Sec. 1.954-3 for a statement and illustration of the 
principles set forth in the preceding sentence.

[T.D. 6683, 28 FR 11183, Oct. 18, 1963, as amended by T.D. 6688, 28 FR 
11632, Oct. 31, 1963]



Sec. 1.955A-1  Shareholder's pro rata share of amount of previously
excluded subpart F income withdrawn from investment in foreign base
company shipping operations.
          

    (a) In general. Section 955 provides rules for determining the 
amount of a controlled foreign corporation's previously excluded subpart 
F income which is withdrawn for any taxable year beginning after 
December 31, 1975, from investment in foreign base company shipping 
operations. Pursuant to section 951(a)(1)(A)(iii) and the regulations 
thereunder, a United States shareholder of such controlled foreign 
corporation must include in his gross income his pro rata share of such 
amount as determined in accordance with paragraph (c) of this section.
    (b) Amount withdrawn by controlled foreign corporation--(1) In 
general. For purposes of sections 951 through 964, the amount of a 
controlled foreign corporation's previously excluded subpart F income 
which is withdrawn for any taxable year from investment in foreign base 
company shipping operations is an amount equal to the decrease for such 
year in such corporation's qualified investments in foreign base company 
shipping operations. Such decrease is, except as provided in Sec. 
1.955A-4--
    (i) An amount equal to the excess of the amount of its qualified 
investments in foreign base company shipping operations at the close of 
the preceding taxable year over the amount of its qualified investments 
in foreign base company shipping operations at the close of the taxable 
year, minus
    (ii) The amount (if any) by which recognized losses on sales or 
exchanges by such corporation during the taxable year of qualified 
investments in foreign base company shipping operations exceed its 
recognized gains on sales or exchanges during such year of qualified 
investments in foreign base company shipping operations,


but only to the extent that the net amount so determined does not exceed 
the limitation determined under subparagraph (2) of this paragraph. See 
Sec. 1.955A-2 for determining the amount of qualified investments in 
foreign base company shipping operations.
    (2) Limitation applicable in determining decreases--(i) In general. 
The limitation referred to in subparagraph (i) of this paragraph for any 
taxable year of a controlled foreign corporation shall be the lesser of 
the following two limitations:
    (A) The sum of (1) the controlled foreign corporation's earnings and 
profits (or deficit in earnings and profits) for the taxable year, 
computed as of the close of the taxable year without diminution by 
reason of any distribution made during the taxable year, (2) the sum of 
its earnings and profits (or deficits in earnings and profits) 
accumulated for prior taxable years beginning after December 31, 1975, 
and (3) the amount described in subparagraph (3) of this paragraph; or
    (B) The sum of the amounts excluded under section 954(b)(2) (see 
subparagraph (4) of this paragraph) from the foreign base company income 
of such corporation for all prior taxable years beginning after December 
31, 1975, minus the sum of the amounts (determined under this paragraph) 
of its previously excluded subpart F income withdrawn from investment in 
foreign base company shipping operations for all such prior taxable 
years.
    (C) For purposes of the immediately preceding subparagrah (B), the 
amount excluded under section 954(b)(2) for a taxable year of a 
controlled foreign corporation (the ``first corporation'') includes (1) 
an amount excluded under section 954(b)(2) by another corporation which 
is a member of a related group (as defined in Sec. 1.955A-3(b)(1)) 
attributable to the first corporation's excess investment (see Sec. 
1.955A-3(c)(4)) for a taxable year beginning after December 31, 1983, 
(2) an amount excluded by a corporation under Sec. 1.954-1(b)(4)(ii)(b) 
by reason of the application of the carryover rule there set forth, and 
(3) an amount equal to the first corporation's

[[Page 364]]

pro rata share of a group excess deduction (see Sec. 1.955A-3(c)(2)) of 
a related group for a taxable year beginning after December 31, 1983 
(but not in excess of that portion of such pro rata share which would 
reduce the first corporation's foreign base company shipping income to 
zero). Such amounts will not be treated as excluded under section 
954(b)(2) by any other corporation.
    (ii) Certain exclusions from earnings and profits. For purposes of 
determining the earnings and profits of a controlled foreign corporation 
under subdivision (i)(A)(1) and (2) of this subparagraph, such earnings 
and profits shall be considered not to include any amounts which are 
attributable to--
    (A)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a)(1)(A)(i), or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a) and have not been distributed; 
or
    (B)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) or would be so included under 
such section but for the fact that such amounts were distributed to such 
shareholder during the taxable year, or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subdivision apply only in determining the limitation 
on a controlled foreign corporation's decrease in qualified investments 
in foreign base company shipping operations. See section 959 and the 
regulations thereunder for rules relating to the exclusion from gross 
income of previously taxed earnings and profits.
    (3) Carryover of amounts relating to investments in less developed 
country shipping companies--(i) In general. The amount described in this 
subparagraph for any taxable year of a controlled foreign corporation 
beginning after December 31, 1975, is the lesser of--
    (A) The excess of the amount described in subdivision (ii) of this 
subparagraph, over the amount described in subdivision (iii) of this 
subparagraph, or
    (B) The limitation determined under subdivision (iv) of this 
subparagraph.
    (ii) Previously excluded subpart F income invested in less developed 
country shipping companies. The amount described in this subdivision for 
all taxable years of a controlled foreign corporation beginning after 
December 31, 1975, is the lesser of--
    (A) The amount of such corporation's qualified investments 
(determined under Sec. 1.955-2 other than paragraph (b)(5) thereof) in 
less developed country shipping companies described in Sec. 1.955-5(b) 
at the close of the last taxable year of such corporation beginning 
before January 1, 1976, or
    (B) The limitation determined under Sec. 1.955-1(b)(2)(i)(b) 
(relating to previously excluded subpart F income) for the first taxable 
year of such corporation beginning after January 1, 1976.
    (iii) Amounts previously carried over. The amount described in this 
subdivision for any taxable year of a controlled foreign corporation 
shall be the sum of the excesses determined for each prior taxable year 
beginning after December 31, 1976, of--
    (A) The amount (determined under this paragraph) of such 
corporation's previously excluded subpart F income withdrawn from 
investment in foreign base company shipping operations, over
    (B) The sum of the earnings and profits determined under 
subparagraph (2)(i)(A)(1) and (2) of this paragraph.
    (iv) Extent attributable to accumulated earnings and profits. The 
limitation determined under this subdivision for any taxable year of a 
controlled foreign corporation is the sum of such controlled foreign 
corporation's earnings and profits (or deficits in earnings and profits) 
accumulated for taxable years beginning after December 31, 1962, and 
before January 1, 1976. For purposes of the preceding sentence, earnings 
and

[[Page 365]]

profits shall be determined by excluding the amounts described in 
subparagraph (2)(ii)(A) and (B) of this paragraph.
    (v) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Throughout the period here involved, A is a United 
States shareholder of controlled foreign corporation M. M is not a 
foreign personal holding company, and M uses the calendar year as the 
taxable year.
    (b) The amount described in this subparagraph for M's taxable year 
1978 with respect to A is determined as follows, based on the facts 
shown in the following table:

(1) Investment in less developed country shipping companies      $10,000
 on December 31, 1975 (subdivision (ii)(A) amount).........
(2) Sec. 1.955-1(b)(2)(i)(b) limitation for 1976                50,000
 (previously excluded subpart F income not withdrawn from
 investment in less developed countries) (subdivision
 (ii)(B) amount)...........................................
(3) Subdivision (ii) amount (lesser of lines (1) and (2))..       10,000
(4) Subdivision (iii) amount: Excess for 1977 of M's               2,000
 previously excluded subpart F income withdrawn from
 investment in foreign base country shipping operations,
 $3,000, over the sum of the amounts determined under
 subparagraphs (2)(i)(A)(1) and (2) of this paragraph,
 $1,000....................................................
                                                            ------------
(5) Excess of line (3) over line (4).......................        8,000
                                                            ============
(6) Sum of M's earnings and profits accumulated for 1962          26,000
 through 1975, determined on December 31, 1978.............
(7) Amount described in this subparagraph for 1978 (lesser         8,000
 of line (5) and line (6)).................................
                                                            ============
 

    (c) For 1978, M's earnings and profits (reduced as provided in Sec. 
1.955-1(b)(2)(ii)(a)(1)) are $19,000, and the amount of M's previously 
excluded subpart F income withdrawn from investment in less developed 
countries determined under Sec. 1.955-1(b)) is $42,000. Consequently, 
$23,000 of M's earnings and profits accumulated for 1962 through 1975 
are attributable to such $42,000 amount, and will therefore be excluded 
under subparagraph (2)(ii))(A)(2) of this paragraph from M's earnings 
and profits accumulated for 1962 through 1975, determined as of December 
31, 1979. No other portion of M's earnings and profits accumulated for 
1962 through 1975 is distributed or included in the gross income of a 
United States shareholder in 1978.
    (d) The amount described in this subparagraph for M's taxable year 
1979 with respect to A is determined as follows, based on the additional 
facts shown in the following table:

(1) Subdivision (ii) amount (line (3) from paragraph (b) of      $10,000
 this example).............................................
(2) Subdivision (iii) amount: (i) Excess for 1977 from line        2,000
 (4) of paragraph (b) of this example......................
 


  (ii) Plus: excess for 1978 of M's previously excluded       0
   subpart F income withdrawn from investment in foreign
   base country shipping operations, $6,000, over the
   sum of the amounts determined under subparagraphs
   (2)(i)(A)(1) and (2) of this paragraph, $25,000......
                                                         -------
 


  (iii) Subdivision (iii) amount...........................        2,000
                                                            ------------
(3) Excess of line (1) over line (2)(iii)..................        8,000
                                                            ============
(4) Sum of M's earnings and profits accumulated for 1962           3,000
 through 1975, determined on December 31, 1979 ($26,000
 minus $23,000)............................................
(5) Amount described in this subparagraph for 1979 (lesser         3,000
 of line (3) and line (4)).................................
                                                            ============
 

    (4) Amount excluded. For purposes of subparagraph (2)(i)(B) of this 
paragraph, the amount excluded under section 954(b)(2) from the foreign 
base company income of a controlled foreign corporation for any taxable 
year beginning after December 31, 1975, is the excess of--
    (i) The amount which would have been equal to the subpart F income 
of such corporation for such taxable year if such corporation had had no 
increase in qualified investments in foreign base company shipping 
operations for such taxable year, over
    (ii) The subpart F income of such corporation for such taxable year.
    (c) Shareholder's pro rata share of amount withdrawn by controlled 
foreign corporation--(1) In general. A United States shareholder's pro 
rata share of a controlled foreign corporation's previously excluded 
subpart F income withdrawn for any taxable year from investment in 
foreign base company shipping operations is his pro rata share of the 
amount withdrawn for such year by such corporation, as determined under 
paragraph (b) of this section. See section 955(a)(3). Such pro rata 
share shall be determined in accordance with the principles of Sec. 
1.195-1(e).
    (2) Special rule. A United States shareholder's pro rata share of 
the net amount determined under paragraph (b)(2)(i)(B) of this section 
with respect to any stock of the controlled foreign corporation owned by 
such shareholder shall be determined without taking into account any 
amount attributable to a period prior to the date on which such 
shareholder acquired such stock.

[[Page 366]]

See section 1248 and the regulations thereunder for rules governing 
treatment of gain from sales or exchanges of stock in certain foreign 
corporations.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 60 percent of the 
only class of stock of M Corporation, a controlled foreign coporation 
throughout the entire period here involved. Both A and M use the 
calendar year as a taxable year. The amount of M's previously excluded 
subpart F income withdrawn for 1978 from investment in foreign base 
company shipping operations is $40,000, and A's pro rata share of such 
amount is $24,000 determined as follows based on the facts shown in the 
following table:

(a) Qualified investments in foreign base company shipping      $125,000
 operations at the close of 1977...........................
(b) Less: qualified investments in foreign base company           75,000
 shipping operations at the close of 1978..................
                                                            ------------
(c) Balance................................................       50,000
(d) Less: excess of recognized losses ($15,000) over              10,000
 recognized gains ($5,000) on sales during 1978 of
 qualified investments in foreign base company shipping
 operations................................................
                                                            ------------
(e) Tentative decrease in qualified investment in foreign         40,000
 base company shipping operations for 1978.................
                                                            ============
(f) Earnings and profits for 1976, 1977, and 1978..........       45,000
(g) Plus: amount determined under paragraph (b)(3) of this             0
 section...................................................
                                                            ------------
(h) Earnings and profits limitation........................       45,000
                                                            ============
(i) Excess of amount excluded under section 954(b)(2) from        50,000
 foreign base company income for 1976 ($75,000) over amount
 of previously excluded subpart F income withdrawn for 1977
 from investment in foreign base company shipping
 operations ($25,000)......................................
(j) M's amount of previously excluded subpart F income            40,000
 withdrawn for 1978 from investment in foreign base company
 shipping operations (item (e), but not to exceed the
 lesser of item (h) or item (i)............................
(k) A's pro rata share of M Corporation's amount of               24,000
 previously excluded subpart F in come withdrawn for 1978
 from investment in foreign base company shipping
 operations (60 percent of $40,000)........................
                                                            ============
 

    Example 2. The facts are the same as in example 1, except that M's 
earnings and profits (determined under paragraph (b)(2) of this section) 
for 1976, 1977, and 1978 (item (f)) are $30,000 instead of $45,000. M's 
amount of previously excluded subpart F income withdrawn for 1978 from 
investment in foreign base company shipping operations is $30,000. A's 
pro rata share of such amount is $18,000 (60 percent of $30,000).
    Example 3. The facts are the same as in example 1, except that the 
excess of the amount excluded under section 954(b)(2) for 1976 from M 
Corporation's foreign base company income over the amount of its 
previously excluded subpart F income withdrawn for 1977 from investment 
in foreign base company shipping operations (item (i)) is $20,000 
instead of $50,000. M's amount of previously excluded subpart F income 
withdrawn for 1978 from investment in foreign base company shipping 
operations is $20,000. A's pro rata share of such amount is $12,000 (60 
percent of $20,000).

[T.D. 7894, 48 FR 22530, May 19, 1983; 48 FR 40888, Sept. 12, 1983]



Sec. 1.955A-2  Amount of a controlled foreign corporation's qualified
investments in foreign base company shipping operations.

    (a) Qualified investments--(1) In general. Under section 955(b), for 
purposes of sections 951 through 964, a controlled foreign corporation's 
``qualified investments in foreign base company shipping operations'' 
are investments in--
    (i) Any aircraft or vessel, to the extent that such aircraft or 
vessel is used (or hired or leased for use) in foreign commerce,
    (ii) Related shipping assets (within the meaning of paragraph (b) of 
this section),
    (iii) Stock or obligations of a related controlled foreign 
corporation, to the extent provided in paragraph (c) of this section,
    (iv) A partnership, to the extent provided in paragraph (d) of this 
section, and
    (v) Stock or obligations of a less developed country shipping 
company described in Sec. 1.955-5(b), as provided in paragraph (h) of 
this section.
    (2) Coordination of provisions. No amount shall be counted as a 
qualified investment in foreign base company shipping operations under 
more than one provision of this section. Thus, for example, if a $10,000 
investment in stock of a controlled foreign corporation is treated as a 
qualified investment in foreign base company shipping operations under 
both subparagraphs (1)(iii) and (v) of this paragraph, then such $10,000 
is counted only once as a qualified investment in foreign base company 
shipping operations.
    (3) Definitions. If the meaning of any term is defined or explained 
in Sec. 1.954-6,

[[Page 367]]

then such term shall have the same meaning when used in this section.
    (4) Extent of use. (i) For purposes of subparagraph (1)(i) of this 
paragraph and paragraph (b)(1) of this section, the extent to which an 
asset of a controlled foreign corporation is used during a taxable year 
in foreign base company shipping operations shall be determined on the 
basis of the proportion for such year which the foreign base company 
shipping income derived from the use of such asset bears to the total 
gross income derived from the use of such asset.
    (ii) For purposes of determining under subdivision (i) of this 
subparagraph the amounts of foreign base company shipping income and 
gross income of a controlled foreign corporation--
    (A) Such amounts shall be deemed to include an arm's length charge 
(see Sec. 1.954-6(h)(5)) for services performed by such corporation for 
itself,
    (B) Such amounts shall be deemed to include an arm's length charge 
for the use of an asset (such as a vessel under construction or laid up 
for repairs) which is held for use in foreign base company shipping 
operations, but is not actually so used,
    (C) Foreign base company shipping income shall be deemed to include 
amounts earned in taxable years beginning before January 1, 1976, and
    (D) The district director shall make such other adjustments to such 
amounts as are necessary to properly determine the extent to which any 
asset is used in foreign base company shipping operations.
    (b) Related shipping assets--(1) In general. For purposes of this 
section, the term ``related shipping asset'' means any asset which is 
used (or held for use) for or in connection with the production of 
income described in Sec. 1.954-6(b)(1)(i) or (ii), but only to the 
extent that such asset is so used (or is so held for use).
    (2) Examples. Examples of assets of a controlled foreign corporation 
which are used (or held for use) for or in connection with the 
production of income described in subparagraph (1) of this paragraph 
include--
    (i) Money, bank deposits, and other temporary investments which are 
reasonably necessary to meet the working capital requirements of such 
corporation in its conduct of foreign base company shipping operations,
    (ii) Accounts receivable and evidences of indebtedness which arise 
from the conduct of foreign base company shipping operations by such 
corporation or by a related person,
    (iii) Amounts (other than amounts described in subdivision (i) of 
this subparagraph) deposited in bank accounts or invested in readily 
marketable securities pursuant to a specific, definite, and feasible 
plan to purchase any tangible asset for use in foreign base company 
shipping operations,
    (iv) Amounts paid into escrow to secure the payment of (A) charter 
hire for an aircraft, vessel, or other asset used in foreign base 
company shipping operations or (B) a debt which constitutes a specific 
charge against such an asset,
    (v) Capitalized expenditures (such as progress payments) made under 
a contract to purchase any asset for use in foreign base company 
shipping operations,
    (vi) Prepaid expense and deferred charges incurred in the course of 
foreign base company shipping operations,
    (vii) Stock acquired and retained to insure a source of supplies or 
services used in the conduct of foreign base company shipping 
operations, and
    (viii) Currency futures acquired and retained as a hedge against 
international currency fluctuations in connection with foreign base 
company shipping operations.
    (3) Limitations--(i) Vessels generally. Notwithstanding any other 
provision of this paragraph, the term ``related shipping assets'' does 
not include any money or other intangible assets of a controlled foreign 
corporation, to the extent that such assets are permitted to accumulate 
in excess of the reasonably anticipated needs of the business.
    (ii) Safe harbor. If a controlled foreign corporation accumulates 
money or other intangible assets pursuant to a plan to purchase one or 
more vessels for use in foreign commerce, and if--
    (A) The amount so accumulated, plus
    (B) The sum of the amounts accumulated by other controlled foreign 
corporations which are related persons (within the meaning of section

[[Page 368]]

954(d)(3)) pursuant to similar plans, does not exceed 110 percent of a 
reasonable down payment on each vessel planned to be purchased within a 
reasonable period, then such plan will be considered to be feasible. For 
purposes of the preceding sentence, a reasonable down payment shall not 
exceed 28 percent of the total cost of acquisition. The determination 
dates applicable to the taxable year of a controlled foreign corporation 
are those set forth in paragraph (c)(2)(ii) of this section. In the case 
of accumulation of assets which do not come within the safe harbor 
limitation of this subdivision (ii), in determining whether such assets 
have accumulated beyond the reasonably anticipated needs of the 
business, factors to be taken into account include, but are not limited 
to, the availability of financing to purchase a vessel and the 
availability of a vessel suitable for the purposes to which the vessel 
is to be put.
    (iii) Other assets. In determining whether a plan to purchase any 
asset other than a vessel for use in foreign base company shipping 
operations is feasible, principles similar to those stated in 
subdivision (ii) of this subparagraph shall be applied.
    (4) Cross-reference. See Sec. 1.954-7(c) for additional 
illustrations bearing on the application of this paragraph.
    (c) Stock and obligations--(1) In general. Investments by a 
controlled foreign corporation (the ``first corporation'') in stock or 
obligations of a second controlled foreign corporation which is a 
related person (within the meaning of section 954(d)(3) are considered 
to be qualified investments in foreign base company shipping operations 
to the extent that the assets of such second corporation are used (or 
held for use) in foreign base company shipping operations. See 
subparagraph (2) of this paragraph. However, an investment in an 
obligation of the second corporation will not be considered a qualified 
investment in foreign base company shipping operations if the obligation 
represents a liability which constitutes a specific charge (nonrecourse 
or otherwise) against an asset of the second corporation which is not 
either--
    (i) An aircraft or vessel used (or held for use) to some extent in 
foreign commerce, or
    (ii) An asset described in paragraphs (a)(1)(ii) through (v) of this 
section.
    (2) Extent of use. On any determination date applicable to a taxable 
year of the first corporation, the extent to which the assets of the 
second corporation are used in foreign base company shipping operations 
shall be determined on the basis of the proportion which the amount of 
such second corporation's qualified investments in foreign base company 
shipping operations bears to its net worth, such proportion to be 
determined at the close of the second corporation's last taxable year 
which ends on or before such determination date. For purposes of the 
preceding sentence--
    (i) A controlled foreign corporation's net worth is the total 
adjusted basis of the corporate assets reduced by the total outstanding 
principal amount of the corporate liabilities, and
    (ii) The determination dates applicable to a taxable year of a 
controlled foreign corporation are--
    (A) Except as provided in (B) of this subdivision, the close of such 
taxable year and the close of the preceding taxable year, and
    (B) With respect to a United States shareholder who has made an 
election under section 955(b)(3) to determine such corporation's 
increase in qualified investments in foreign base company shipping 
operations at the close of the following taxable year, the close of such 
taxable year and the close of the taxable year immediately following 
such taxable year.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. On December 31, 1976, controlled foreign corporation X 
owns 100 percent of the single class of stock of controlled foreign 
corporation Y. X and Y both use the calendar year as the taxable year. 
On December 31, 1976, Y's assets consist of a vessel used in foreign 
commerce, related shipping assets, and other assets unrelated to its 
foreign base company shipping operations. On such date Y has qualified 
investments in foreign base company shipping operations (determined 
under paragraph (g) of this section) of

[[Page 369]]

$60,000, and a net worth of $100,000. If X's investment in the stock of 
Y is $50,000, then $30,000 of such amount, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.012


is a qualified investment in foreign base company shipping operations.
    Example 2. The facts are the same as in example 1, except that on 
December 31, 1976, Y's assets consist entirely of a vessel used in 
foreign commerce and related shipping assets, Y has qualified 
investments in foreign base company shipping operations (determined 
under paragraph (g) of this section) of $16,000 and (therefore) a net 
worth of $16,000. If X's investment in the stock of Y is $50,000, then 
the entire $50,000, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.013


is a qualified investment in foreign base company shipping operations.
    Example 3. On December 31, 1980, controlled foreign corporation J 
owns two notes of controlled foreign corporation K, which is a related 
person (within the meaning of section 954(d)(3)). Both J and K use the 
calendar year as the taxable year. J's adjusted basis in each of the two 
notes is $100,000. The first note is secured only by the general credit 
of K. The second note is secured by (and, therefore, constitutes a 
specific charge on) a hotel owned by K in a foreign country. On December 
31, 1980, K has qualified investments in foreign base company shipping 
operation with an adjusted basis of $500,000 (before applying the rules 
of paragraph (g) of this section). The adjusted basis of all of K's 
corporate assets is $1,100,000. K's only liabilities are the two notes. 
The amount of K's qualified investments in foreign base company shipping 
operations (determined under paragraph (g) of this section) is $450,000. 
K's net worth is $900,000. The amount of J's qualified investment in 
foreign base company shipping operations in respect of the first note is 
$50,000, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.014


The amount of J's qualified investment in respect of the second note is 
zero (see the last sentence of paragraph (c)(1) of this section).

    (d) Partnerships--(1) In general. A controlled foreign corporation's 
investment in a partnership at the close of any taxable year of such 
corporation shall be considered a qualified investment in foreign base 
company shipping operations to the extent of the proportion which such 
corporation's foreign base company shipping income for such taxable year 
would bear to its gross income for such taxable year if--
    (i) Such corporation had realized no income other than its 
distributive share of the partnership gross income, and
    (ii) Such corporation's income were adjusted in accordance with the 
rules stated in paragraphs (a)(4)(ii)(B) and (D) of this section.
    (2) Transitional rule. For purposes of subparagraph (1)(i) of this 
paragraph, the controlled foreign corporation's distributive share of 
the partnership gross income shall not include any amount attributable 
to income earned by the partnership before the first day of such 
corporation's first taxable year beginning after December 31, 1975.
    (3) Cross-reference. See paragraph (g)(4) of this section for rules 
relating to the determination of the amount of a controlled foreign 
corporation's investment in a partnership.
    (e) Trusts--(1) In general. An investment in a trust is not a 
qualified investment in a foreign base company shipping operations.
    (2) Grantor trusts. Notwithstanding subparagraph (1) of this 
pargraph, if a controlled foreign corporation is treated as the owner of 
any portion of a trust under subpart E of part I of subchapter J 
(relating to grantors and others treated as substantial owners), then 
for purposes of this section such controlled foreign corporation is 
deemed to be the actual owner of such portion of the assets of the 
trust. Accordingly, its investments in such assets (as determined under 
paragraph (g)(5) of this section) may be treated as a qualified 
investment in foreign base company shipping operations.
    (3) Definitions. For purposes of this section, the term ``trust'' 
means a trust as defined in Sec. 301.7701-4.
    (f) Excluded property. For purposes of paragraph (a) of this 
section, property acquired principally for the purpose of artificially 
increasing the amount of a controlled foreign corporation's qualified 
investments in foreign base company shipping operations will not be

[[Page 370]]

recognized; whether an item of property is acquired principally for such 
purpose will depend upon all the facts and circumstances of each case. 
One of the factors that will be considered in making such a 
determination with respect to an item of property is whether the item is 
disposed of within 6 months after the date of its acquisition.
    (g) Amount attributable to property--(1) General rule. For purposes 
of this section, the amount taken into account under section 955(b)(4) 
with respect to any property which constitutes a qualified investment in 
foreign base company shipping operations shall be its adjusted basis as 
of the applicable determination date, reduced by the outstanding 
principal amount of any liability (other than a liability described in 
subparagraph (2) of this paragraph) to which such property is subject on 
such date including a liability secured only by the general credit of 
the controlled foreign corporation. Liabilities shall be taken into 
account in the following order:
    (i) The adjusted basis of each and every item of corporate property 
shall be reduced by any specific charge (non-recourse or otherwise) to 
which such item is subject. For this purpose, if a liability constitutes 
a specific charge against several items of property and cannot 
definitely be allocated to any single item of property, the specific 
charge shall be apportioned against each of such items of property in 
that ratio which the adjusted basis of such item on the applicable 
determination date bears to the adjusted basis of all such items on such 
date. The excess against property over the adjusted basis of such 
property shall be taken into account as a liability secured only by the 
general credit of the corporation.
    (ii) A liability which is evidenced by an open account or which is 
secured only by the general credit of the controlled foreign corporation 
shall be apportioned against each and every item of corporate property 
in that ratio which the adjusted basis of such item on the applicable 
determination date (reduced as provided in subdivision (i) of this 
subparagraph) bears to the adjusted basis of all the corporate property 
on such date (reduced as provided in subdivision (i) of this 
subparagraph); provided that no liability shall be apportioned under 
this subdivision against any stock or obligations described in paragraph 
(h)(1) of this section.
    (2) Excluded charges. For purposes of subparagraph (1) of this 
paragraph, a liability created principally for the purpose of 
artificially increasing or decreasing the amount of a controlled foreign 
corporation's qualified investments in foreign base company shipping 
operations will not be recognized. Whether a liability is created 
principally for such purpose will depend upon all the facts and 
circumstances of each case. One of the factors that will be considered 
in making such a determination with respect to a loan is whether the 
loan was both created after November 20, 1974, and is from a related 
person, as defined in section 954(d)(3) and paragraph (e) of Sec. 
1.954-1. Another such factor is whether the liability was created after 
March 29, 1975, in a taxable year beginning before January 1, 1976. For 
purposes of this paragraph (g)(2), payments on liabilities which are 
represented by an open account are credited against the account 
transactions arising earliest in time.
    (3) Statement required. If for purposes of this section the adjusted 
basis of property which constitutes a qualified investment in foreign 
base company shipping operations by a controlled foreign corporation is 
reduced on the ground that such property is subject to a liability, each 
United States shareholder shall attach to his return a statement setting 
forth the adjusted basis of the property before the reduction and the 
amount and nature of the reduction.
    (4) Partnership interest. If a controlled foreign corporation is a 
partner in a partnership, its investment in the partnership taken into 
account under section 955(b)(4) shall be its adjusted basis in the 
partnership determined under section 722 or 742, adjusted as provided in 
section 705, and reduced as provided in subparagraph (1) of this 
paragraph. (However, if the partnership is not engaged solely in the 
conduct of foreign base company shipping operations,

[[Page 371]]

such amount shall be taken into account only to the extent provided in 
paragraph (d)(1) of this section).
    (5) Grantor trust. If a controlled foreign corporation is deemed to 
own a portion of the assets of a trust under paragraph (e)(2) of this 
section then the amount taken into account under section 955 (b)(4) with 
respect to such assets shall be determined as provided in subparagraph 
(1) of this paragraph by the application of the following rules:
    (i) Such controlled foreign corporation's adjusted basis in such 
assets shall be deemed to be a proportionate share of the trust's 
adjusted basis in such assets, and
    (ii) A proportionate share of the liabilities of the trust shall be 
deemed to be liabilities of such controlled foreign corporation and to 
constitute specific charges against such assets.
    (6) Translation into United States dollars. The amounts determined 
in accordance with this paragraph shall be translated into United States 
dollars in accordance with the principles of Sec. 1.964-1(e)(4).
    (h) Investments in shipping companies under prior law--(1) In 
general. If an amount invested in stock or obligations of a less 
developed country shipping company described in Sec. 1.955-5(b) is 
treated as a qualified investment in less developed countries under 
Sec. 1.955-2 (applied without regard to paragraph (b)(5)(ii) thereof) 
on the applicable determination date for purposes of section 954(g) or 
section 955(a)(2) with respect to a taxable year beginning after 
December 31, 1975, then such amount shall be treated as a qualified 
investment in foreign base company shipping operations on such 
determination date. See section 955(b)(5).
    (2) Effect on prior law. See Sec. 1.955-2(b)(5)(ii) for the rule 
that investments which are treated as qualified investments in foreign 
base company shipping operations under subparagraph (1) of this 
paragraph shall not be treated as qualified investments in less 
developed countries for purposes of section 951(a)(1)(A)(ii).
    (3) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) Throughout the period here involved, controlled foreign 
corporation X owns 100 percent of the single class of stock of 
controlled foreign corporation Y, X and Y each use the calendar years as 
the taxable year. At the close of 1975, X's $50,000 investment in the 
stock of Y is treated as a qualified investment in less developed 
countries under Sec. 1.955-2 (applied without regard to Sec. 1.955-
2(b)(5)(ii), and Y is a less developed country shipping company 
described in Sec. 1.955-5(b).
    (b) On December 31, 1976, Y is still a less developed country 
shipping company and X's $50,000 investment in the stock of Y is still 
treated as a qualified investment in less developed countries under 
Sec. 1.955-2 (applied without regard to Sec. 1.955-2(b)(5)(ii). Under 
subparagraph (1) of this paragraph X's entire $50,000 investment in the 
stock of Y is treated as a qualified investment in foreign base company 
shipping operations.
    (c) For 1977, Y's gross income is $10,000 and Y's foreign base 
company shipping income is $7,500. Since Y fails to meet the 80-percent 
income test of Sec. 1.955-5(b)(1), Y is no longer a less developed 
country shipping company described in Sec. 1-955-5(b), and X's 
investment in the stock of Y is no longer treated as a qualified 
investment in less developed countries under Sec. 1.955-2 (applied 
without regard to Sec. 1.955-2(b)(5)(ii). However, assume that on 
December 31, 1977, Y's net worth (as defined in paragraph (c)(2)(1) of 
this section) is $100,000, that Y's qualified investments in foreign 
base company shipping operations (determined under this section) on 
December 31, 1977, are $75,000, and that X's investment in the stock of 
Y (as determined under paragraph (g) of this section) continues to be 
$50,000. Then $67,500, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.015


of X's $50.000 investment in the stock of Y is treated as a qualified 
investment in foreign company shipping operations under paragraph (c) of 
this section.
    (d) For 1978, all of Y's gross income is foreign base company 
shipping income. Although Y is again a less developed country shipping 
company described in Sec. 1.955-5(b), X's investment in the stock of Y 
is no longer treated as a qualified investment in less developed 
countries under Sec. 1.955-2(b)(5)(iii). Thus, X's investment in the 
stock of Y is not treated as a qualified investment in foreign base 
company shipping operations under subparagraph (1) of this paragraph. 
However, X's investment in the stock of Y may be so

[[Page 372]]

treated under another provision of this section, as was the case in item 
(c) of this example.

(Secs. 955 (b)(2) and 7805 of the Internal Revenue Code of 1954 (89 
Stat. 63; 26 U.S.C. 955(b)(2), and 68A Stat. 917; 26 U.S.C. 7805))

[T.D. 7894, 48 FR 22532, May 19, 1983; 48 FR 40888, Sept. 12, 1983, as 
amended by T.D. 7959, 49 FR 22280, May 29, 1984]



Sec. 1.955A-3  Election as to qualified investments by related persons.

    (a) In general. If a United States shareholder elects the benefits 
of section 955(b) 2 with respect to a related group (as defined in 
paragraph (b)(1) of this section) of controlled foreign corporations, 
then an investment in foreign base company shipping operation made by 
one member of such group will be treated as having been made by another 
member to the extent provided in paragraph (c)(4) of this section, and 
each member will be subject to the other provisions of paragraph (c) of 
this section. An election once made shall apply for the taxable year for 
which it is made and for all subsequent years unless the election is 
revoked or a new election is made to add one or more controlled foreign 
corporations to election coverage. For the manner of making an election 
under section 955(b)(2), and for rules relating to the revocation of 
such an election, see paragraph (d) of this section. For rules relating 
to the coordination of sections 955(b)(2) and 955(b)(3), see paragraph 
(e) of this section.
    (b) Related group--(1) Related group defined. The term ``related 
group'' means two or more controlled foreign corporations, but only if 
all of the following requirements are met:
    (i) All such corporations use the same taxable year.
    (ii) The same United States shareholder controls each such 
corporation within the meaning of section 954(d)(3) at the end of such 
taxable year, and
    (iii) Such United States shareholder elects to treat such 
corporations as a related group.
    (iv) If any of the corporations is on a 52-53 week taxable year and 
if all of the taxable years of the corporations end within the same 7-
day period, the rule of paragraph (b)(1)(i) of this section shall be 
deemed satisfied.
    (v) An election under paragraph (b)(1)(iii) of this section will not 
be valid in the case of an election by a U.S. shareholder (the ``first 
U.S. shareholder'') if--
    (A) The first U.S. shareholder controls a second U.S. shareholder,
    (B) The second U.S. shareholder controls one or more controlled 
foreign corporations, and
    (C) Any of the controlled foreign corporations are the subject of 
the election by the first U.S. shareholder, unless the second U.S. 
shareholder consents to the election by the first U.S. shareholder.
    (2) Group taxable years defined. The ``group taxable year'' is the 
common taxable year of a related group.
    (3) Limitation. If a United States shareholder elects to treat two 
or more corporations as a related group for a group taxable year (the 
``first group taxable year''), then such United States shareholder (and 
any other United States shareholder which is controlled by such 
shareholder) may not also elect to treat two or more other corporations 
as a related group for a group taxable year any day of which falls 
within the first group taxable year.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M owns 100 percent of the only class 
of stock of controlled foreign corporations A, B, C, D, and E. A, B, and 
C use the calendar year as the taxable year. D and E use the fiscal year 
ending on June 30 as the taxable year. M may elect to treat A, B and C 
as a related group. However, M may not elect to treat C, D, and E as a 
related group.
    Example 2. The facts are the same as in example 1. In addition, M 
elects to treat A, B, and C as a related group for the group taxable 
year which ends on December 31, 1976. M may not also elect to treat D 
and E as a related group for the group taxable year ending on June 30, 
1977.
    Example 3. United States shareholder A owns 60 percent of the only 
class of stock of controlled foreign corporation X and 40 percent of the 
only class of stock of controlled foreign corporation Y. United States 
shareholder B owns the other 40 percent of the stock of X and the other 
60 percent of the stock of Y. Neither A nor B (nor both together) may 
elect to treat X and Y as a related group.


[[Page 373]]


    (c) Effect of election. If a United States shareholder elects to 
treat two or more controlled foreign corporations as a related group for 
any group taxable year then, for purposes of determining the foreign 
base company income (see Sec. 1.954-1) and the increase or decrease in 
qualified investments in foreign base company shipping operations (see 
Sec. Sec. 1.954-7. 1.955A-1, and 1.955A-4) of each member of such group 
for such year, the following rules shall apply:
    (1) Intragroup dividends. The gross income of each member of the 
related group shall be deemed not to include dividends received from any 
other member of such group, to the extent that such dividends are 
attributable (within the meaning of Sec. 1.954-6(f)(4)) to foreign base 
company shipping income. In determining net foreign base company 
shipping income, deductions allocable to intragroup dividends 
attributable to foreign base company shipping income shall not be 
allowed.
    (2) Group excess deduction. (i) The deductions allocable under Sec. 
1.954-1(c) to the foreign base company shipping income of each member of 
the related group shall be deemed to include such member's pro rata 
share of the group excess deduction.
    (ii) The group excess deduction for the group taxable year is the 
sum of the excesses for each member of the related group (having an 
excess) of--
    (A) The member's deductions (determined without regard to this 
subparagraph) allocable to foreign base company shipping income for such 
year, over
    (B) The member's foreign base company shipping income for such year.
    (iii) A member's pro rata share of the group excess deduction is the 
amount which bears the same ratio to such group excess deduction as--
    (A) The excess of such member's foreign base company shipping income 
over the deductions (so determined) allocable thereto, bears to
    (B) The sum of such excesses for each member of the related group 
having an excess.
    (iv) For purposes of this subparagraph, ``foreign base company 
shipping income'' means foreign base company shipping income (as defined 
in Sec. 1.954-6), reduced by excluding therefrom all amounts which 
are--
    (A) Excluded from subpart F income under section 952(b) (relating to 
exclusion of United States income) or
    (B) Excluded from foreign base company income under section 
954(b)(4) (relating to exception for foreign corporation not availed of 
to reduce taxes).
    (v) The application of this subparagraph may be illustrated by the 
following example:

    Example. Controlled foreign corporations X, Y, and Z are a related 
group for calendar year 1976. The excess group deduction for 1976 is $9, 
X's pro rata share of the group excess deduction is $6, and Y's pro rata 
share is $3, determined as follows on the basis of the facts shown in 
the following table:

------------------------------------------------------------------------
                                               X      Y      Z     Group
------------------------------------------------------------------------
(1) Gross shipping income.................    $100    $90    $90
(2) Shipping deductions...................      60     70     80
(3) Net shipping income...................      40     20    (9)
(4) Group excess deduction................  ......  .....  .....      80
(5) X's pro rata share of group excess           6
 deduction ($9 x $40/$60).................
(6) Y's pro rata share of group excess      ......      3  .....  ......
 deduction ($9 x $20/$60).................
------------------------------------------------------------------------

    (3) Intragroup investments. On both of the determination dates 
applicable to the group taxable year for purposes of section 954(g) or 
section 955(a)(2), the qualified investments in foreign base company 
shipping operations of each member of the related group shall be deemed 
not to include stock of any other member of the related group. In 
addition, neither the gains nor the losses on dispositions of such stock 
during the group taxable year shall be taken into account under Sec. 
1.955A-1(b)(1)(ii) in determining the decrease in qualified investments 
in foreign base company shipping operations of any member of such 
related group.
    (4) Group excess investment. (i) On the later (and only the later) 
of the two determination dates applicable to the group taxable year for 
purposes of section 954(g) or section 955(a)(2), the qualified 
investments in foreign base company shipping operations of each member 
of the related group shall be deemed to include such member's pro rata 
share of the group excess investment.

[[Page 374]]

    (ii) The group excess investment for the group taxable year is the 
sum of the excess for each member of the related group (having an 
excess) of--
    (A) The member's increase in qualified investments in foreign base 
company shipping operations (determined under Sec. 1.954-7 after the 
application of subparagraph (3) of this paragraph) for such year, over
    (B) The member's foreign base company shipping income for such year.
    (iii) A member's pro rata share of the group excess investment is 
the amount which bears the same ratio to such group excess investment 
as--
    (A) Such member's shortfall, in qualified investments bears to
    (B) the sum of the shortfalls in qualified investments of each 
member of such related group having a shortfall.
    (iv) If a member has an increase in qualified investments in foreign 
base company shipping operations (determined as provided in Sec. 1.954-
7 after the application of subparagraph (3) of this paragraph) for the 
group taxable year, then such member's ``shortfall in qualified 
investments'' is the excess of--
    (A) Such member's foreign base company shipping income for such 
year, over
    (B) Such increase.
    (v) If a member has a decrease in qualified investments in foreign 
base company shipping operations (determined under Sec. 1.955A-1(b)(1) 
or Sec. 1.955A-4(a), whichever is applicable, after the application of 
subparagraph (3) of this paragraph) for the group taxable year, then 
such member's ``shortfall in qualified investments'' is the sum of--
    (A) Such member's foreign base company shipping income for such year 
and
    (B) Such decrease.
    (vi) For purposes of this subparagraph, ``foreign base company 
shipping income'' means foreign base company shipping income (as defined 
in subparagraph (2)(iv) of this paragraph), reduced by the deductions 
allocable thereto under Sec. 1.954-1(c) (including the additional 
deductions described in subparagraph (2) of this paragraph).
    (vii) The application of paragraphs (c)(1), (3), and (4) of this 
section may be illustrated by the following example:

    Example. (a) Controlled foreign corporations R, S, and T are a 
related group for calendar year 1977. R and S do not own the stock of 
any member of the related group.
    (b) On December 31, 1977, T has qualified investments in foreign 
base company shipping operations (determined without regard to 
paragraphs (c)(3) and (4)) of $105, of which $15 consists of stock of S. 
After application of paragraph (c)(3) (but before application of 
paragraph (c)(4)), on December 31, 1977, T has qualified investments in 
foreign base company shipping operations of $90, determined as follows:

(1) Qualified investments (determined without regard to             $105
 paragraph (c)(3)) on December 31, 1977.........................
(2) Less: Qualified investments in stock of another member of a       15
 related group (as required by paragraph (c)(3))................
                                                                 -------
(3) Balance.....................................................      90
 

    (c) During 1977, T's foreign base company shipping income is $180, 
determined without regard to paragraph (c)(1). Included in the $180 is 
$5 in dividends in respect of T's stock in S. During 1977, T has 
shipping deductions of $91. Of T's shipping deductions, $1 is allocable 
to the dividends from S. After application of paragraph (c)(1), T's net 
shipping income during 1977 is $85, determined as follows:

(1) Foreign base company shipping income.................  .....    $180
(2) Less: intragroup dividends (as required by paragraph   .....       5
 (c)(1)).................................................
                                                                 -------
(3) Balance..............................................  .....     175
(4) Shipping deductions..................................    $91
(5) Less: deductions allocable to intragroup dividends         1
 (as required by paragraph (c)(1)).......................
                                                          -------
(6) Balance..............................................     90
(7) Net shipping income (line (3) minus line (6))........  .....      85
 

    (d) During 1977 (without regard to paragraph (c)(4)), R's increase 
in qualified investments in foreign base company shipping operations is 
$120; S's decrease is $55; and T's increase is $35, determined on the 
basis of the facts shown in the following table. In all cases, the 
listed amounts of qualified investments on December 31, 1976, reflect 
any adjustments required by paragraph (c)(3) for 1976, but not any 
adjustment required by paragraph (c)(4) for 1976 (see Sec. Sec. 1.955A-
3 (c)(3) and (4)(i)).

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Qualified investments on December 31, 1977 (in    $220   $150    $90
 the case of T, taken from line (3) of part (b) of
 this example).....................................
(2) Qualified investments on December 31, 1976.....    100    205     55
                                                    --------------------
(3) Increase (decrease) (line (1) minus line (2))..    120   (55)     35
------------------------------------------------------------------------

    (e) In 1977, R's net shipping income is $100; S's is $95; and T's is 
$85, determined as follows:

[[Page 375]]



------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Gross foreign base company shipping income (in    $200   $180   $175
 the case of T, taken from line (3) of part (c) of
 this example).....................................
(2) Shipping deductions (in the case of T, taken       100     85     90
 from line (6) of part (c) of this example)........
                                                    --------------------
(3) Net shipping income (line (1) minus line (2))..    100     95     85
------------------------------------------------------------------------

    (f) By application of paragraph (c)(4) for 1977, S's pro rata share 
of the group excess investment is $15, and T's pro rata share is $5, 
determined as follows:

------------------------------------------------------------------------
                                               R      S      T     Group
------------------------------------------------------------------------
(1) Net shipping income (taken from line      $100    $95    $85
 (3) of part (e) of this example).........
(2) Increase (decrease) in qualified           120   (55)     35
 investments (taken from line (3) of part
 (d) of this example).....................
(3) Excess investment.....................      20  .....  .....     $20
(4) Shortfall.............................  ......    150     50     200
(5) S's pro rata share of group excess      ......     15
 investment ($20 x $150/$200).............
(6) T's pro rata share of group excess      ......  .....      5  ......
 investment ($20 x $50/$200)..............
------------------------------------------------------------------------

    (g) After application of paragraph (c)(4), for purposes of 
determining their increase or decrease in qualified investments in 
foreign base company shipping operations for 1977, on December 31, 1977, 
the amount of R's qualified investments is $200; the amount of S's is 
$165; and the amount of T's is $95, determined as follows:

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Qualified investments on December 31, 1977        $220   $150    $90
 (taken from line (1) of part (d) of this example).
(2) Plus: pro rata share of group excess investment  .....     15      5
 (as required by paragraph (c)(4)) (taken from
 lines (5) and (6) of part (f) of this example)....
(3) Minus: Excess investment treated as investments     20
 of related group members (taken from line (3) of
 part (f) of this example).........................
                                                    --------------------
(4) Total qualified investments....................    200    165     95
------------------------------------------------------------------------

    (h) After application of paragraph (c)(1), (3), and (4), during 
1977, R's increase in qualified investments in foreign base company 
shipping operations is $100; S's decrease is $40; and T's increase is 
$40, determined as set forth in the table below. In all cases, the 
listed amounts of qualified investments on December 31, 1976, reflect 
any similar adjustments required by paragraph (c)(3) for 1976, but not 
any adjustment required by paragraph (c)(4) for 1976 (see Sec. 1.955A-
3(c)(3) and (4)(i)).

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Qualified investments on December 31, 1977        $200   $165    $95
 (taken from line (4) of part (g) of this example).
(2) Qualified investments on December 31, 1976 (see    100    205     55
 line (2) of part (d) of this example).............
                                                    --------------------
(3) Increase (decrease) (line (1) minus line (2))..    100   (40)     40
------------------------------------------------------------------------

    (5) Collateral effect. (i) An election under this section by a 
United States shareholder to treat two or more controlled foreign 
corporations as a related group for a group taxable year shall have no 
effect on--
    (A) Any other United States shareholder (including a minority 
shareholder of a member of such related group).
    (B) Any other controlled foreign corporation, and
    (C) The foreign personal holding company income, foreign base 
company sales income, and foreign base company services income, and the 
deductions allocable under Sec. 1.954-1(c) thereto, of any member of 
such related group.
    (ii) See Sec. 1.952-1(c)(2)(ii) for the effect of an election under 
this section on the computation of earnings and profits and deficits in 
earnings and profits under section 952 (c) and (d).
    (iii) The application of this subparagraph may be illustrated by the 
following example:

    Example. United States shareholder A owns 80 percent of the only 
class of stock of controlled foreign corporations X and Y. United States 
shareholder B owns the other 20 percent of the stock of X and Y. X and Y 
both use the calendar year as the taxable year. A elects to treat X and 
Y as a related group for 1977. For purposes of determining the amounts 
includible in B's gross income under section 951(a) in respect of X and 
Y, the election made by A shall be disregarded and all of B's 
computations shall be made without regard to this section, as 
illustrated in Sec. 1.952-3(d).

    (d) Procedure--(1) Time and manner of making election. A United 
States shareholder shall make an election under this section to treat 
two or more controlled foreign corporations as a related group for a 
group taxable year

[[Page 376]]

and subsequent years by filing a statement to such effect with the 
return for the taxable year within which or with which such group 
taxable year ends. The statement shall include the following 
information:
    (i) The name, address, taxpayer identification number, and taxable 
year of the United States shareholder;
    (ii) The name, address, and taxable year of each controlled foreign 
corporation which is a member of the related group and is to be subject 
to the election; and
    (iii) A schedule showing the calculations by which the amounts 
described in this section have been determined for the taxable year for 
which the election is first effective. With respect to each subsequent 
taxable year to which the election applies, a new schedule showing 
calculations of such amounts for that taxable year must be filed with 
the return for that taxable year. A consent to an election required by 
paragraph (b)(1)(v) of this section shall include the same information 
required for the election statement.
    (2) Revocation. (i) Except as provided in subdivision (ii) of this 
subparagraph, an election under this section by a United States 
shareholder shall be binding for the group taxable year for which it is 
made and for subsequent years.
    (ii) Upon application by the United States shareholder (and any 
other United States shareholder controlled by such shareholder which 
consented under paragraph (b)(1)(v) of this section to the election), an 
election made under this section may, subject to the approval of the 
Commissioner, be revoked. An application to revoke the election, as of a 
specified group taxable year, with respect to one or more (but not all) 
controlled foreign corporations, subject to an election shall be deemed 
to be an application to revoke the election. Approval will not be 
granted unless a material and substantial change in circumstances occurs 
which could not have been anticipated when the election was made. The 
application for consent to revocation shall be made by mailing a letter 
for such purpose to Commissioner of Internal Revenue, Attention: T:C:C, 
Washington, DC 20224, containing a statement of the facts which justify 
such consent. If a member of a related group subject to an election 
ceases to meet the requirements of paragraph (b) of this section for 
membership in the group by reason of any action taken by it or any 
member of the group or the electing United States shareholder, then the 
election will be deemed to be revoked as of the beginning of the taxable 
year in which such action occurred. If such action is taken principally 
for the purpose of revoking the election without applying for and 
obtaining the approval of the Commissioner to the revocation, then no 
further election covering any member of that related group may be made 
by any United States shareholder for the remainder of the taxable year 
in which the action occurred and the five succeeding taxable years.
    (e) Coordination with section 955(b)(3). If a United States 
shareholder elects under this section to treat two or more controlled 
foreign corporations as a related group for any taxable year, and if 
such United States shareholder is required under Sec. 1.955A-4(c)(2) 
for purposes of filing any return to estimate the qualified investments 
in foreign base company shipping operations of any member of such group, 
then such United States shareholder shall, for purposes of filing such 
return, determine the amount includible in his gross income in respect 
of each member of such related group on the basis of such estimate. If 
the actual amount of such investments is not the same as the amount of 
the estimate, the United States shareholder shall immediately notify the 
Commissioner. The Commissioner will thereupon redetermine the amount of 
tax of such United States shareholder for the year or years with respect 
to which the incorrect amount was taken into account. The amount of tax, 
if any, due upon such redetermination shall be paid by the United States 
shareholder upon notice and demand by the district director. The amount 
of tax, if any, shown by such redetermination to have been overpaid 
shall be credited or refunded to the United States shareholder in 
accordance with the provisions of sections 6402 and 6511 and the 
regulations thereunder. If a United States shareholder elects under

[[Page 377]]

this section and if the United States shareholder has made an election 
under section 955(b)(3) as to at least one member of the related group, 
then the qualified investment amounts necessary for the calculations of 
paragraphs (c)(3) and (4) of this section shall be obtained, for each 
member of the related group, as of the determination dates applicable to 
each of the members.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. (a) Controlled foreign corporations X and Y are wholly 
owned subsidiaries of domestic corporation M, X and Y use the calendar 
year as the taxable year. For 1977, X and Y are not export trade 
corporations (as defined in section 971(a)), nor have they any income 
derived from the insurance of United States risks (within the meaning of 
section 963(a)). M does not elect to treat X and Y as a related group 
for 1977.
    (b) For 1977, X and Y each have gross income (determined as provided 
in Sec. 1.951-6(h)(1)) of $1,000. X's foreign base company income is 
$20 and Y's foreign base company imcome is $0, determined as follows, 
based on the facts shown in the following table:

------------------------------------------------------------------------
                                                          X         Y
------------------------------------------------------------------------
(1) Foreign lease company shipping income...........    $1,000    $1,000
(2) Less: amounts excluded from subpart F income             0         0
 under section 952(b) (relating to U.S. income) and
 amounts excluded from foreign base company income
 under section 945(b)(4) (relating to corporation
 not availed of to reduce taxes)....................
                                                     -------------------
(3) Balance.........................................     1,000     1,000
(4) Less: deductions allocable under Sec. 1.954-         800     1,040
 1(c) to balance....................................
                                                     -------------------
(5) Remaining balance...............................       200         0
                                                     ===================
(6) Less: Increase in qualified investments in             180
 foreign base company shipping operations...........
                                                     -------------------
(7) Foreign base company income.....................        20  ........
------------------------------------------------------------------------

    (c) For 1977, Y has a withdrawal of previously excluded Subpart F 
income from investment in foreign base company shipping operations of 
$20, determined as follows, on the basis of the facts shown in the 
following table:

(1) Qualified investments in foreign base company shipping        $1,210
 operations at December 31, 1976..............................
(2) Less: qualified investments in foreign base company            1,170
 shipping operations at December 31, 1977.....................
                                                               ---------
(3) Balance...................................................        40
(4) Less: excess of recognized losses over recognized gains on        20
 sales during 1977 of qualified investments in foreign base
 company shipping operations..................................
                                                               ---------
(5) Tentative decrease in qualified investments in foreign            20
 base company shipping operations for 1977....................
                                                               =========
(6) Limitation described in Sec. 1.955A-1(b)(2).............       160
(7) Y's amount of previously excluded subpart F income                20
 withdrawn from investment in foreign base company shipping
 operations (lesser of lines (5) and (6)).....................
                                                               =========
 

    Example 2. (a) The facts are the same as in example 1, except that M 
does elect to treat X and Y as a related group for 1977.
    (b) The group excess deduction, which is solely attributable to Y's 
net shipping loss, is $40 (i.e., $1,040-$1,000). Since X is the only 
member of the related group with net shipping income, X's pro rata share 
of the group excess deduction is the entire $40 amount.
    (c) X's foreign base company income for 1977 is zero, determined as 
follows:

(1) Preliminary net foreign base company shipping income (line      $200
 (b)(5) of example 1).........................................
(2) Less: X's pro rata share of group excess deduction........        40
                                                               ---------
(3) Remaining balance.........................................       160
(4) Less: increase in qualified investments in foreign base          180
 company shipping operations..................................
                                                               ---------
(5) Foreign base company income...............................         0
                                                               =========
 

    (d) The group excess investment, which is solely attributable to X's 
excess investment, is $20 (i.e., $180 minus $160). Since Y is the only 
member of the related group with a shortfall in qualified investments, 
Y's share of the group excess investment is the entire $20 amount.
    (e) During 1976 and 1977, Y owns no stock of X. Y's withdrawal of 
previously excluded subpart F income from investment in foreign base 
company shipping operations for 1977 is zero, determined as follows:

(1) Qualified investments at December 31, 1976................    $1,210
(2)(i) Qualified investments at December 31, 1977 (determined      1,170
 without regard to paragraph (c)(4) of this section)..........
  (ii) Y's pro rata share of group excess investment..........        20
                                                               ---------
  (iii) Total qualified investments at December 31, 1977 (Line     1,190
   (i) plus line (ii).........................................
                                                               ---------
(3) Balance (line (1) minus line (2)(iii).....................        20
(4) Less: excess of recognized losses over recognized gains on        20
 sales during 1977 of qualified investments in foreign base
 company shipping operations..................................
                                                               ---------
(5) Decrease in qualified investments for 1977................         0
                                                               =========
 


[[Page 378]]


(Secs. 955 (b)(2) and 7805 of the Internal Revenue Code of 1954 (89 
Stat. 63; 26 U.S.C. 955(b)(2), and 68A Stat. 917; 26 U.S.C. 7805))

[T.D. 7894, 48 FR 22535, May 19, 1983; 48 FR 40888, Sept. 12, 1983, as 
amended by T.D. 7959, 49 FR 22280, May 29, 1984]



Sec. 1.955A-4  Election as to date of determining qualified investmen
t in foreign base company shipping operations.

    (a) Nature of election. In lieu of determining the increase under 
the provisions of section 954(g) and Sec. 1.954-7(a) or the decrease 
under the provisions of section 955(a)(2) and Sec. 1.955A-1(b) in a 
controlled foreign corporation's qualified investments in foreign base 
company shipping operations for a taxable year in the manner provided in 
such provisions, a United States shareholder of such controlled foreign 
corporation may elect, under the provisions of section 955(b)(3) and 
this section, to determine such increase in accordance with the 
provisions of Sec. 1.954-7(b) and to determine such decrease by 
ascertaining the amount by which--
    (1) Such controlled foreign corporation's qualified investments in 
foreign base company shipping operations at the close of such taxable 
year exceed its qualified investments in foreign base company shipping 
operations at the close of the taxable year immediately following such 
taxable year, and reducing such excess by
    (2) The amount determined under Sec. 1.955A-1(b)(1)(ii) for such 
taxable year subject to the limitation provided in Sec. 1.995A-1(b)(2) 
for such taxable year. An election under this section may be made with 
respect to each controlled foreign corporation with respect to which a 
person is a United States shareholder within the meaning of section 
951(b), but the election may not be exercised separately with respect to 
the increases and the decreases of such controlled foreign corporation. 
If an election is made under this section to determine the increase of a 
controlled foreign corporation in accordance with the provisions of 
Sec. 1.954-7(b), subsequent decreases of such controlled foreign 
corporation shall be determined in accordance with this paragraph and 
not in accordance with Sec. 1.955A-1(b).
    (b) Time and manner of making election--(1) Without consent. An 
election under this section with respect to a controlled foreign 
corporation shall be made without the consent of the Commissioner by a 
United States shareholder's filing a statement to such effect with his 
return for his taxable year in which or with which ends the first 
taxable year of such controlled foreign corporation in which--
    (i) Such shareholder is a United States shareholder, and
    (ii) Such controlled foreign corporation realizes foreign base 
company shipping income, as defined in Sec. 1.954-6.


The statement shall contain the name and address of the controlled 
foreign corporation and identification of such first taxable year of 
such corporation.
    (2) With consent. An election under this section with respect to a 
controlled foreign corporation may be made by a United States 
shareholder at any time with the consent of the Commissioner. Consent 
will not be granted unless the United States shareholder and the 
Commissioner agree to the terms, conditions, and adjustments under which 
the election will be effected. The application for consent to elect 
shall be made by the United States shareholder's mailing a letter for 
such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute an amount described in section 
954(b)(2) in accordance with the election provided in this section. The 
application shall include the following information.
    (i) The name, address, and taxpayer identification number, and 
taxable year of the United States shareholder;
    (ii) The name and address of the controlled foreign corporation;
    (iii) The first taxable year of the controlled foreign corporation 
for which income is to be computed under the election;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in foreign base company shipping operations at the close of 
its preceding taxable year; and
    (v) The sum of the amounts excluded under section 954(b)(2) and 
Sec. 1.954-1(b)(1) from the foreign base company income

[[Page 379]]

of the controlled foreign corporation for all prior taxable years during 
which such shareholder was a United States shareholder of such 
corporation and the sum of the amounts of its previously excluded 
subpart F income withdrawn from investment in foreign base company 
shipping operations for all prior taxable years during which such 
shareholder was a United States shareholder of such corporation.
    (c) Effect of election--(1) General. Except as provided in 
subparagraphs (3) and (4) of this paragraph, an election under this 
section with respect to a controlled foreign corporation shall be 
binding on the United States shareholder and shall apply to all 
qualified investments in foreign base company shipping operations 
acquired, or disposed of, by such controlled foreign corporation during 
the taxable year following its taxable year for which income is first 
computed under the election and during all succeeding taxable years of 
such corporation.
    (2) Returns. Any return of a United States shareholder required to 
be filed before the completion of a period with respect to which 
determinations are to be made as to a controlled foreign corporation's 
qualified investments in foreign base company shipping operations for 
purposes of computing such shareholder's taxable income shall be filed 
on the basis of an estimate of the amount of the controlled foreign 
corporation's qualified investments in foreign base company shipping 
operations at the close of the period. If the actual amount of such 
investments is not the same as the amount of the estimate, the United 
States shareholder shall immediately notify the Commissioner. The 
Commissioner will thereupon redetermine the amount of tax of such United 
States shareholder for the year or years with respect to which the 
incorrect amount was taken into account. The amount of tax, if any, due 
upon such redetermination shall be paid by the United States shareholder 
upon notice and demand by the district director. The amount of tax, if 
any, shown by such redetermination to have been overpaid shall be 
credited or refunded to the United States shareholder in accordance with 
the provisions of sections 6402 and 6511 and the regulations thereunder.
    (3) Revocation. Upon application by the United States shareholder, 
the election made under this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless the United 
States shareholder and the Commissioner agree to the terms, conditions, 
and adjustments under which the revocation will be effected. Unless such 
agreement provides otherwise, the change in the controlled foreign 
corporation's qualified investments in foreign base company shipping 
operations for its first taxable year for which income is computed 
without regard to the election previously made will be considered to be 
zero for purposes of effectuating the revocation. The application for 
consent to revocation shall be made by the United States shareholder's 
mailing a letter for such purpose to the Commissioner of Internal 
Revenue, Washington, DC 20224. The application shall be mailed before 
the close of the first taxable year of the controlled foreign 
corporation with respect to which the shareholder desires to compute the 
amounts described in section 954(b)(2) or 955(a) without regard to the 
election provided in this section. The application shall include the 
following information:
    (i) The name, address, and taxpayer identification number of the 
United States shareholder:
    (ii) The name and address of the controlled foreign corporation;
    (iii) The taxable year of the controlled foreign corporation for 
which such amounts are to be computed;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in foreign base company shipping operations at the close of 
its preceding taxable year;
    (v) The sum of the amounts excluded under section 954(b)(2) and 
Sec. 1.954-1(b)(1) from the foreign base company income of the 
controlled foreign corporation for all prior taxable years during which 
such shareholder was a United States shareholder of such corporation and 
the sum of the amounts of its previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations 
for

[[Page 380]]

all prior taxable years during which such shareholder was a United 
States shareholder of such corporation; and
    (vi) The reasons for the request for consent to revocation.
    (4) Transfer of stock. If during any taxable year of a controlled 
foreign corporation--
    (i) A United States shareholder who has made an election under this 
section with respect to such controlled foreign corporation sells, 
exchanges, or otherwise disposes of all or part of his stock in such 
controlled foreign corporation, and
    (ii) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange, or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
change in the controlled foreign corporation's qualified investments in 
foreign base company shipping operations for such taxable year shall be 
considered to be zero. If the United States shareholder's successor in 
interest is entitled to and does make an election under paragraph (b)(1) 
of this section to determine the controlled foreign corporation's 
increase in qualified investments in foreign base company shipping 
operations for the taxable year in which he acquires such stock, such 
increase with respect to the stock so acquired shall be determined in 
accordance with the provisions of Sec. 1.954-7(b)(1). If the controlled 
foreign corporation realizes no foreign base company income from which 
amounts are excluded under section 954(b)(2) and Sec. 1.954-1(b)(1) for 
the taxable year in which the United States shareholder's successor in 
interest acquires such stock and such successor in interest makes an 
election under paragraph (b)(1) of this section with respect to a 
subsequent taxable year of such controlled foreign corporation, the 
increase in the controlled foreign corporation's qualified investments 
in foreign base company shipping operations for such subsequent taxable 
year shall be determined in accordance with the provisions of Sec. 
1.954-7(b)(2).
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Foreign corporation A is a wholly owned subsidiary of 
domestic corporation M. Both corporations use the calendar year as a 
taxable year. In a statement filed with its return for 1977, M makes an 
election under section 955(b)(3) and the election remains in force for 
the taxable year 1978. At December 31, 1978, A's qualified investments 
in foreign base company shipping operations amount to $100,000; and, at 
December 31, 1979, to $80,000. For purposes of paragraph (a)(1) of this 
section, A Corporation's decrease in qualified investments in foreign 
base company shipping operations for the taxable year 1978 is $20,000 
and is determined by ascertaining the amount by which A Corporation's 
qualified investments in foreign base company shipping operations at 
December 31, 1978 ($100,000) exceed its qualified investments in foreign 
base company shipping operations at December 31, 1979 ($80,000).
    Example 2. The facts are the same as in example 1 except that A 
experiences no changes in qualified investments in foreign base company 
shipping operations during its taxable years 1980 and 1981. If M's 
election were to remain in force, A's acquisitions and dispositions of 
qualified investments in foreign base company shipping operations during 
A's taxable year 1982 would be taken into account in determining whether 
A has experienced an increase or a decrease in qualified investments in 
foreign base company shipping operations for its taxable year 1981. 
However, M duly files before the close of A's taxable year 1981 as 
application for consent to revocation of M Corporation's election under 
section 955(b)(3), and, pursuant to an agreement between the 
Commissioner and M, consent is granted by the Commissioner. Assuming 
such agreement does not provide otherwise, A's change in qualifed 
investments in foreign base company shipping operations for its taxable 
year 1981 is zero because the effect of the revocation of the election 
is to treat acquisitions and dispositions of qualified investments in 
foreign base company shipping operations actually occurring in 1982 as 
having occurred in such year rather than in 1981.
    Example 3. The facts are the same as in example 2 except that A's 
qualified investments in foreign base company shipping operations at 
December 31, 1982, amount to $70,000. For purposes of paragraph 
(b)(1)(i) of Sec. 1.955A-1, the decrease in A's qualified investments 
in foreign base company shipping operations for the taxable year 1982 is 
$10,000 and is determined by ascertaining the amount by which A's 
qualified investments in foreign base company shipping operations at 
December 31, 1981 ($80,000) exceed its qualified investments in foreign 
base company shipping operations at December 31, 1982 ($70,000).
    Example 4. The facts are the same as in example 1. Assume further 
that on September

[[Page 381]]

30, 1979, M sells 40 percent of the only class of stock of A to N 
Corporation, a domestic corporation. N uses the calendar year as a 
taxable year. A remains a controlled foreign corporation immediately 
after such sale of its stock. A's qualified investments in foreign base 
company shipping operations at December 31, 1980, amount to $90,000. The 
changes in A Corporation's qualified investments in foreign base company 
shipping operations occurring in its taxable year 1979 are considered to 
be zero with respect to the 40-percent stock interest acquired by N 
Corporation. The entire $20,000 reduction in A Corporation's qualified 
investments in foreign base company shipping operations which occurs 
during the taxable year 1979 is taken into account by M for purposes of 
paragraph (c)(1) of this section in determining its tax liability for 
the taxable year 1978. A's increase in qualified investments in foreign 
base company shipping operations for the taxable year 1979 with respect 
to the 60-percent stock interest retained by M is $6,000 and is 
determined by ascertaining M's pro rata share (60 percent) of the amount 
by which A's qualified investments in foreign base company shipping 
operations at December 31, 1980 ($90,000) exceed its qualified 
investments in foreign base company shipping operations at December 31, 
1979 ($80,000). N does not make an election under section 955(b)(3) in 
its return for its taxable year 1980. Corporation A's increase in 
qualified investments in foreign base company shipping operations for 
the taxable year 1980 with respect to the 40-percent stock interest 
acquired by N is $4,000.

[T.D. 7894, 48 FR 22539, May 19, 1983]



Sec. 1.956-1  Shareholder's pro rata share of the average of the
amounts of United States property held by a controlled foreign 
corporation.

    (a) Overview and scope--(1) In general. Subject to the provisions of 
section 951(a) and the regulations in this part, a United States 
shareholder of a controlled foreign corporation is required to include 
in gross income the amount determined under section 956 with respect to 
the shareholder for the taxable year but only to the extent not excluded 
from gross income under section 959(a)(2) and the regulations in this 
part.
    (2) Reduction for certain United States shareholders--(i) In 
general. For a taxable year of a controlled foreign corporation, the 
amount determined under section 956 with respect to each share of stock 
of the controlled foreign corporation owned (within the meaning of 
section 958(a)) by a United States shareholder is the amount that would 
be determined under section 956 with respect to such share for the 
taxable year, absent the application of this paragraph (a)(2) for the 
taxable year (such amount, the tentative section 956 amount, and in the 
aggregate with respect to all shares owned (within the meaning of 
section 958(a)) by the United States shareholder, the aggregate 
tentative section 956 amount), reduced by the amount of the deduction 
under section 245A, if any, that the shareholder would be allowed if the 
shareholder received as a distribution from the controlled foreign 
corporation an amount equal to the tentative section 956 amount with 
respect to such share on the last day during the taxable year on which 
the foreign corporation is a controlled foreign corporation 
(hypothetical distribution). For purposes of the preceding sentence, in 
the case of a United States shareholder that is a domestic partnership, 
the aggregate amount of the deductions under section 245A, if any, that 
domestic corporations that are partners of the domestic partnership 
(including indirect partners through other partnerships) would be 
allowed with respect to a hypothetical distribution is treated as the 
amount of the deduction under section 245A that the domestic partnership 
would be allowed.
    (ii) Determination of the amount of the deduction that would be 
allowed under section 245A with respect to a hypothetical distribution. 
For purposes of determining the amount of the deduction under section 
245A that a United States shareholder would be allowed with respect to a 
share of stock of a controlled foreign corporation by reason of a 
hypothetical distribution, the rules in paragraphs (a)(2)(ii)(A) through 
(C) of this section apply--
    (A) If a United States shareholder owns a share of stock of a 
controlled foreign corporation indirectly (within the meaning of section 
958(a)(2)), then--
    (1) Sections 245A(a) through (d), 246(a), and 959 apply to the 
hypothetical distribution as if the United States shareholder directly 
owned (within the meaning of section 958(a)(1)(A)) the share;

[[Page 382]]

    (2) Section 245A(e) applies to the hypothetical distribution as if 
the distribution were made to the United States shareholder through each 
entity by reason of which the United States shareholder indirectly owns 
such share and pro rata with respect to the equity that gives rise to 
such indirect ownership;
    (3) To the extent that a distribution treated as made to a 
controlled foreign corporation pursuant to the hypothetical distribution 
by reason of paragraph (a)(2)(ii)(A)(2) of this section would be subject 
to section 245A(e)(2), the United States shareholder is treated as not 
being allowed a deduction under section 245A by reason of the 
hypothetical distribution; and
    (4) Section 246(c) applies to the hypothetical distribution by 
substituting the phrase ``owned (within the meaning of section 958(a))'' 
for the term ``held'' each place it appears in section 246(c);
    (B) Section 246(c) applies to the hypothetical distribution by 
substituting ``the last day during the taxable year on which the foreign 
corporation is a controlled foreign corporation'' for the phrase ``the 
date on which such share becomes ex-dividend with respect to such 
dividend'' in section 246(c)(1)(A); and
    (C) The hypothetical distribution is treated as attributable first 
to earnings and profits of the controlled foreign corporation described 
in section 959(c)(2), then to earnings and profits of the controlled 
foreign corporation described in section 959(c)(3).
    (iii) Special rule in the case of domestic partnerships--(A) In 
general. In the case of a domestic partnership whose tentative section 
956 amount with respect to a share of stock of a controlled foreign 
corporation is reduced pursuant to paragraph (a)(2)(i) of this section 
for a taxable year, the portion of any inclusion under section 
951(a)(1)(B) of the domestic partnership with respect to such share for 
the taxable year allocated to a partner of the domestic partnership 
(including an indirect partner through one or more other partnerships) 
must equal the product of the inclusion and the ratio determined by 
dividing--
    (1) The net hypothetical distribution income with respect to the 
partner; by
    (2) The aggregate of the net hypothetical distribution income with 
respect to all of the partners of the domestic partnership.
    (B) Definition of net hypothetical distribution income. The term net 
hypothetical distribution income means, with respect to a hypothetical 
distribution to a domestic partnership and a partner of the domestic 
partnership (including an indirect partner through one or more other 
partnerships), the amount of the hypothetical distribution that would be 
allocable to the partner reduced by the amount of the deduction under 
section 245A with respect to the hypothetical distribution that would be 
allowable to the partner.
    (3) Examples. The examples in this paragraph (a)(3) illustrate the 
application of paragraph (a)(2) of this section.
    (i) Example 1--(A) Facts. (1) USP, a domestic corporation, owns all 
of the single class of stock of FC, a foreign corporation. The stock of 
FC consists of 100 shares, and USP satisfies the holding period 
requirement of section 246(c) (as modified by paragraph (a)(2)(ii)(B) of 
this section) with respect to each share of FC stock. Any dividend from 
FC to USP would not constitute a hybrid dividend for purposes of section 
245A(e). FC owns all of the stock of USS, a domestic corporation. FC's 
adjusted basis in the stock of USS is $0.
    (2) The functional currency of FC is the U.S. dollar. FC has $100x 
of undistributed earnings as defined in section 245A(c)(2) at the end of 
the taxable year, $90x of which constitute undistributed foreign 
earnings as defined in section 245A(c)(3), and $10x of which are 
described in section 245(a)(5)(B) (that is, earnings attributable to a 
dividend that FC received from USS). None of the earnings and profits of 
FC are described in section 959(c)(1) or (2) or are earnings and profits 
attributable to income excluded from subpart F income under section 
952(b). FC's applicable earnings (as defined in section 956(b)(1)) are 
$100x. FC also has held an obligation of USP with an adjusted basis of 
$120x on every day during the taxable year of FC, and such obligation 
was acquired while all of its stock was owned by USP.

[[Page 383]]

    (B) Analysis. Because USP directly owns all of the stock of FC at 
the end of FC's taxable year, USP's aggregate tentative section 956 
amount with respect to FC is $100x, the lesser of USP's pro rata share 
of the average amounts of United States property held by FC ($120x) and 
its pro rata share of FC's applicable earnings ($100x). Under paragraph 
(a)(2)(i) of this section, USP's section 956 amount with respect to FC 
is its aggregate tentative section 956 amount with respect to FC reduced 
by the deduction under section 245A that USP would be allowed if USP 
received an amount equal to its aggregate tentative section 956 amount 
as a distribution with respect to the FC stock. USP would be allowed a 
$90x deduction under section 245A with respect to the foreign-source 
portion of the $100x hypothetical distribution (that is, an amount of 
the dividend that bears the same ratio to the dividend as the $90x of 
undistributed foreign earnings bears to the $100x of undistributed 
earnings). Accordingly, USP's section 956 amount with respect to FC is 
$10x, its aggregate tentative section 956 amount ($100x) with respect to 
FC reduced by the amount of the deduction that USP would have been 
allowed under section 245A with respect to the hypothetical distribution 
($90x).
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(a)(3)(i)(A) of this section (the facts in Example 1), except that all 
$100x of FC's undistributed earnings are described in section 959(c)(2).
    (B) Analysis. As in paragraph (a)(3)(i)(B) of this section (the 
analysis in Example 1), USP's aggregate tentative section 956 amount 
with respect to FC is $100x, the lesser of USP's pro rata share of the 
average amounts of United States property held by FC ($120x) and its pro 
rata share of FC's applicable earnings ($100x). However, paragraph 
(a)(2) of this section does not reduce USP's section 956 amount because 
USP would not be allowed any deduction under section 245A with respect 
to the $100x hypothetical distribution by reason of section 959(a) and 
(d). Accordingly, USP's section 956 amount is $100x. However, under 
sections 959(a)(2) and 959(f)(1), USP's inclusion under section 
951(a)(1)(B) with respect to FC is $0, because USP's section 956 amount 
with respect to FC does not exceed the earnings and profits of FC 
described in section 959(c)(2) with respect to USP. The $100x of 
earnings and profits of FC described in section 959(c)(2) are 
reclassified as earnings and profits described in section 959(c)(1).
    (iii) Example 3--(A) Facts. The facts are the same as in paragraph 
(a)(3)(i)(A) of this section (the facts in Example 1), except that FC 
has $200x of undistributed earnings, which constitute undistributed 
foreign earnings as defined in section 245A(c)(3), of which $100x are 
described in section 959(c)(1)(A) and $100x are described in section 
959(c)(3).
    (B) Analysis. USP's aggregate tentative section 956 amount with 
respect to FC is $20x, the lesser of $20x, the excess of USP's pro rata 
share of the average amounts of United States property held by FC 
($120x) over the earnings and profits described in section 959(c)(1)(A) 
with respect to USP ($100x), and its pro rata share of FC's applicable 
earnings ($100x). Under paragraph (a)(2)(i) of this section, USP's 
section 956 amount with respect to FC is its aggregate tentative section 
956 amount with respect to FC reduced by the deduction under section 
245A that USP would be allowed if USP received an amount equal to its 
aggregate tentative section 956 amount as a distribution with respect to 
the FC stock. USP would be allowed a $20x deduction under section 245A 
with respect to the foreign-source portion of the $20x hypothetical 
distribution, which, under paragraph (a)(2)(ii)(C) of this section, is 
treated as attributable to the earnings and profits of FC described in 
section 959(c)(3) despite the fact that FC has $100x of earnings and 
profits described in section 959(c)(1)(A) that would otherwise be 
distributed before earnings and profits described in section 959(c)(3). 
Accordingly, USP's section 956 amount with respect to FC is $0, its 
aggregate tentative section 956 amount ($20x) with respect to FC reduced 
by the amount of the deduction that USP would have been allowed under 
section 245A with respect to the hypothetical distribution after 
applying the rule in

[[Page 384]]

paragraph (a)(2)(ii)(C) of this section ($20x).
    (iv) Example 4--(A) Facts. The facts are the same as in paragraph 
(a)(3)(i)(A) of this section (the facts in Example 1), except that USP 
is a domestic partnership in which USC1 and USC2, each a domestic 
corporation, and USI, a United States citizen, have owned 50%, 30%, and 
20%, respectively, of the capital and profits interests for five years.
    (B) Analysis. As in paragraph (a)(3)(i)(B) of this section (the 
analysis in Example 1), USP's aggregate tentative section 956 amount 
with respect to FC is $100x. Under paragraph (a)(2)(i) of this section, 
USP's section 956 amount with respect to FC is its aggregate tentative 
section 956 amount with respect to FC reduced by the aggregate amount of 
deductions under section 245A that USC1, USC2, and USI would be allowed 
if USP received an amount equal to its aggregate tentative section 956 
amount as a distribution with respect to the FC stock. Assuming that, 
under section 245A, USC1 and USC2 would be allowed a $45x deduction and 
a $27x deduction, respectively, with respect to the foreign-source 
portion of their $50x and $30x distributive shares of the $100x 
hypothetical distribution (that is, an amount of the dividend that bears 
the same ratio to the dividend as the $90x of undistributed foreign 
earnings bears to the $100x of undistributed earnings), USP's section 
956 amount with respect to FC is $28x, its aggregate tentative section 
956 amount ($100x) with respect to FC reduced by the aggregate amount of 
the deductions that its partners would have been allowed under section 
245A with respect to the hypothetical distribution ($72x ($45x + $27x)). 
Under paragraph (a)(2)(iii) of this section, the portion of its $28x 
inclusion under section 951(a)(1)(B) with respect to FC that is 
allocated to USC1 is $5x ($28x x (($50x-$45x)/($50x-$45x + $30x-$27x + 
$20x))); the portion that is allocated to USC2 is $3x ($28x x (($30x-
$27x) / ($50x-$45x + $30x-$27x + $20x))); and the portion that is 
allocated to USI is $20x ($28x x ($20x / ($50x-$45x + $30x-$27x + 
$20x))).
    (v) Example 5--(A) Facts. (1) USP, a domestic corporation, owns all 
of the single class of stock of FC1, a foreign corporation, and has held 
such stock for five years. FC1 has held 70% of the single class of stock 
of FC2, a foreign corporation, for three years. The other 30% of the FC2 
stock has been held since FC2's formation by a foreign individual 
unrelated to USP or FC1. Any dividend from FC2 or FC1 to FC1 or USP, 
respectively, would not constitute a hybrid dividend for purposes of 
section 245A(e). FC2 has a calendar taxable year. On December 1, Year 1, 
FC1 acquires the remaining 30% of the stock of FC2 for cash. On June 30, 
Year 2, FC1 sells to a third party the 30% of FC2 stock acquired in Year 
1 at no gain. FC2 made no distributions during Year 1.
    (2) The functional currency of FC1 and FC2 is the U.S. dollar. For 
Year 1, FC2 has $120x of undistributed earnings as defined in section 
245A(c)(2), all of which constitute undistributed foreign earnings. None 
of the earnings and profits of FC2 are described in section 959(c)(1) or 
(2) or are earnings and profits attributable to income excluded from 
subpart F income under section 952(b). FC2's applicable earnings (as 
defined in section 956(b)(1)) for Year 1 are $120x. FC2 has held an 
obligation of USP with an adjusted basis of $100x on every day of Year 1 
that was acquired while USP owned all of the stock of FC1 and FC1 held 
70% of the single class of stock of FC2.
    (B) Analysis. Because USP indirectly owns (within the meaning of 
section 958(a)) all of the stock of FC2 at the end of Year 1, USP's 
aggregate tentative section 956 amount with respect to FC2 for Year 1 is 
$100x, the lesser of USP's pro rata share of the average amounts of 
United States property held by FC2 ($100x) and its pro rata share of 
FC2's applicable earnings ($120x). Under paragraph (a)(2)(i) of this 
section, USP's section 956 amount with respect to FC2 for Year 1 is its 
aggregate tentative section 956 amount with respect to FC2 reduced by 
the deduction under section 245A that USP would be allowed if USP 
received an amount equal to its aggregate tentative section 956 amount 
as a distribution with respect to the FC2 stock that USP owns indirectly 
within the meaning of section 958(a)(2). For purposes of

[[Page 385]]

determining the consequences of this hypothetical distribution, under 
paragraph (a)(2)(ii)(A)(1) of this section, USP is treated as owning the 
FC2 stock directly. In addition, under paragraph (a)(2)(ii)(A)(4) of 
this section, the holding period requirement of section 246(c) is 
applied by reference to the period during which USP owned (within the 
meaning of section 958(a)) the stock of FC2. Therefore, with respect to 
the hypothetical distribution from FC2 to USP, USP would satisfy the 
holding period requirement under section 246(c) with respect to the 70% 
of the FC2 stock that USP indirectly owned for three years through FC1, 
but not with respect to the 30% of the FC2 stock that USP indirectly 
owned through FC1 for a period of less than 365 days. Accordingly, USP's 
section 956 amount with respect to FC2 for Year 1 is $30x, its aggregate 
tentative section 956 amount ($100x) reduced by the amount of the 
deduction that USP would have been allowed under section 245A with 
respect to the hypothetical distribution ($70x).
    (b) Amount of United States property held indirectly by a controlled 
foreign corporation--(1) General rule. For purposes of section 956, 
United States property held indirectly by a controlled foreign 
corporation includes--
    (i) United States property held on behalf of the controlled foreign 
corporation by a trustee or a nominee;
    (ii) United States property acquired by any other foreign 
corporation that is controlled by the controlled foreign corporation if 
a principal purpose of creating, organizing, or funding by any means 
(including through capital contributions or debt) the other foreign 
corporation is to avoid the application of section 956 with respect to 
the controlled foreign corporation; and
    (iii) Property acquired by a partnership that is controlled by the 
controlled foreign corporation if the property would be United States 
property if held directly by the controlled foreign corporation, and a 
principal purpose of creating, organizing, or funding by any means 
(including through capital contributions or debt) the partnership is to 
avoid the application of section 956 with respect to the controlled 
foreign corporation.
    (2) Control. For purposes of paragraphs (b)(1)(ii) and (iii) of this 
section, a controlled foreign corporation controls a foreign corporation 
or partnership if the controlled foreign corporation and the other 
foreign corporation or partnership are related within the meaning of 
section 267(b) or section 707(b). For this purpose, in determining 
whether two corporations are members of the same controlled group under 
section 267(b)(3), a person is considered to own stock owned directly by 
such person, stock owned for the purposes of section 1563(e)(1), and 
stock owned with the application of section 267(c).
    (3) Coordination rule. Paragraph (b)(1)(iii) of this section applies 
only to the extent that the amount of United States property that is 
treated under that paragraph as held indirectly by a controlled foreign 
corporation through the partnership exceeds the sum of--
    (i) The amount of United States property described in paragraph 
(b)(1)(iii) of this section that is treated as held by the controlled 
foreign corporation as a result of the application of Sec. 1.956-4(b) 
with respect to the partnership; and
    (ii) The amount of United States property that is treated as held by 
the controlled foreign corporation as a result of the application of 
Sec. 1.956-4(c) with respect to any portion of an obligation 
attributable to the funding described in paragraph (b)(1)(iii) of this 
section of the partnership by the controlled foreign corporation.
    (4) Examples. The examples in this paragraph (b)(4) illustrate the 
rules of this paragraph (b). In each example, P is a United States 
citizen that wholly owns two controlled foreign corporations, FS1 and 
FS2.
    (i) Example 1--(A) Facts. FS1 sells inventory to FS2 in exchange for 
trade receivables due in 60 days. Avoiding the application of section 
956 with respect to FS1 was not a principal purpose of establishing the 
trade receivables. FS2 has no earnings and profits, and FS1 has 
substantial accumulated earnings and profits. FS2 makes a loan to P 
equal to the amount it owes FS1 under the trade receivables. FS2 pays 
the trade receivables according to their terms.

[[Page 386]]

    (B) Result. FS1 will not be considered to indirectly hold United 
States property under this paragraph (b) because the funding of FS2 
through the sale of inventory in exchange for the establishment of trade 
receivables was not undertaken with a principal purpose of avoiding the 
application of section 956 with respect to FS1.
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(b)(4)(i)(A) of this section (the facts in Example 1), except that, with 
a principal purpose of avoiding the application of section 956 with 
respect to FS1, FS1 and FS2 agree to defer FS2's payment obligation, and 
FS2 does not timely pay the receivables.
    (B) Result. FS1 is considered to hold indirectly United States 
property under this paragraph (b) and Sec. 1.956-2(a) because there was 
a funding of FS2, a principal purpose of which was to avoid the 
application of section 956 with respect to FS1.
    (iii) Example 3--(A) Facts. FS1 has $100x of post-1986 undistributed 
earnings and profits and $100x post-1986 foreign income taxes, but does 
not have any cash. FS2 has earnings and profits of at least $100x, no 
post-1986 foreign income taxes, and substantial cash. Neither FS1 nor 
FS2 has earnings and profits described in section 959(c)(1) or section 
959(c)(2). FS2 loans $100x to FS1. FS1 then loans $100x to P. An income 
inclusion by P of $100x under sections 951(a)(1)(B) and 956 with respect 
to FS1 would result in foreign income taxes deemed paid by P under 
section 960. A principal purpose of funding FS1 through the loan from 
FS2 is to avoid the application of section 956 with respect to FS2.
    (B) Result. Under paragraph (b)(1)(ii) of this section, FS2 is 
considered to indirectly hold the $100x obligation of P that is held by 
FS1. As a result, P has an income inclusion of $100x under sections 
951(a)(1)(B) and 956 with respect to FS2, and the foreign income taxes 
deemed paid by P under section 960 is $0. P does not have an income 
inclusion under sections 951(a)(1)(B) and 956 with respect to FS1 
related to the $100x loan from FS1 to P.
    (iv) Example 4--(A) Facts. FS1 deposits $100x with BK, an unrelated 
foreign financial institution. FS2 subsequently borrows $100x from BK. 
BK would not have loaned the $100x to FS2 on the same terms absent FS1's 
deposit. FS2 loans the $100x borrowed from BK to P. FS2 has no earnings 
and profits, and FS1 has substantial accumulated earnings and profits. A 
principal purpose for the transactions is to avoid the application of 
section 956 with respect to FS1.
    (B) Result. FS1 is considered to hold indirectly United States 
property under this paragraph (b) and Sec. 1.956-2(a) because FS1's 
deposit with BK, which facilitates BK's loan to FS2, is considered a 
funding by FS1 of FS2, a principal purpose of which was to avoid the 
application of section 956 with respect to FS1.
    (v) Example 5--(A) Facts. FS1 sells inventory to FS2 in exchange for 
$100x. The sale occurred in the ordinary course of FS1's trade or 
business and FS2's trade or business, and the terms of the sale are 
consistent with terms that would be observed among parties dealing at 
arm's length. FS1 makes a $100x loan to P. FS2 has no earnings and 
profits, and FS1 has substantial accumulated earnings and profits.
    (B) Result. FS2 will not be considered to indirectly hold United 
States property under this paragraph (b) because a sale in the ordinary 
course of business for cash on terms that are consistent with those that 
would be observed among parties dealing at arm's length does not 
constitute a funding.
    (vi) Example 6--(A) Facts. In Year 1, FS2 loans $100x to FS1 to 
finance FS1's trade or business. The terms of the loan are consistent 
with those that would be observed among parties dealing at arm's length. 
In Year 2, FS1 repays the loan in accordance with the terms of the loan. 
Immediately after the repayment by FS1, FS2 loans $100x to P. FS2 has no 
earnings and profits, and FS1 has substantial accumulated earnings and 
profits.
    (B) Result. FS1 will not be considered to indirectly hold United 
States property under this paragraph (b) because a repayment of a loan 
that has terms that are consistent with those that would be observed 
among parties dealing at arm's length and that is repaid consistent with 
those terms does not constitute a funding.

[[Page 387]]

    (vii) Example 7--(A) Facts. FS1 has substantial earnings and 
profits. P and FS1 are the only partners in FPRS, a foreign partnership. 
FS1 contributes $600x cash to FPRS in exchange for a 60% interest in the 
partnership, and P contributes real estate located outside the United 
States ($400x value) to FPRS in exchange for a 40% interest in the 
partnership. There are no special allocations in the FPRS partnership 
agreement. FPRS lends $100x to P. Under Sec. 1.956-4(b) and Sec. 
1.956-2(a), FS1 is treated as holding United States property of $60x 
(60% x $100x) as a result of the FPRS loan to P. A principal purpose of 
creating, organizing, or funding FPRS is to avoid the application of 
section 956 with respect to FS1.
    (B) Result. Before taking into account paragraph (b)(3) of this 
section, because FS1 controls FPRS and a principal purpose of creating, 
organizing, or funding FPRS was to avoid the application of section 956 
with respect to FS1, FS1 is considered under paragraph (b)(1)(iii) of 
this section to indirectly hold the $100x obligation of P that would be 
United States property if held directly by FS1. However, under paragraph 
(b)(3) of this section, FS1 is treated as holding United States property 
under paragraph (b)(1)(iii) only to the extent the amount held 
indirectly under paragraph (b)(1)(iii) of this section exceeds the sum 
of the amount of the United States property that FS1 is treated as 
holding as a result of the application of Sec. 1.956-4(b) with respect 
to FPRS. The amount of United States property that FS1 is treated as 
indirectly holding under paragraph (b)(1)(iii) of this section and Sec. 
1.956-2(a) ($100x) exceeds the amount determined under Sec. 1.956-4(b) 
($60x) by $40x. Thus, FS1 is considered to hold United States property 
within the meaning of section 956(c) in the amount of $100x ($60x under 
Sec. 1.956-4(b) and $40x under paragraphs (b)(1)(iii) and (b)(3) of 
this section).
    (viii) Example 8--(A) Facts. FS1 and FS2 have substantial earnings 
and profits. P and FS1 are the only partners in FPRS, a foreign 
partnership. There are no special allocations in the FPRS partnership 
agreement. P's liquidation value percentage with respect to FPRS is 40%, 
and FS1's liquidation value percentage with respect to FPRS is 60%. FS2 
lends $100x to FPRS, and FPRS lends $100x to P. Under Sec. 1.956-4(c) 
and Sec. 1.956-2(a), FS2 is treated as holding United States property 
of $40x (40% x $100x) as a result of its loan to FPRS. A principal 
purpose of funding FPRS is to avoid the application of section 956 with 
respect to FS2.
    (B) Result. Before taking into account paragraph (b)(3) of this 
section, because FS2 controls FPRS and a principal purpose of funding 
FPRS was to avoid the application of section 956 with respect to FS2, 
FS2 is considered under paragraph (b)(1)(iii) of this section to 
indirectly hold the $100x obligation of P that would be United States 
property if held directly by FS2. However, under paragraph (b)(3) of 
this section, FS2 is treated as holding United States property under 
paragraph (b)(1)(iii) only to the extent the amount held indirectly 
under paragraph (b)(1)(iii) of this section exceeds the amount of United 
States property that FS2 is treated as holding as a result of the 
application of Sec. 1.956-4(c) with respect to the obligation with 
which FS2 funds FPRS. The amount of United States property that FS2 is 
treated as indirectly holding under paragraph (b)(1)(iii) of this 
section and Sec. 1.956-2(a) ($100x) exceeds the amount determined under 
Sec. 1.956-4(c) ($40x) by $60x. Thus, FS2 is considered to hold United 
States property within the meaning of section 956(c) in the amount of 
$100x ($40x under Sec. 1.956-4(c) and $60x under paragraphs (b)(1)(iii) 
and (b)(3) of this section). P does not have an income inclusion under 
sections 951(a)(1)(B) and 956 with respect to FS1 related to the P 
obligation held by FPRS.
    (c)-(d) [Reserved]
    (e) Amount attributable to property--(1) General rule. Except as 
provided in subparagraph (2) of this paragraph, for purposes of 
paragraph (b)(1) of this section the amount taken into account with 
respect to any United States property shall be its adjusted basis, as of 
the applicable determination date, reduced by any liability (other than 
a liability described in subparagraph (3) of this paragraph) to which 
such property is subject on such date. To be taken into account under 
this subparagraph, a liability must constitute a specific charge against 
the property involved.

[[Page 388]]

Thus, a liability evidenced by an open account or a liability secured 
only by the general credit of the controlled foreign corporation will 
not be taken into account. On the other hand, if a liability constitutes 
a specific charge against several items of property and cannot 
definitely be allocated to any single item of property, the liability 
shall be apportioned against each of such items of property in that 
ratio which the adjusted basis of such item on the applicable 
determination date bears to the adjusted basis of all such items at such 
time. A liability in excess of the adjusted basis of the property which 
is subject to such liability shall not be taken into account for the 
purpose of reducing the adjusted basis of other property which is not 
subject to such liability. See Sec. 1.956-1(e)(6) for a special rule 
for determining amounts attributable to United States property acquired 
as the result of certain nonrecognition transactions.
    (2) Rule for pledges and guarantees. For purposes of this section, 
the amount of an obligation treated as held (before application of Sec. 
1.956-4(b)) as a result of a pledge or guarantee described in Sec. 
1.956-2(c) is the unpaid principal amount of the obligation on the 
applicable determination date.
    (3) Excluded charges. For purposes of subparagraph (1) of this 
paragraph, a specific charge created with respect to any item of 
property principally for the purpose of artificially increasing or 
decreasing the amount of a controlled foreign corporation's investment 
of earnings in United States property will not be recognized; whether a 
specific charge is created principally for such purpose will depend upon 
all the facts and circumstances of each case. One of the factors that 
will be considered in making such a determination with respect to a loan 
is whether the loan is from a related person, as defined in section 954 
(d)(3) and paragraph (e) of Sec. 1.954-1.
    (4) Statement required. If for purposes of this section a United 
States shareholder of a controlled foreign corporation reduces the 
adjusted basis of property which constitutes United States property on 
the ground that such property is subject to a liability, he shall attach 
to his return a statement setting forth the adjusted basis of the 
property before the reduction and the amount and nature of the 
reduction.
    (5) [Reserved] For further guidance, see Sec. 1.956-1T(e)(5).
    (6) Adjusted basis of property acquired in certain nonrecognition 
transactions--(i) Scope. This paragraph (e)(6) provides rules for 
determining, solely for purposes of applying section 956, the adjusted 
basis of specified United States property acquired by a controlled 
foreign corporation pursuant to an exchange in which the controlled 
foreign corporation's basis in such specified United States property is 
determined under section 362(a). This paragraph (e)(6) also applies if 
specified United States property, the adjusted basis in which has been 
determined under these regulations, is transferred (in one or more 
subsequent exchanges) to a related person (within the meaning of section 
954(d)(3)), pursuant to one or more exchanges in which the related 
person's adjusted basis in such property is determined, in whole or in 
part, by reference to the transferor controlled foreign corporation's 
adjusted basis in such property.
    (ii) Definition of specified United States property. For purposes of 
this paragraph (e)(6), specified United States property is stock of a 
domestic corporation described in section 956(c)(1)(B) or an obligation 
of a domestic corporation described in section 956(c)(1)(C) that is 
acquired by a controlled foreign corporation from the domestic issuing 
corporation. Specified United States property does not include property 
described in section 956(c)(2).
    (iii) Adjusted basis of specified United States property. Solely for 
purposes of applying section 956, the adjusted basis of specified United 
States property acquired by a controlled foreign corporation in 
connection with an exchange to which this paragraph (e)(6) applies shall 
be no less than the fair market value of any property transferred by the 
controlled foreign corporation in exchange for such specified United 
States property. For purposes of this paragraph (e)(6), the term 
property has the meaning set forth in section 317(a), but also includes 
any liability that is

[[Page 389]]

assumed by the controlled foreign corporation in connection with the 
exchange notwithstanding the application of section 357(a). The 
assumption of a liability by the controlled foreign corporation in 
connection with the exchange will be considered the transfer of 
property. The fair market value of such property will be the amount of 
the liability assumed. The fair market value of any property transferred 
by the controlled foreign corporation in exchange for the specified 
United States property shall be determined at the time of the exchange.
    (iv) Timing. For purposes of Sec. 1.956-2(d)(1)(i)(a), a controlled 
foreign corporation that acquires specified United States property in an 
exchange to which this paragraph (e)(6) applies acquires an adjusted 
basis in such property at the time of the controlled foreign 
corporation's exchange of property for such specified United States 
property.
    (v) Transfers to r elated persons. If a controlled foreign 
corporation transfers specified United States property, the adjusted 
basis in which has been determined under this paragraph (e)(6), to a 
related person (within the meaning of section 954(d)(3)) (related person 
transferee) in one or more exchanges pursuant to which the related 
person transferee's adjusted basis in such specified United States 
property is determined, in whole or in part, by reference to the 
controlled foreign corporation's adjusted basis in such specified United 
States property, then, solely for purposes of applying section 956 
following such exchange, the controlled foreign corporation's adjusted 
basis in any United States property received in the exchange (or 
exchanges) shall be no less than the aggregate adjusted basis of the 
specified United States property as determined under paragraph 
(e)(6)(iii) of this section, and the related person transferee's 
adjusted basis in such specified United States property shall be no less 
than the adjusted basis of such specified United States property in the 
hands of the controlled foreign corporation as determined under 
paragraph (e)(6)(iii) of this section. This paragraph (e)(6)(v) shall 
also apply in the case of one or more successive transfers of the 
specified United States property by a related person transferee to one 
or more persons related to the controlled foreign corporation (within 
the meaning of section 954(d)(3)). This paragraph (e)(6)(v) shall apply 
regardless of whether a subsequent transfer was part of a plan (or 
series of related transactions) that includes the controlled foreign 
corporation's acquisition of the specified United States property.
    (vi) Examples. The rules of this paragraph (e)(6) are illustrated by 
the following examples:

    Example 1. (i) Facts. USP, a domestic corporation, is the common 
parent of an affiliated group that joins in the filing of a consolidated 
return. USP owns 100 percent of the stock of US1 and US2, both domestic 
corporations and members of the USP consolidated group. US1 owns 100 
percent of the stock of CFC, a controlled foreign corporation. US2 
issues $100x of its stock to CFC in exchange for $10x of CFC stock and 
$90x cash. US2's transfer of its stock to CFC is described in section 
351, US2 recognizes no gain in the exchange under section 1032(a), and 
CFC's basis in the US2 stock acquired in the exchange is determined 
under section 362(a).
    (ii) Analysis. The US2 stock acquired by CFC in the exchange 
constitutes specified United States property under paragraph (e)(6)(ii) 
of this section because CFC acquires the US2 stock from US2, the issuing 
corporation. Therefore, because CFC's adjusted basis in the US2 stock is 
determined under section 362(a), then for purposes of applying section 
956, CFC's adjusted basis in the US2 stock shall, under paragraph 
(e)(6)(iii) of this section, be no less than $90x, the fair market value 
of the property exchanged by CFC for the US2 stock (the $10x of CFC 
stock issued in the exchange does not constitute property for purposes 
of paragraph (e)(6)(iii) of this section). Pursuant to paragraph 
(e)(6)(iv) of this section, for purposes of Sec. 1.956-2(d)(1)(i)(a) 
CFC shall be treated as acquiring its adjusted basis of no less than 
$90x in the US2 stock at the time of its transfer of property to US2 in 
exchange for the US2 stock. The result would be the same if, instead of 
CFC transferring $90x of cash to US2 in the exchange, CFC assumes a $90x 
liability of US2.
    Example 2. (i) Facts. USP, a domestic corporation, owns 100 percent 
of the stock of USS, a domestic corporation. USP also owns 100 percent 
of the stock of CFC, a controlled foreign corporation. USP's adjusted 
basis in its USS stock equals the fair market value of the USS stock, or 
$100x. USP transfers its USS stock to CFC in exchange for $100x of CFC 
stock. USP's transfer of its USS stock

[[Page 390]]

to CFC is described in section 351, USP recognizes no gain in the 
exchange under section 351(a), and CFC's adjusted basis in the USS stock 
acquired in the exchange, determined under section 362(a), equals $100x.
    (ii) Analysis. The USS stock acquired by CFC in the exchange does 
not constitute specified United States property under paragraph 
(e)(6)(ii) of this section because CFC acquires the USS stock from USP. 
Therefore, CFC's adjusted basis in the USS stock, for purposes of 
section 956, is not determined under this paragraph (e)(6). Instead, 
CFC's adjusted basis in the USS stock is determined under the general 
rule of section 956(a) and under paragraphs (e)(1) through (4) of this 
section. As determined under section 362(a), CFC's adjusted basis in the 
USS stock is $100x.
    Example 3. (i) Facts. USP, a domestic corporation, owns 100 percent 
of the stock of CFC1, a controlled foreign corporation. CFC1 holds 
specified United States property (within the meaning of paragraph 
(e)(6)(ii) of this section) with an adjusted basis of $30x for purposes 
of applying section 956 that was determined under paragraph (e)(6)(iii) 
of this section. CFC1 owns 100 percent of the stock of CFC2, a 
controlled foreign corporation. CFC1 transfers the specified United 
States property to CFC2 in an exchange described in section 351. CFC2's 
adjusted basis in the specified United States property is determined 
under section 362(a).
    (ii) Analysis. In the section 351 exchange, CFC1 transferred 
specified United States property to CFC2 with an adjusted basis that was 
determined under paragraph (e)(6)(iii) of this section. Further, CFC2's 
adjusted basis in the specified United States property is determined 
under section 362(a) by reference, in whole or in part, to CFC1's 
adjusted basis in such property. Therefore, for purposes of applying 
section 956, pursuant to paragraph (e)(6)(v) of this section CFC2's 
adjusted basis in the specified United States property shall be no less 
than $30x. Paragraph (e)(6)(v) of this section would also apply if CFC2 
subsequently transfers the specified United States property to another 
person related to CFC1 (within the meaning of section 954(d)(3)) if such 
related person's adjusted basis in the specified United States property 
is determined by reference, in whole or in part, to CFC2's adjusted 
basis in such property. See also Sec. 1.956-1T(b)(4) if one of the 
principal purposes of CFC1's transfer of property to CFC2 was the 
avoidance of the application of section 956 with respect to CFC1.

    (f) [Reserved] For further guidance, see Sec. 1.956-1T(f).
    (g) Applicability dates. (1) Paragraph (a)(1) of this section 
applies to taxable years of controlled foreign corporations ending on or 
after November 3, 2016, and to taxable years of United States 
shareholders in which or with which such taxable years end.
    (2) Paragraph (b) of this section applies to taxable years of 
controlled foreign corporations ending on or after September 1, 2015, 
and to taxable years of United States shareholders in which or with 
which such taxable years end, with respect to property acquired on or 
after September 1, 2015. See paragraph (b)(4) of Sec. 1.956-1T, as 
contained in 26 CFR part 1 revised as of April 1, 2015, for the rules 
applicable to taxable years of controlled foreign corporations ending 
before September 1, 2015, and property acquired before September 1, 
2015. For purposes of this paragraph (g)(2), a deemed exchange of 
property pursuant to section 1001 on or after September 1, 2015 
constitutes an acquisition of the property on or after that date.
    (3) Paragraph (e)(2) of this section applies to taxable years of 
controlled foreign corporations ending on or after November 3, 2016, and 
taxable years of United States shareholders in which or with which such 
taxable years end, with respect to pledges or guarantees entered into on 
or after September 1, 2015. For purposes of this paragraph (g)(3), a 
pledgor or guarantor is treated as entering into a pledge or guarantee 
when there is a significant modification, within the meaning of Sec. 
1.1001-3(e), of an obligation with respect to which it is a pledgor or 
guarantor on or after September 1, 2015.
    (4) Paragraphs (a)(2) and (3) of this section apply to taxable years 
of controlled foreign corporations beginning on or after July 22, 2019, 
and to taxable years of a United States shareholder in which or with 
which such taxable years of the controlled foreign corporations end. 
Notwithstanding the preceding sentence, a United States shareholder may 
apply paragraphs (a)(2) and (3) of this section to taxable years of 
controlled foreign corporations beginning after December 31, 2017, and 
to taxable years of the United States shareholder in which or with which 
such taxable years of the controlled foreign corporations end, provided 
that the United States shareholder and United States persons that are 
related (within the meaning of section 267 or 707) to the

[[Page 391]]

United States shareholder consistently apply those paragraphs with 
respect to all controlled foreign corporations in which they are United 
States shareholders for taxable years of the controlled foreign 
corporations beginning after December 31, 2017.
    (5) Paragraph (e)(6) of this section applies to property acquired in 
exchanges occurring on or after June 24, 2011.

[T.D. 6704, 29 FR 2600, Feb. 20, 1964, as amended by T.D. 6795, 30 FR 
942, Jan. 29, 1965; T.D. 7712, 45 FR 52374, Aug. 7, 1980; T.D. 8209, 53 
FR 22171, June 14, 1988; T.D. 9402, 73 FR 35582, June 24, 2008; T.D. 
9630, 76 FR 36994, June 24, 2011; T.D. 9733, 80 FR 52981, Sept. 2, 2015; 
80 FR 66416, Oct. 29, 2015; T.D. 9792, 81 FR 76505, Nov. 3, 2016; T.D. 
9859, 84 FR 23717, May 23, 2019; 84 FR 29799, June 25, 2019]



Sec. 1.956-1T  Shareholder's pro rata share of the average of the 
amounts of United States property held by a controlled foreign 
corporation (temporary).

    (a)-(e)(4) [Reserved]
    (5) Exclusion for certain recourse obligations. For purposes of 
Sec. 1.956-1(e)(1) of the regulations, in the case of an investment in 
United States property consisting of an obligation of a related person, 
as defined in section 954(d)(3) and paragraph (f) of Sec. 1.954-1, a 
liability will not be recognized as a specific charge if the liability 
representing the charge is with recourse with respect to the general 
credit or other assets of the investing controlled foreign corporation.
    (e)(6) [Reserved] For further guidance, see Sec. 1.956-1(e)(6).
    (f) Effective/applicability date. Paragraph (e)(5) of this section 
applies to investments made on or after June 14, 1988.
    (g)-(h) [Reserved]

[T.D. 9792, 81 FR 76507, Nov. 3, 2016; 81 FR 95471, Dec. 28, 2016]



Sec. 1.956-2  Definition of United States property.

    (a) Included property--(1) In general. For purposes of section 
956(a) and Sec. 1.956-1, United States property is (except as provided 
in paragraph (b) of this section) any property acquired (within the 
meaning of paragraph (d)(1) of this section) by a foreign corporation 
(whether or not a controlled foreign corporation at the time) during any 
taxable year of such foreign corporation beginning after December 31, 
1962, which is--
    (i) Tangible property (real or personal) located in the United 
States;
    (ii) Stock of a domestic corporation;
    (iii) An obligation (as defined in paragraph (d)(2) of this section) 
of a United States person (as defined in section 957(d)); or
    (iv) Any right to the use in the United States of--
    (a) A patent or copyright,
    (b) An invention, model, or design (whether or not patented),
    (c) A secret formula or process, or
    (d) Any other similar property right, which is acquired or developed 
by the foreign corporation for use in the United States by any person. 
Whether a right described in this subdivision has been acquired or 
developed for use in the United States by any person is to be determined 
from all the facts and circumstances of each case. As a general rule, a 
right actually used principally in the United States will be considered 
to have been acquired or developed for use in the United States in the 
absence of affirmative evidence showing that the right was not so 
acquired or developed for such use.
    (2) Illustrations. The application of the provisions of this 
paragraph may be illustrated by the following examples:

    Example 1. Foreign corporation R uses as a taxable year a fiscal 
year ending on June 30. Corporation R acquires on June 1, 1963, and 
holds on June 30, 1963, $100,000 of tangible property (not described in 
section 956(b)(2)) located in the United States. Corporation R's 
aggregate investment in United States property at the close of its 
taxable year ending June 30, 1963, is zero since the property which is 
acquired on June 1, 1963, is not acquired during a taxable year of R 
Corporation beginning after December 31, 1962. Assuming no change in R 
Corporation's aggregate investment in United States property during its 
taxable year ending June 30, 1964, R Corporation's increase in earnings 
invested in United States property for such taxable year is zero.
    Example 2. Foreign corporation S uses the calendar year as a taxable 
year and is a controlled foreign corporation for its entire taxable year 
1965. Corporation S is not a controlled foreign corporation at any time 
during its taxable years 1963 and 1964. Corporation S owns on December 
31, 1964, $100,000 of tangible property (not described in section

[[Page 392]]

956(b)(2)) located in the United States which it acquires during taxable 
years beginning after December 31, 1962. Corporation S's aggregate 
investment in United States property on December 31, 1964, is $100,000. 
Corporation S's current and accumulated earnings and profits (determined 
as provided in paragraph (b) of Sec. 1.956-1) as of December 31, 1964, 
are in excess of $100,000. Assuming no change in S Corporation's 
aggregate investment in United States property during its taxable year 
1965, S Corporation's increase in earnings invested in United States 
property for such taxable year is zero.
    Example 3. Foreign corporation T uses the calendar year as a taxable 
year and is a controlled foreign corporation for its entire taxable 
years 1963, 1964, and 1966. At December 31, 1964, T Corporation's 
investment in United States property is $100,000. Corporation T is not a 
controlled foreign corporation at any time during its taxable year 1965 
in which it acquires $25,000 of tangible property (not described in 
section 956(b)(2)) located in the United States. On December 31, 1965, T 
Corporation holds the United States property of $100,000 which it held 
on December 31, 1964, and, in addition, the United States property 
acquired in 1965. Corporation T's aggregate investment in United States 
property at December 31, 1965, is $125,000. Corporation T's current and 
accumulated earnings and profits (determined as provided in paragraph 
(b) of Sec. 1.956-1) as of December 31, 1965, are in excess of 
$125,000, and T Corporation pays no amount during 1965 to which section 
959 (c)(1) applies. Assuming no change in T Corporation's aggregate 
investment in United States property during its taxable year 1966, T 
Corporation's increase in earnings invested in United States property 
for such taxable year is zero.

    (3) Treatment of disregarded entities. For purposes of section 956, 
an obligation of a business entity (as defined in Sec. 301.7701-2(a) of 
this chapter) that is disregarded as an entity separate from its owner 
for federal tax purposes under Sec. Sec. 301.7701-1 through 301.7701-3 
of this chapter is treated as an obligation of its owner.
    (4) Certain foreign stock and obligations held by expatriated 
foreign subsidiaries following an inversion transaction--(i) General 
rule. Except as provided in paragraph (a)(4)(ii) of this section, for 
purposes of section 956 and paragraph (a) of this section, United States 
property includes an obligation of a foreign person and stock of a 
foreign corporation when the following conditions are satisfied--
    (A) The obligation or stock is held by a controlled foreign 
corporation that is an expatriated foreign subsidiary, regardless of 
whether, when the obligation or stock was acquired, the acquirer was a 
controlled foreign corporation or an expatriated foreign subsidiary;
    (B) The foreign person or foreign corporation is a non-EFS foreign 
related person, regardless of whether, when the obligation or stock was 
acquired, the foreign person or foreign corporation was a non-EFS 
foreign related person; and
    (C) The obligation or stock was acquired--
    (1) During the applicable period; or
    (2) In a transaction related to the inversion transaction.
    (ii) Exceptions. For purposes of section 956 and paragraph (a) of 
this section, United States property does not include--
    (A) Any obligation of a non-EFS foreign related person arising in 
connection with the sale or processing of property if the amount of the 
obligation at no time during the taxable year exceeds the amount that 
would be ordinary and necessary to carry on the trade or business of 
both the other party to the sale or processing transaction and the non-
EFS foreign related person had the sale or processing transaction been 
made between unrelated persons; and
    (B) Any obligation of a non-EFS foreign related person to the extent 
the principal amount of the obligation does not exceed the fair market 
value of readily marketable securities sold or purchased pursuant to a 
sale and repurchase agreement or otherwise posted or received as 
collateral for the obligation in the ordinary course of its business by 
a United States or foreign person which is a dealer in securities or 
commodities.
    (iii) Definitions. The definitions in Sec. 1.7874-12 apply for the 
purposes of the application of paragraphs (a)(4), (c)(5), and (d)(2) of 
this section.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (a)(4). For purposes of the examples, FA, a foreign 
corporation, wholly owns DT, a domestic corporation, which, in

[[Page 393]]

turn, wholly owns FT, a foreign corporation that is a controlled foreign 
corporation. FA also wholly owns FS, a foreign corporation that is a 
controlled foreign corporation for its taxable year beginning January 1, 
2017, but not for prior taxable years except as a result of a 
transaction described in the facts of an example. All entities have a 
calendar year tax year for U.S. tax purposes. FA acquired DT in an 
inversion transaction that was completed on January 1, 2015.

    Example 1. (A) Facts. FT acquired an obligation of FS on January 31, 
2015.
    (B) Analysis. Pursuant to Sec. 1.7874-12, DT is a domestic entity, 
FT is an expatriated foreign subsidiary, and FS is a non-EFS foreign 
related person. In addition, FT acquired the FS obligation during the 
applicable period. Thus, as of January 31, 2015, the obligation of FS is 
United States property with respect to FT for purposes of section 956(a) 
and this paragraph (a).
    Example 2. (A) Facts. The facts are the same as in Example 1 of this 
paragraph (a)(4)(iv), except that on February 15, 2015, FT contributed 
assets to FS in exchange for 60% of the stock of FS, by vote and value.
    (B) Analysis. As a result of the transaction on February 15, 2015, 
FS became a controlled foreign corporation with respect to which an 
expatriated entity, DT, is a United States shareholder. Accordingly, 
under Sec. 1.7874-12(a)(9), FS is an expatriated foreign subsidiary, 
and is therefore not a non-EFS foreign related person. Thus, as of 
February 15, 2015, the stock and obligation of FS are not United States 
property with respect to FT for purposes of section 956(a) and this 
paragraph (a). FS is not excluded from the definition of expatriated 
foreign subsidiary pursuant to Sec. 1.7874-12(a)(9)(ii) because FS was 
not a CFC on the completion date.
    Example 3. (A) Facts. Before the inversion transaction, FA also 
wholly owns USP, a domestic corporation, which, in turn, wholly owns, 
LFS, a foreign corporation that is a controlled foreign corporation. DT 
was not a United States shareholder of LFS on or before the completion 
date. On January 31, 2015, FT contributed assets to LFS in exchange for 
60% of the stock of LFS, by vote and value. FT acquired an obligation of 
LFS on February 15, 2015.
    (B) Analysis. LFS is a foreign related person. Because LFS was a 
controlled foreign corporation and a member of the EAG with respect to 
the inversion transaction on the completion date, and DT was not a 
United States shareholder with respect to LFS on or before the 
completion date, LFS is excluded from the definition of expatriated 
foreign subsidiary pursuant to Sec. 1.7874-12(a)(9)(ii). Thus, pursuant 
to Sec. 1.7874-12(a)(16), LFS is a non-EFS foreign related person, and 
the stock and obligation of LFS are United States property with respect 
to FT for purposes of section 956(a) and this paragraph (a). The fact 
that FT contributed assets to LFS in exchange for 60% of the stock of 
LFS does not change this result.
    Example 4. (A) Facts. The facts are the same as in Example 3 of this 
paragraph (a)(4)(iv), except that on February 10, 2015, LFS organized a 
new foreign corporation (LFSS), transferred all of its assets to LFSS, 
and liquidated, in a transaction treated as a reorganization described 
in section 368(a)(1)(F), and FT acquired an obligation of LFSS, instead 
of LFS, on February 15, 2015. On March 1, 2015, LFSS acquired an 
obligation of FS.
    (B) Analysis. LFS is a controlled foreign corporation with respect 
to which USP, an expatriated entity, is a United States shareholder. USP 
is an expatriated entity because on the completion date, USP and DT 
became related to each other within the meaning of section 267(b). 
Because LFSS was not a member of the EAG with respect to the inversion 
transaction on the completion date, LFSS is not excluded from the 
definition of expatriated foreign subsidiary pursuant to Sec. 1.7874-
12(a)(9)(ii). Accordingly, under Sec. 1.7874-12(a)(9)(i), LFFS is an 
expatriated foreign subsidiary and is therefore not a non-EFS foreign 
related person. Thus, the stock and obligation of LFSS are not United 
States property with respect to FT for purposes of section 956(a) and 
paragraph (a) of this section. However, because LFSS is an expatriated 
foreign subsidiary, pursuant to Sec. 1.7874-12(a)(9), the obligation of 
FS, a non-EFS foreign related person, is United States property with 
respect to LFSS for purposes of section 956(a) and this paragraph (a).

    (b) Exceptions--(1) Excluded property. For purposes of section 
956(a) and paragraph (a) of this section, United States property does 
not include the following types of property held by a foreign 
corporation:
    (i) Obligations of the United States.
    (ii) Money.
    (iii) Deposits with persons carrying on the banking business, unless 
the deposits serve directly or indirectly as a pledge or guarantee 
within the meaning of paragraph (c) of this section. See paragraph 
(e)(2) of Sec. 1.956-1.
    (iv) Property located in the United States which is purchased in the 
United States for export to, or use in, foreign countries. For purposes 
of this subdivision, property to be used outside the United States will 
be considered property to be used in a foreign country. Whether property 
is of a type

[[Page 394]]

described in this subdivision is to be determined from all the facts and 
circumstances in each case. Property which constitutes export trade 
assets within the meaning of section 971(c)(2) and paragraph (c)(3) of 
Sec. 1.971-1 will be considered property of a type described in this 
subdivision.
    (v) Any obligation (as defined in paragraph (d)(2) of this section) 
of a United States person (as defined in section 957(d)) arising in 
connection with the sale or processing of property if the amount of such 
obligation outstanding at any time during the taxable year of the 
foreign corporation does not exceed an amount which is ordinary and 
necessary to carry on the trade or business of both the other party to 
the sale or processing transaction and the United States person, or, if 
the sale or processing transaction occurs between related persons, would 
be ordinary and necessary to carry on the trade or business of both the 
other party to the sale or processing transaction and the United States 
person if such persons were unrelated persons. Whether the amount of an 
obligation described in this subdivision is ordinary and necessary is to 
be determined from all the facts and circumstances in each case.
    (vi) Any aircraft, railroad rolling stock, vessel, motor vehicle, or 
container used in the transportation of persons or property in foreign 
commerce and used predominantly outside the United States. Whether 
transportation property described in this paragraph (b)(1)(vi) is used 
in foreign commerce and predominantly outside the United States is to be 
determined from all the facts and circumstances of each case. As a 
general rule, such transportation property will be considered to be used 
predominantly outside the United States if 70 percent or more of the 
miles traversed (during the taxable year at the close of which a 
determination is made under section 956(a)(2)) in the use of such 
property are traversed outside the United States or if such property is 
located outside the United States 70 percent of the time during such 
taxable year. Notwithstanding the above, an aircraft or vessel, 
including component parts, is excluded from United States property if 
the aircraft or vessel is leased in foreign commerce (as the term is 
defined in Sec. 1.954-2(c)(2)(v)) and rents derived from leasing such 
aircraft or vessel are excluded from foreign personal holding company 
income under section 954(c)(2)(A).
    (vii) An amount of assets described in paragraph (a) of this section 
of an insurance company equivalent to the unearned premiums or reserves 
which are ordinary and necessary for the proper conduct of that part of 
its insurance business which is attributable to contracts other than 
those described in section 953(a)(1) and the regulations thereunder. For 
purposes of this subdivision, a reserve will be considered ordinary and 
necessary for the proper conduct of an insurance business if, under the 
principles of paragraph (c) of Sec. 1.953-4, such reserve would qualify 
as a reserve required by law. See paragraph (d)(3) of Sec. 1.954-2 for 
determining, for purposes of this subdivision, the meaning of insurance 
company and of unearned premiums.
    (viii) For taxable years beginning after December 31, 1975, the 
voting or nonvoting stock or obligations of an unrelated domestic 
corporation. For purposes of this subdivision, an unrelated domestic 
corporation is a domestic corporation which is neither a United States 
shareholder (as defined in section 951(b)) of the controlled foreign 
corporation making the investment, nor a corporation 25 percent or more 
of whose total combined voting power of all classes of stock entitled to 
vote is owned or considered as owned (within the meaning of section 958 
(b)) by United States shareholders of the controlled foreign corporation 
making the investment. The determination of whether a domestic 
corporation is an unrelated corporation is made immediately after each 
acquisition of stock or obligations by the controlled foreign 
corporations.
    (ix) For taxable years beginning after December 31, 1975, movable 
drilling rigs or barges and other movable exploration and exploitation 
equipment (other than a vessel or an aircraft) when used on the 
Continental Shelf (as defined in section 638) of the United States in 
the exploration for, development, removal, or transportation of natural 
resources from or under ocean

[[Page 395]]

waters. Property used on the Continental Shelf includes property located 
in the United States which is being constructed or is in storage or in 
transit within the United States for use on the Continental Shelf. In 
general, the type of property which qualifies for the exception under 
this subdivision includes any movable property which would be entitled 
to the investment credit if used outside the United States in certain 
geographical areas of the Western Hemisphere pursuant to section 
48(a)(2)(B)(x) (without reference to sections 49 and 50).
    (x) An amount of--
    (a) A controlled foreign corporation's assets described in paragraph 
(a) of this section equivalent to its earnings and profits which are 
accumulated after December 31, 1962, and are attributable to items of 
income described in section 952(b) and the regulations thereunder, 
reduced by the amount of
    (b) The earnings and profits of such corporation which are applied 
in a taxable year of such corporation beginning after December 31, 1962, 
to discharge a liability on property, but only if the liability was in 
existence at the close of such corporation's taxable year immediately 
preceding its first taxable year beginning after December 31, 1962, and 
the property would have been United States property if it had been 
acquired by such corporation immediately before such discharge.


For purposes of this subdivision, distributions made by such corporation 
for any taxable year shall be considered first made out of earnings and 
profits for such year other than earnings and profits referred to in (a) 
of this subdivision.
    (xi) [Reserved] For further guidance, see Sec. 1.956-2T(b)(1)(xi).
    (2) Statement required. If a United States shareholder of a 
controlled foreign corporation excludes any property from the United 
States property of such controlled foreign corporation on the ground 
that section 956(b)(2) applies to such excluded property, he shall 
attach to his return a statement setting forth, by categories described 
in paragraph (a)(1) of this section, the amount of United States 
property of the controlled foreign corporation and, by categories 
described in subparagraph (1) of this paragraph, the amount of such 
property which is excluded.
    (c) Treatment of pledges and guarantees--(1) General rule. Except as 
provided in paragraph (c)(4) of this section, for purposes of section 
956, any obligation of a United States person with respect to which a 
controlled foreign corporation or a partnership is a pledgor or 
guarantor will be considered to be held by the controlled foreign 
corporation or the partnership, as the case may be. See Sec. 1.956-
1(e)(2) for rules that determine the amount of the obligation treated as 
held by a pledgor or guarantor under this paragraph (c). For rules that 
treat an obligation of a foreign partnership as an obligation of the 
partners in the foreign partnership for purposes of section 956, see 
Sec. 1.956-4(c).
    (2) Indirect pledge or guarantee. If the assets of a controlled 
foreign corporation or a partnership serve at any time, even though 
indirectly, as security for the performance of an obligation of a United 
States person, then, for purposes of paragraph (c)(1) of this section, 
the controlled foreign corporation or partnership will be considered a 
pledgor or guarantor of that obligation. If a partnership is considered 
a pledgor or guarantor of an obligation, a controlled foreign 
corporation that is a partner in the partnership will not also be 
treated as a pledgor or guarantor of the obligation solely as a result 
of its ownership of an interest in the partnership. For purposes of this 
paragraph, a pledge of stock of a controlled foreign corporation 
representing at least 66\2/3\ percent of the total combined voting power 
of all classes of voting stock of such corporation will be considered an 
indirect pledge of the assets of the controlled foreign corporation if 
the pledge is accompanied by one or more negative covenants or similar 
restrictions on the shareholder effectively limiting the corporation's 
discretion to dispose of assets and/or incur liabilities other than in 
the ordinary course of business. See Sec. 1.956-4(d) for guidance on 
the treatment of indirect pledges or guarantees of an obligation of a 
partnership attributed to its partners under Sec. 1.956-4(c).
    (3) Illustrations. The following examples illustrate the application 
of this paragraph (c):


[[Page 396]]


    Example 1. A, a United States person, borrows $100,000 from a bank 
in foreign country X on December 31, 1964. On the same date controlled 
foreign corporation R pledges its assets as security for A's performance 
of A's obligation to repay such loan. The place at which or manner in 
which A uses the money is not material. For purposes of paragraph (b) of 
Sec. 1.956-1, R Corporation will be considered to hold A's obligation 
to repay the bank $100,000, and, under the provisions of paragraph 
(e)(2) of Sec. 1.956-1, the amount taken into account in computing R 
Corporation's aggregate investment in United States property on December 
31, 1964, is the unpaid principal amount of the obligation on that date 
($100,000).
    Example 2. The facts are the same as in example 1, except that R 
Corporation participates in the transaction, not by pledging its assets 
as security for A's performance of A's obligation to repay the loan, but 
by agreeing to buy for $1,00,000 at maturity the note representing A's 
obligation if A does not repay the loan. Separate arrangements are made 
with respect to the payment of the interest on the loan. The agreement 
of R Corporation to buy the note constitutes a guarantee of A's 
obligation. For purposes of paragraph (b) of Sec. 1.956-1, R 
Corporation will be considered to hold A's obligation to repay the bank 
$100,000, and, under the provisions of paragraph (e)(2) of Sec. 1.956-
1, the amount taken into account in computing R Corporation's aggregate 
investment in United States property on December 31, 1964, is the unpaid 
principal amount of the obligation on that date ($100,000).
    Example 3. A, a United States person, borrows $100,000 from a bank 
on December 10, 1981, pledging 70 percent of the stock of X, a 
controlled foreign corporation, as collateral for the loan. A and X use 
the calendar year as their taxable year. in the loan agreement, among 
other things, A agrees not to cause or permit X Corporation to do any of 
the following without the consent of the bank:
    (a) Borrow money or pledge assets, except as to borrowings in the 
ordinary course of business of X Corporation;
    (b) Guarantee, assume, or become liable on the obligation of 
another, or invest in or lend funds to another;
    (c) Merge or consolidate with any other corporation or transfer 
shares of any controlled subsidiary;
    (d) Sell or lease (other than in the ordinary course of business) or 
otherwise dispose of any substantial part of its assets;
    (e) Pay or secure any debt owing by X Corporation to A; and
    (f) Pay any dividends, except in such amounts as may be required to 
make interest or principal payments on A's loan from the bank.
    A retains the right to vote the stock unless a default occurs by A. 
Under paragraph (c)(2) of this section, the assets of X Corporation 
serve indirectly as security for A's performance of A's obligation to 
repay the loan and X Corporation will be considered a pledgor or 
guarantor with respect to that obligation. For purposes of paragraph (b) 
of Sec. 1.956-1, X Corporation will be considered to hold A's 
obligation to repay the bank $100,000 and under paragraph (e)(2) of 
Sec. 1.956-1, the amount taken into account in computing X 
Corporation's aggregate investment in United States property on December 
31, 1981, is the unpaid principal amount of the obligation on that date.
    Example 4. (i) Facts. USP, a domestic corporation, owns 70% of the 
stock of FS, a controlled foreign corporation, and a 90% interest in 
FPRS, a foreign partnership. X, an unrelated foreign person, owns 30% of 
the stock of FS. Y, an unrelated foreign person, owns a 10% interest in 
FPRS. There are no special allocations in the FPRS partnership 
agreement. FPRS borrows $100x from Z, an unrelated person. FS pledges 
its assets as security for FPRS's performance of its obligation to repay 
the $100x loan. USP's share of the $100x FPRS obligation, determined in 
accordance with its liquidation value percentage, is $90x. Under Sec. 
1.956-4(c), $90x of the FPRS obligation is treated as an obligation of 
USP for purposes of section 956.
    (ii) Result. For purposes of section 956, under paragraph (c)(1) of 
this section, FS is considered to hold an obligation of USP in the 
amount of $90x, and thus is treated as holding United States property in 
the amount of $90x.

    (4) Special rule for certain conduit financing arrangements. The 
rule contained in subparagraph (1) of this paragraph shall not apply to 
a pledge or a guarantee by a controlled foreign corporation to secure 
the obligation of a United States person if such United States person is 
a mere conduit in a financing arrangement. Whether the United States 
person is a mere conduit in a financing arrangement will depend upon all 
the facts and circumstances in each case. A United States person will be 
considered a mere conduit in a financing arrangement in a case in which 
a controlled foreign corporation pledges stock of its subsidiary 
corporation, which is also a controlled foreign corporation, to secure 
the obligation of such United States person, where the following 
conditions are satisfied:
    (i) Such United States person is a domestic corporation which is not 
engaged in the active conduct of a trade or business and has no 
substantial assets other than those arising out of its

[[Page 397]]

relending of the funds borrowed by it on such obligation to the 
controlled foreign corporation whose stock is pledged; and
    (ii) The assets of such United States person are at all times 
substantially offset by its obligation to the lender.
    (5) Special guarantee and pledge rule for expatriated foreign 
subsidiaries--(i) General rule. In applying paragraphs (c)(1) and (2) of 
this section to a controlled foreign corporation that is an expatriated 
foreign subsidiary, the phrase ``of a United States person or a non-EFS 
foreign related person'' is substituted for the phrase ``of a United 
States person'' each place it appears.
    (ii) Additional rules. The rule in paragraph (c)(5)(i) of this 
section--
    (A) Applies regardless of whether, when the pledge or guarantee was 
entered into or treated as entered into, the controlled foreign 
corporation was a controlled foreign corporation or an expatriated 
foreign subsidiary, or a foreign person whose obligation is subject to 
the pledge or guarantee, or deemed pledge or guarantee, was a non-EFS 
foreign related person; and
    (B) Applies to pledges or guarantees entered into, or treated 
pursuant to paragraph (c)(2) of this section as entered into--
    (1) During the applicable period; or
    (2) In a transaction related to the inversion transaction.
    (d) Definitions--(1) Meaning of ``acquired''--(i) Applicable rules. 
For purposes of this section--
    (a) Property shall be considered acquired by a foreign corporation 
when such corporation acquires an adjusted basis in the property;
    (b) Property which is an obligation of a United States person with 
respect to which a controlled foreign corporation is a pledgor or 
guarantor (within the meaning of paragraph (c) of this section) shall be 
considered acquired when the corporation becomes liable as a pledgor or 
guarantor or is otherwise considered a pledgor or guarantor (within the 
meaning of paragraph (c)(2) of this section); and
    (c) Property shall not be considered acquired by a foreign 
corporation if--
    (1) Such property is acquired in a transaction in which gain or loss 
would not be recognized under this chapter to such corporation if such 
corporation were a domestic corporation;
    (2) The basis of the property acquired by the foreign corporation is 
the same as the basis of the property exchanged by such corporation; and
    (3) The property exchanged by the foreign corporation was not United 
States property (as defined in paragraph (a)(1) of this section) but 
would have been such property if it had been acquired by such 
corporation immediately before such exchange.
    (ii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation R uses the calendar year as a taxable 
year and acquires before January 1, 1963, stock of domestic corporation 
M having as to R Corporation an adjusted basis of $10,000. The stock of 
M Corporation is not United States property of R Corporation on December 
31, 1962, since it is not acquired in a taxable year of R Corporation 
beginning on or after January 1, 1963. On June 30, 1963, R Corporation 
sells the M Corporation stock for $15,000 in cash and expends such 
amount in acquiring stock of domestic corporation N which has as to R 
Corporation an adjusted basis of $15,000. For purposes of determining R 
Corporation's aggregate investment in United States property on December 
31, 1963, R Corporation has, by virtue of acquiring the stock of N 
Corporation, acquired $15,000 of United States property.
    Example 2. Foreign corporation S, a controlled foreign corporation 
for the entire period here involved, uses the calendar year as a taxable 
year and purchases for $100,000 on December 31, 1963, tangible property 
(not described in section 956(b)(2)) located in the United States and 
having a remaining estimated useful life of 10 years, subject to a 
mortgage of $80,000 payable in 5 annual installments. The property 
constitutes United States property as of December 31, 1963, and the 
amount taken into account for purposes of determining the aggregate 
amount of S Corporation's investment in United States property under 
paragraph (b) of Sec. 1.956-1 is $20,000. No depreciation is sustained 
with respect to the property during the taxable year 1963. During the 
taxable year 1964, S Corporation pays $16,000 on the mortgage and 
sustains $10,000 of depreciation with respect to the property. As of 
December 31, 1964, the amount taken into account with respect to the 
property for purposes of determining the aggregate amount of S 
Corporation's investment in United States property under paragraph (b) 
of Sec. 1.956-1 is $26,000, computed as follows:

Cost of property.............................................   $100,000

[[Page 398]]

 
  Less: Reserve for depreciation.............................     10,000
                                                    -----------
   Adjusted basis of property................................     90,000
  Less: Liability to which property is subject:
    Gross amount of mortgage.......................   $80,000
    Payment during 1964............................    16,000
                                                    ----------
                                                     ........     64,000
                                                              ----------
Amount taken into account (12-31-64).........................     26,000
 

    Example 3. Controlled foreign corporation T uses the calendar year 
as a taxable year and acquires on December 31, 1963, $10,000 of United 
States property not described in section 956(b)(2); no depreciation is 
sustained with respect to the property during 1963. Corporation T's 
current and accumulated earnings and profits (determined as provided in 
paragraph (b) of Sec. 1.956-1) as of December 31, 1963, are in excess 
of $10,000, and T Corporation's United States shareholders include in 
their gross income under section 951(a)(1)(B) their pro rata share of T 
Corporation's increase ($10,000) for 1963 in earnings invested in United 
States property. On January 1, 1964, T Corporation acquires an 
additional $10,000 of United States property not described in section 
956(b)(2). Each of the two items of property has an estimated useful 
life of 5 years, and T Corporation sustains $4,000 of depreciation with 
respect to such properties during its taxable year 1964. Corporation T's 
current and accumulated earnings and profits as of December 31, 1964, 
exceed $16,000, determined as provided in paragraph (b) of Sec. 1.956-
1. Corporation T pays no amounts during 1963 to which section 959(c)(1) 
applies. Corporation T's investment of earnings in United States 
property at December 31, 1964, is $16,000, and its increase for 1964 in 
earnings invested in United States property is $6,000.
    Example 4. Foreign corporation U uses the calendar year as a taxable 
year and acquires before January 1, 1963, stock in domestic corporation 
M having as to U Corporation an adjusted basis of $10,000. On December 
1, 1964, pursuant to a statutory merger described in section 368(a)(1), 
M Corporation merges into domestic corporation N, and U Corporation 
receives on such date one share of stock in N Corporation, the surviving 
corporation, for each share of stock it held in M Corporation. Pursuant 
to section 354 no gain or loss is recognized to U Corporation, and 
pursuant to section 358 the basis of the property received (stock of N 
Corporation) is the same as that of the property exchanged (stock of M 
Corporation). Corporation U is not considered for purposes of section 
956 to have acquired United States property by reason of its receipt of 
the stock in N Corporation.
    Example 5. The facts are the same as in example 4, except that U 
Corporation acquires the stock of M Corporation on February 1, 1963, 
rather than before January 1, 1963. For purposes of determining U 
Corporation's aggregate investment in United States property on December 
31, 1963, U Corporation has, by virtue of acquiring the stock of M 
Corporation, acquired $10,000 of United States property. Corporation U 
pays no amount during 1963 to which section 959(c)(1) applies. The 
reorganization and resulting acquisition on December 1, 1964, by U 
Corporation of N Corporation's stock also represents an acquisition of 
United States property; however, assuming no other change in U 
Corporation's aggregate investment in United States property during 
1964, U Corporation's increase for such year in earnings invested in 
United States property is zero.

    (2) Obligation defined. For purposes of section 956 and this 
section, the term ``obligation'' includes any bond, note, debenture, 
certificate, bill receivable, account receivable, note receivable, open 
account, or other indebtedness, whether or not issued at a discount and 
whether or not bearing interest, except that the term does not include--
    (i) Any indebtedness arising out of the involuntary conversion of 
property which is not United States property within the meaning of 
paragraph (a) of this section;
    (ii) Any obligation of a United States person (as defined in section 
957(c)) arising in connection with the provision of services by a 
controlled foreign corporation to the United States person if the amount 
of the obligation outstanding at any time during the taxable year of the 
controlled foreign corporation does not exceed an amount which would be 
ordinary and necessary to carry on the trade or business of the 
controlled foreign corporation and the United States person if they were 
unrelated. The amount of the obligations shall be considered to be 
ordinary and necessary to the extent of such receivables that are paid 
within 60 days;
    (iii) Any obligation of a non-EFS foreign related person arising in 
connection with the provision of services by an expatriated foreign 
subsidiary to the non-EFS foreign related person if the amount of the 
obligation outstanding at any time during the taxable year of the 
expatriated foreign subsidiary does not exceed an amount which would be 
ordinary and necessary to carry on the trade or business of the 
expatriated foreign subsidiary and the non-EFS foreign related person if 
they

[[Page 399]]

were unrelated. The amount of the obligations shall be considered to be 
ordinary and necessary to the extent of such receivables that are paid 
within 60 days; or
    (iv) Any obligation of a United States person (as defined in section 
957(c)) that is collected within 30 days from the time it is incurred (a 
30-day obligation), unless the controlled foreign corporation that holds 
the 30-day obligation holds for 60 or more calendar days during the 
taxable year in which it holds the 30-day obligation any obligations 
which, without regard to the exclusion described in this paragraph 
(d)(2)(iv), would constitute United States property within the meaning 
of section 956 and paragraph (a) of this section.
    (e) Effective/applicability date. The last sentence of paragraph 
(b)(1)(vi) of this section applies to taxable years of controlled 
foreign corporations beginning on or after May 2, 2006, and for taxable 
years of United States shareholders with or within which such taxable 
years of the controlled foreign corporations end. Taxpayers may elect to 
apply the rule of the last sentence of paragraph (b)(1)(vi) of this 
section to taxable years of controlled foreign corporations beginning 
after December 31, 2004, and for taxable years of United States 
shareholders with or within which such taxable years of the controlled 
foreign corporations end. If an election is made to apply the last two 
sentences of Sec. 1.954-2(c)(2)(ii) and Sec. 1.954-2(c)(2)(v) through 
(vii) to taxable years of a controlled foreign corporation beginning 
after December 31, 2004, then the election must also be made for the 
last sentence of paragraph (b)(1)(vi) of this section.
    (f) [Reserved] For further guidance, see Sec. 1.956-2T(f).
    (g) [Reserved]
    (h) Effective/applicability date. (1) Paragraph (a)(3) of this 
section applies to taxable years of controlled foreign corporations 
ending on or after November 3, 2016, and taxable years of United States 
shareholders in which or with which such taxable years end, with respect 
to obligations held on or after November 3, 2016.
    (2) Paragraphs (c)(1), (c)(2), and Example 4 of paragraph (c)(3) of 
this section apply to taxable years of controlled foreign corporations 
ending on or after November 3, 2016, and taxable years of United States 
shareholders in which or with which such taxable years end, with respect 
to pledges and guarantees entered into on or after September 1, 2015. 
For purposes of this paragraph (h)(2), a pledgor or guarantor is treated 
as entering into a pledge or guarantee when there is a significant 
modification, within the meaning of Sec. 1.1001-3(e), of an obligation 
with respect to which it is a pledgor or guarantor on or after September 
1, 2015.
    (3) Except as otherwise provided in this paragraph (h)(3), 
paragraphs (a)(4) and (c)(5) of this section apply to obligations or 
stock acquired or to pledges or guarantees entered into, or treated as 
entered into, on or after September 22, 2014, but only if the inversion 
transaction was completed on or after September 22, 2014. The phrase ``, 
regardless of whether, when the obligation or stock was acquired, the 
acquirer was a controlled foreign corporation or an expatriated foreign 
subsidiary'' in paragraph (a)(4)(i)(A) of this section, the phrase 
``regardless of whether, when the obligation or stock was acquired, the 
foreign person or foreign corporation was a non-EFS foreign related 
person'' in paragraph (a)(4)(i)(B) of this section, and paragraphs 
(a)(4)(i)(C)(2), (c)(5)(ii)(A), and (c)(5)(ii)(B)(2) of this section 
apply to obligations or stock acquired or pledges or guarantees entered 
into or treated as entered into on or after April 4, 2016, but only if 
the inversion transaction was completed on or after September 22, 2014. 
Paragraph (a)(4)(ii) of this section applies to obligations acquired on 
or after April 4, 2016. For inversion transactions completed on or after 
September 22, 2014, however, taxpayers may elect to apply paragraph 
(a)(4)(ii) of this section to an obligation acquired before April 4, 
2016. For purposes of paragraph (a)(4)(i) of this section and this 
paragraph (h)(3), a deemed exchange of an obligation or stock pursuant 
to section 1001 constitutes an acquisition of the obligation or stock. 
For purposes of paragraph (c)(5) of this section and this paragraph 
(h)(3), a pledgor or guarantor or deemed pledgor or guarantor is treated 
as entering into a pledge or

[[Page 400]]

guarantee when there is a significant modification, within the meaning 
of Sec. 1.1001-3(e), of an obligation with respect to which it is a 
pledgor or guarantor or is treated as a pledgor or guarantor.
    (4) Paragraphs (d)(2)(i) and (ii) of this section are effective June 
14, 1988, with respect to investments made on or after June 14, 1988.
    (5) Paragraph (d)(2)(iii) of this section applies to obligations 
acquired on or after April 4, 2016, but only if the inversion 
transaction was completed on or after September 22, 2014. For inversion 
transactions completed on or after September 22, 2014, however, 
taxpayers may elect to apply paragraph (d)(2)(iii) of this section to an 
obligation acquired on or after September 22, 2014, and before April 4, 
2016. For purposes of paragraph (d)(2)(iii) of this section and this 
paragraph (h)(5), a significant modification, within the meaning of 
Sec. 1.1001-3(e), of an obligation on or after April 4, 2016, 
constitutes an acquisition of an obligation on or after April 4, 2016.
    (6) Paragraph (d)(2)(iv) of this section applies to obligations held 
on or after September 16, 1988. See Sec. 1.956-2T(d)(2)(v), as 
contained in 26 CFR part 1 revised as of April 1, 2017, for additional 
rules applicable to certain taxable years of a foreign corporation 
beginning before January 1, 2011.

(Secs. 956(c), 7805, Internal Revenue Code of 1954 (76 Stat. 1017, 68A 
Stat. 917; (26 U.S.C. 956(c) and 7805 respectively)))

[T.D. 6704, 29 FR 2601, Feb. 20, 1964, as amended by T.D. 7712, 45 FR 
52374, Aug. 7, 1980; T.D. 7797, 46 FR 57675, Nov. 25, 1981; T.D. 8209, 
53 FR 22171, June 14, 1988; T.D. 9008, 67 FR 48025, July 23, 2002; T.D. 
9406, 73 FR 38117, July 3, 2008; T.D. 9525, 76 FR 26181, May 6, 2011; 
T.D. 9589, 77 FR 27614, May 11, 2012; T.D. 9761, 81 FR 20886, Apr. 8, 
2016; T.D. 9792, 81 FR 76507, Nov. 3, 2016; T.D. 9834, 83 FR 32536, July 
12, 2018]



Sec. 1.956-2T  Definition of United States Property (temporary).

    (a)(1) through (a)(3) [Reserved] For further guidance, see Sec. 
1.956-2(a) through (b)(1)(x).
    (4) [Reserved]
    (b)(1) introductory text through (b)(1)(x) [Reserved] For further 
guidance, see Sec. 1.956-2(a) through (b)(1)(x).
    (xi) An obligation of a United States person arising from a 
nonperiodic payment by a controlled foreign corporation (within the 
meaning of section 957(a)) with respect to a notional principal contract 
described in Sec. 1.446-3T(g)(4)(ii)(B)(1) or (2) if the following 
conditions are satisfied--
    (A) The controlled foreign corporation that makes the nonperiodic 
payment is either a dealer in securities (within the meaning of section 
475(c)(1)) or a dealer in commodities; and
    (B) The conditions set forth in Sec. 1.446-3T(g)(4)(ii)(C)(1) 
(relating to full margin or collateral in cash) are satisfied.
    (C) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(xi):

    Example 1. Full margin--cleared contract. (i) A domestic corporation 
(U.S.C.) wholly owns a controlled foreign corporation (CFC) that is a 
dealer in securities under section 475(c)(1). CFC enters into an 
interest rate swap contract with unrelated counterparty B. The contract 
is required to be cleared and is accepted for clearing by a U.S.-
registered derivatives clearing organization (DCO). CFC is not a member 
of the DCO. CFC uses a U.S. affiliate (CM), which is a member of the 
DCO, as its clearing member to submit the contract to be cleared. CM is 
a domestic corporation that is wholly owned by U.S.C.. The standardized 
terms of the contract provide that, for a term of X years, CFC will pay 
B a fixed coupon of 1% per year and receive a floating coupon on a 
notional principal amount of $Y. When CFC and B enter into the contract, 
the market coupon for similar interest rate swaps is 2% per year. The 
DCO requires CFC to make an upfront payment to compensate B for the 
below-market annual coupon payments that B will receive, and CFC makes 
the upfront payment in cash. CFC makes the upfront payment through CM to 
the DCO, which then makes the payment to B. The DCO also requires B to 
post initial variation margin in an amount equal to the upfront payment 
and requires each party to post and collect daily variation margin in an 
amount equal to the change in the fair market value of the contract on a 
daily basis for the entire term of the contract. B posts the initial 
variation margin in U.S. dollars, which is received by CFC (through DCO 
and CM), and the parties post and collect daily variation margin in U.S. 
dollars.
    (ii) Because the contract is subject to initial variation margin in 
an amount equal to the upfront payment and daily variation margin in an 
amount equal to the change in the fair market value of the contract on a

[[Page 401]]

daily basis for the entire term of the contract, the contract is 
described in Sec. 1.446-3T(g)(4)(ii)(B)(1). Furthermore, because the 
additional conditions set forth in this paragraph (b)(1)(xi) are 
satisfied, the obligation of CM arising from the upfront payment by CFC 
does not constitute United States property for purposes of section 956.
    Example 2. Full margin--uncleared contract. (i) Assume the same 
facts as in Example 1, except for the following. CFC's counterparty to 
the contract is U.S.C., CM is not involved, and the contract is not 
required to be cleared and is not accepted for clearing by a U.S.-
registered derivatives clearing organization. The contract requires CFC 
to make an upfront payment to compensate U.S.C. for the below-market 
annual coupon payments that U.S.C. will receive, and CFC makes the 
upfront payment in U.S. dollars. Pursuant to the requirements of a 
federal regulator, U.S.C. is obligated to post initial variation margin 
with CFC in an amount equal to CFC's upfront payment, and U.S.C. and CFC 
are obligated to post and collect daily variation margin in an amount 
equal to the change in the fair market value of the contract on a daily 
basis for the entire term of the contract. U.S.C. posts the initial 
variation margin in U.S. dollars, which is received by CFC, and the 
parties post and collect daily variation margin in U.S. dollars.
    (ii) Because the contract is subject to initial variation margin in 
an amount equal to the upfront payment and daily variation margin in an 
amount equal to the change in the fair market value of the contract on a 
daily basis for the entire term of the contract, the contract is 
described in Sec. 1.446-3T(g)(4)(ii)(B)(2). Furthermore, because the 
additional conditions set forth in this paragraph (b)(1)(xi) are 
satisfied, the obligation of U.S.C. arising from the upfront payment by 
CFC does not constitute United States property for purposes of section 
956.

    (b)(2) through (c)(4) [Reserved] For further guidance, see Sec. 
1.956-2(b)(2) through (c)(4).
    (5) [Reserved]
    (d) introductory text through (d)(1) [Reserved] For further 
guidance, see Sec. 1.956-2(b)(2) through (d)(1).
    (2) [Reserved]
    (e) [Reserved] For further guidance see Sec. 1.956-2(e).
    (f) Effective/applicability date. Paragraph (b)(1)(xi) of this 
section applies to payments described in Sec. 1.956-2T(b)(1)(xi) made 
on or after May 8, 2015. Taxpayers may apply the rules of paragraph 
(b)(1)(xi) to payments made before May 8, 2015.
    (g) Expiration date. The applicability of paragraph (b)(1)(xi) of 
this section expires on May 7, 2018.
    (h) [Reserved]

[T.D. 8209, 53 FR 22171, June 14, 1988, as amended at T.D. 9406, 73 FR 
38117, July 3, 2008; T.D. 9525, 76 FR 26181, May 6, 2011; T.D. 9589, 77 
FR 27614, May 11, 2012; T.D. 9719, 80 FR 26442, May 8, 2015; T.D. 9761, 
81 FR 20886, Apr. 8, 2016; T.D. 9761, 81 FR 46833, July 19, 2016; T.D. 
9834, 83 FR 32538, July 12, 2018]



Sec. 1.956-3  Certain trade or service receivables acquired from 
United States persons.

    (a) In general. For purposes of section 956(a) and Sec. 1.956-1, 
the term ``United States property'' also includes any trade or service 
receivable if the trade or service receivable is acquired (directly or 
indirectly) from a related person who is a United States person (as 
defined in section 7701(a)(30)) (a related United States person) and the 
obligor under the receivable is a United States person. A trade or 
service receivable described in this paragraph is considered to be 
United States property notwithstanding the exceptions (other than 
subparagraph (H)) contained in section 956(c)(2). The terms ``trade or 
service receivable'' and ``related person'' have the respective meanings 
given to the terms by section 864(d) and the regulations thereunder, 
including Sec. 1.864-8T(b). For purposes of this section, the exception 
in Sec. 1.956-2T(d)(2)(ii) does not apply to trade or service 
receivables described in this paragraph.
    (b) Acquisition of a trade or service receivable--(1) General rule. 
The rules of Sec. 1.864-8T(c)(1) apply to determine whether a 
controlled foreign corporation has acquired a trade or service 
receivable.
    (2) Indirect acquisitions--(i) Acquisition through unrelated person. 
A trade or service receivable is considered acquired from a related 
person when it is acquired from an unrelated person who acquired 
(directly or indirectly) the receivable from a person who is a related 
person to the acquiring person.
    (ii) Acquisition by nominee, pass-through entity, or related foreign 
corporation. A controlled foreign corporation is treated as holding a 
trade or service receivable that is held by a nominee on its behalf, or 
by a simple trust or other

[[Page 402]]

pass-through entity (other than a partnership) to the extent of its 
direct or indirect ownership or beneficial interest in such simple trust 
or other pass-through entity. See Sec. Sec. 1.956-1(b) and 1.956-4(b) 
for rules that may treat a controlled foreign corporation as indirectly 
holding a trade or service receivable held by a foreign corporation or 
partnership. A controlled foreign corporation that is treated as holding 
a trade or service receivable held by another person (the direct holder) 
(or that would be treated as holding the receivable if the receivable 
were United States property or would be United States property if held 
directly by the controlled foreign corporation) is considered to have 
acquired the receivable from the person from whom the direct holder 
acquired the receivable. This paragraph (b)(2)(ii) does not limit the 
application of paragraph (b)(2)(iii) of this section. The following 
examples illustrate the application of this paragraph (b)(2)(ii):

    Example 1. (i) Facts. A domestic corporation, P, wholly owns a 
controlled foreign corporation, FS, with substantial earnings and 
profits. FS contributes $200x of cash to a partnership, PRS, in exchange 
for an 80% partnership interest. An unrelated foreign person contributes 
real estate located in a foreign country with a fair market value of 
$50x to PRS for the remaining 20% partnership interest. There are no 
special allocations in the PRS partnership agreement. PRS uses the $200x 
of cash received from FS to purchase trade receivables from P. The 
obligors with respect to the trade receivables are United States persons 
that are not related to any partner in PRS. The liquidation value 
percentage, as determined under Sec. 1.956-4(b), for FS with respect to 
PRS is 80%. A principal purpose of funding PRS (through FS's cash 
contribution) is to avoid the application of section 956 with respect to 
FS.
    (ii) Result. Under Sec. 1.956-4(b)(1), FS is treated as holding 80% 
of the trade receivables acquired by PRS from P, with a basis equal to 
$160x (80% x $200x, PRS's basis in the trade receivables). However, 
because FS controls PRS and a principal purpose of FS funding PRS was to 
avoid the application of section 956 with respect to FS, under Sec. 
1.956-1(b), if the trade receivables would be United States property if 
held directly by FS, FS additionally would be treated as holding the 
trade receivables to the extent that they exceed the amount of the 
receivables it holds under Sec. 1.956-4(b), which is $40x ($200x-
$160x). Accordingly, under this paragraph (b)(2)(ii), FS is treated as 
having acquired from P, a related United States person, the trade 
receivables that it is treated as holding with a basis equal to $200x 
($160x + $40x). Thus, FS is treated as holding United States property 
with a basis of $200x under paragraph (a) of this section.
    Example 2. (i) Facts. A domestic corporation, P, wholly owns a 
controlled foreign corporation, FS1, that has earnings and profits of at 
least $300x. FS1 organizes a foreign corporation, FS2, with a $200x cash 
contribution. FS2 uses the cash contribution to purchase trade 
receivables from P. The obligors with respect to the trade receivables 
are unrelated United States persons. A principal purpose of funding FS2 
(through FS1's cash contribution) is to avoid the application of section 
956 with respect to FS1.
    (ii) Result. Under Sec. 1.956-1(b), if the trade receivables held 
by FS2 were United States property, FS1 would be treated as holding the 
trade receivables held by FS2 because FS1 controls FS2 and a principal 
purpose of FS1 funding FS2 was to avoid the application of section 956 
with respect to FS1. Accordingly, under this paragraph (b)(2)(ii), FS1 
is treated as having acquired from P, a related United States person, 
the trade receivables that it would be treated as holding with a basis 
equal to $200x. Thus, FS1 is treated as holding United States property 
with a basis of $200x under paragraph (a) of this section.

    (iii) Swap or pooling arrangements. A trade or service receivable of 
a United States person is considered to be a trade or service receivable 
acquired from a related United States person and subject to the rules of 
this section when it is acquired in accordance with an arrangement that 
involves two or more groups of related persons, if the groups are 
unrelated to each other and the effect of the arrangement is that one or 
more persons in each group acquire (directly or indirectly) trade or 
service receivables from one or more unrelated United States persons who 
are also parties to the arrangement in exchange for reciprocal purchases 
of receivables from related United States persons. The following example 
illustrates the application of this paragraph (b)(2)(iii):

    Example. (i) Facts. 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 from M, N, O, and/or P.

[[Page 403]]

The obligors under some or all of the receivables acquired by each of A, 
B, C, and D are United States persons.
    (ii) Result. The effect of the prearranged plan is that each of A, 
B, C, and D acquires trade or service receivables of United States 
persons from one or more unrelated United States persons who are also 
parties to the arrangement, in exchange for reciprocal purchases of 
receivables from a related United States person. Accordingly, each of A, 
B, C, and D is treated as holding a trade or service receivable acquired 
from a related United States person and is subject to the rules of this 
section. As a result, each of A, B, C, and D is treated as holding an 
amount of United States property equal to its adjusted basis in the 
receivables acquired pursuant to the arrangement with respect to which 
the obligors are United States persons.

    (iv) Financing arrangements. If a controlled foreign corporation 
participates (directly or indirectly) in a lending transaction that 
results in a loan to a United States person who purchases property 
described in section 1221(a)(1) (inventory property) or services from a 
related United States person, or to any person who purchases from a 
related United States person trade or service receivables under which 
the obligor is a United States person, or to a person who is a related 
person with respect 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 is considered to have 
indirectly acquired a trade or service receivable described in paragraph 
(a) of this section. For purposes of this paragraph (b)(2)(iv), it is 
immaterial that the sums lent are not, in fact, the sums used to finance 
the purchase of the inventory property or services or trade or service 
receivables from a related United States person. The amount to be taken 
into account with respect to the United States property treated as held 
by a controlled foreign corporation as a result of the application of 
this paragraph (b)(2)(iv) is the lesser of the amount lent pursuant to a 
lending transaction described in this paragraph (b)(2)(iv) and the 
purchase price of the inventory property, services, or trade or service 
receivables. The following examples illustrate the application of this 
paragraph (b)(2)(iv):

    Example 1. (i) Facts. P, a domestic corporation, owns all of the 
outstanding stock of FS1, a controlled foreign corporation. P sells 
inventory property for $200x to X, an unrelated United States person. 
FS1 makes a $100x short-term loan to X, which loan would not have been 
made or maintained on the same terms but for X's purchase of P's 
inventory property.
    (ii) Result. FS1 directly participates in a lending transaction 
described in this paragraph (b)(2)(iv). Thus, FS1 is considered to have 
acquired a trade or service receivable described in paragraph (a) of 
this section. That is, FS1 is considered to have acquired a trade or 
service receivable of a United States person from a related United 
States person. As a result, FS1 is treated as holding United States 
property in the amount of $100x.
    Example 2. (i) Facts. The facts are the same as in Example 1 of this 
paragraph (b)(2)(iv), except that instead of loaning money to X 
directly, FS1 deposits $300x with an unrelated financial institution 
that loans $200x to X in order for X to purchase P's inventory property. 
The loan would not have been made or maintained on the same terms but 
for the corresponding deposit.
    (ii) Result. FS1 is considered to have acquired a trade or service 
receivable described in paragraph (a) of this section because FS1 
indirectly participates in a lending transaction described in this 
paragraph (b)(2)(iv). See Rev. Rul. 87-89, 1987-2 CB 195. That is, FS1 
is considered to have acquired a trade or service receivable of a United 
States person from a related United States person. Thus, FS1 is treated 
as holding United States property in the amount of $200x.
    Example 3. (i) Facts. P, a domestic corporation, owns all of the 
outstanding stock of FS1, a controlled foreign corporation. FS1 makes a 
$300x loan to U, an unrelated foreign corporation, in connection with 
U's purchase from P of receivables from the sale of inventory property 
by P to United States obligors for $200x.
    (ii) Result. FS1 is considered to have acquired a trade or service 
receivable described in paragraph (a) of this section because FS1 
directly participates in a lending transaction described in this 
paragraph (b)(2)(iv). That is, FS1 is considered to have acquired a 
trade or service receivable of a United States person from a related 
United States person. Thus, FS1 is treated as holding United States 
property in the amount of $200x.

    (c) Substitution of obligor. For purposes of this section, the 
substitution of another person for a United States obligor is 
disregarded, unless it can be demonstrated by the parties to the 
transaction that the primary purpose

[[Page 404]]

for the arrangement was not the avoidance of section 956. The following 
example illustrates the application of this paragraph (c):

    Example. (i) Facts. P, a domestic corporation, owns all of the 
outstanding stock of FS1, a controlled foreign corporation with 
substantial accumulated earnings and profits. P sells inventory property 
to X, a domestic corporation unrelated to P. To pay for the inventory 
property, X arranges for a foreign financing entity to issue a note to 
P. P then sells the note to FS1. P and X cannot demonstrate that the 
primary purpose for X's assignment of the payment obligation to the 
foreign financing entity was not the avoidance of section 956.
    (ii) Result. The substitution of the foreign financing entity for X 
is disregarded, and FS1 is treated as holding an obligation of a United 
States person acquired from a related United States person. Thus, FS1 is 
treated as holding United States property in the amount of the purchase 
price of the note.

    (d) Effective/applicability date. (1) Except as provided in 
paragraph (d)(2) of this section, this section applies to trade or 
service receivables acquired (directly or indirectly) after March 1, 
1984.
    (2) Paragraph (b)(2)(ii) of this section applies to taxable years of 
controlled foreign corporations ending on or after November 3, 2016, and 
taxable years of United States shareholders in which or with which such 
taxable years end, with respect to trade or service receivables acquired 
on or after September 1, 2015. For purposes of this paragraph (d), a 
significant modification, within the meaning of Sec. 1.1001-3(e), of a 
trade or service receivable on or after September 1, 2015, constitutes 
an acquisition of the trade or service receivable on or after that date.

[T.D. 9792, 81 FR 76508, Nov. 3, 2016]



Sec. 1.956-4  Certain rules applicable to partnerships.

    (a) Overview. This section provides rules concerning the application 
of section 956 to certain obligations of and property held by a 
partnership. Paragraph (b) of this section provides rules concerning 
United States property held indirectly by a controlled foreign 
corporation through a partnership. Paragraph (c) of this section 
provides rules that generally treat obligations of a foreign partnership 
as obligations of the partners in the foreign partnership, as well as a 
special rule that treats a partner that is a United States person as 
owing additional amounts of a partnership obligation in certain 
circumstances. Paragraph (d) of this section sets forth a rule 
concerning the application of the indirect pledge or guarantee rule to 
obligations of partnerships. Paragraph (e) of this section provides that 
obligations of a domestic partnership are obligations of a United States 
person. Paragraph (f) of this section provides effective and 
applicability dates. See Sec. Sec. 1.956-1(b) and 1.956-2(c) for 
additional rules applicable to partnerships.
    (b) Property held indirectly through a partnership--(1) General 
rule. For purposes of section 956, a partner in a partnership is treated 
as holding its attributable share of any property held by the 
partnership (including an obligation that the partnership is treated as 
holding as a result of the application of Sec. 1.956-2(c)). A partner's 
attributable share of partnership property is determined under the rules 
set forth in paragraph (b)(2) of this section. An upper-tier 
partnership's attributable share of the property of a lower-tier 
partnership is treated as property of the upper-tier partnership for 
purposes of applying this paragraph (b)(1) to the partners of the upper-
tier partnership. For purposes of section 956, a partner's adjusted 
basis in the property of the partnership equals the partner's 
attributable share of the partnership's adjusted basis in the property, 
as determined under the rules set forth in paragraph (b)(2) of this 
section, taking into account any adjustments to basis under section 
743(b) (with respect to the partner) or section 734(b) or any similar 
adjustments to basis. The rules in Sec. 1.956-1(e)(2) apply to 
determine the amount of an obligation treated as held by a partnership 
as a result of the application of Sec. 1.956-2(c). See Sec. 1.956-1(b) 
for special rules that may treat a controlled foreign corporation as 
holding a greater amount of United States property held by a partnership 
than the amount determined under this section.
    (2) Methodology--(i) Liquidation value percentage--(A) Calculation. 
Except as otherwise provided in paragraph (b)(2)(ii) of this section, 
for purposes of

[[Page 405]]

paragraph (b)(1) of this section, a partner's attributable share of 
partnership property is determined in accordance with the partner's 
liquidation value percentage. For purposes of this paragraph (b)(2)(i) 
and paragraph (c)(1) of this section, the liquidation value of a 
partner's interest in a partnership is the amount of cash the partner 
would receive with respect to the interest if, on the applicable 
determination date, as provided in paragraph (b)(2)(i)(B) of this 
section, the partnership sold all of its assets for cash equal to the 
fair market value of such assets (taking into account section 7701(g)), 
satisfied all of its liabilities (other than those described in Sec. 
1.752-7), paid an unrelated third party to assume all of its Sec. 
1.752-7 liabilities in a fully taxable transaction, and then liquidated. 
A partner's liquidation value percentage is the ratio (expressed as a 
percentage) of the liquidation value of the partner's interest in the 
partnership divided by the aggregate liquidation value of all of the 
partners' interests in the partnership.
    (B) Determination date. The determination date with respect to a 
partnership is the most recent of--
    (1) The formation of the partnership;
    (2) An event described in Sec. 1.704-1(b)(2)(iv)(f)(5) or Sec. 
1.704-1(b)(2)(iv)(s)(1) (a revaluation event), irrespective of whether 
the capital accounts of the partners are adjusted in accordance with 
Sec. 1.704-1(b)(2)(iv)(f); or
    (3) The first day of the partnership's taxable year, as determined 
under section 706, provided the liquidation value percentage determined 
for any partner on that day would differ from the most recently 
determined liquidation value percentage of that partner by more than 10 
percentage points.
    (ii) Special allocations. For purposes of paragraph (b)(1) of this 
section, if a partnership agreement provides for the allocation of book 
income (or, where appropriate, book gain) from a subset of the property 
of the partnership to a partner other than in accordance with the 
partner's liquidation value percentage in a particular taxable year (a 
special allocation), then the partner's attributable share of that 
property is determined solely by reference to the partner's special 
allocation with respect to the property, provided the special allocation 
will be respected for federal income tax purposes under section 704(b) 
and the regulations thereunder and does not have a principal purpose of 
avoiding the purposes of section 956.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. (i) Facts. USP, a domestic corporation, wholly owns FS, a 
controlled foreign corporation, which, in turn, owns an interest in 
FPRS, a foreign partnership. The remaining interest in FPRS is owned by 
an unrelated foreign person. FPRS holds non-depreciable property with an 
adjusted basis of $100x (the ``FPRS property'') that would be United 
States property if held by FS directly. At the close of quarter 1 of 
year 1, the liquidation value percentage, as determined under paragraph 
(b)(2) of this section, for FS with respect to FPRS is 25%. There are no 
special allocations in the FPRS partnership agreement.
    (ii) Result. Under paragraph (b)(1) of this section, for purposes of 
section 956, FS is treated as holding its attributable share of the 
property held by FPRS with an adjusted basis equal to its attributable 
share of FPRS's adjusted basis in such property. Under paragraph (b)(2) 
of this section, FS's attributable share of property held by FPRS is 
determined in accordance with FS's liquidation value percentage, which 
is 25%. Thus, FS's attributable share of the FPRS property is 25%, and 
its attributable share of FPRS's basis in the FPRS property is $25x. 
Accordingly, for purposes of determining the amount of United States 
property held by FS as of the close of quarter 1 of year 1, FS is 
treated as holding United States property with an adjusted basis of 
$25x.
    Example 2. (i) Facts. The facts are the same as in Example 1 of this 
paragraph (b)(3), except that the FPRS partnership agreement, which 
satisfies the requirements of section 704(b), specially allocates 80% of 
the income with respect to the FPRS property to FS. The special 
allocation does not have a principal purpose of avoiding the purposes of 
section 956.
    (ii) Result. Under paragraph (b)(1) of this section, for purposes of 
section 956, FS is treated as holding its attributable share of property 
held by FPRS with an adjusted basis equal to its attributable share of 
FPRS's adjusted basis in such property. In general, FS's attributable 
share of property held by FPRS is determined in accordance with FS's 
liquidation value percentage. However, because the special allocation 
does not have a principal purpose of avoiding the purposes of section 
956, under paragraph (b)(2)(ii) of this section, FS's attributable share 
of the FPRS property is determined by

[[Page 406]]

reference to its special allocation. FS's special allocation percentage 
for the FPRS property is 80%, and thus FS's attributable share of the 
FPRS property is 80% and its attributable share of FPRS's basis in the 
FPRS property is $80x. Accordingly, for purposes of determining the 
amount of United States property held by FS as of the close of quarter 1 
of year 1, FS is treated as holding United States property with an 
adjusted basis of $80x.
    Example 3. (i) Facts. USP, a domestic corporation, wholly owns FS, a 
controlled foreign corporation, which, in turn, owns an interest in 
FPRS, a foreign partnership. USP owns the remaining interest in FPRS. 
FPRS holds property (the ``FPRS property'') that would be United States 
property if held by FS directly. The FPRS property has an adjusted basis 
of $100x and is anticipated to appreciate in value but generate 
relatively little income. The FPRS partnership agreement, which 
satisfies the requirements of section 704(b), specially allocates 80% of 
the income with respect to the FPRS property to USP and 80% of the gain 
with respect to the disposition of FPRS property to FS. The special 
allocation does not have a principal purpose of avoiding the purposes of 
section 956.
    (ii) Result. Because the special allocation does not have a 
principal purpose of avoiding the purposes of section 956, under 
paragraph (b)(2)(ii) of this section, FS's attributable share of the 
FPRS property is determined by reference to a special allocation with 
respect to the FPRS property. Given the income and gain anticipated with 
respect to the FPRS property, it is appropriate to determine FS's 
attributable share of the property in accordance with the special 
allocation of gain. Accordingly, for purposes of determining the amount 
of United States property held by FS in each year that FPRS holds the 
FPRS property, FS's attributable share of the FPRS property is 80% and 
its attributable share of FPRS's basis in the FPRS property is $80x. 
Thus, FS is treated as holding United States property with an adjusted 
basis of $80x.

    (c) Obligations of a foreign partnership--(1) In general. Except as 
provided in paragraphs (c)(2) and (c)(3) of this section, for purposes 
of section 956, an obligation of a foreign partnership is treated as a 
separate obligation of each of the partners in the partnership to the 
extent of each partner's share of the obligation. A partner's share of 
the partnership's obligation is determined in accordance with the 
partner's liquidation value percentage, as determined under the rules 
set forth in paragraph (b)(2)(i) of this section, without regard to the 
rules set forth in paragraph (b)(2)(ii) of this section. An upper-tier 
partnership's share of an obligation of a lower-tier partnership is 
treated as an obligation of the upper-tier partnership for purposes of 
applying this paragraph (c)(1) to the partners of the upper-tier 
partnership.
    (2) Exception for obligations of partnerships in which neither the 
lending controlled foreign corporation nor any person related to the 
lending controlled foreign corporation is a partner. For purposes of 
applying section 956 with respect to a controlled foreign corporation, 
an obligation of a foreign partnership is treated as an obligation of a 
foreign partnership, and not as an obligation of its partners, if 
neither the controlled foreign corporation nor any person related to the 
controlled foreign corporation within the meaning of section 954(d)(3) 
is a partner in the partnership. For purposes of section 956, an 
obligation treated as an obligation of a foreign partnership pursuant to 
this paragraph (c)(2) is not an obligation of a United States person.
    (3) Special obligor rule in the case of certain partnership 
distributions--(i) General rule. For purposes of determining a partner's 
share of a foreign partnership's obligation under section 956, if the 
foreign partnership distributes an amount of money or property to a 
partner that is related to a controlled foreign corporation within the 
meaning of section 954(d)(3) and whose obligation would be United States 
property if held (or if treated as held) by the controlled foreign 
corporation, and the foreign partnership would not have made the 
distribution but for a funding of the partnership through an obligation 
held (or treated as held) by the controlled foreign corporation, 
notwithstanding Sec. 1.956-1(e), the partner's share of the partnership 
obligation is the greater of--
    (A) The partner's share of the partnership obligation as determined 
under paragraph (c)(1) of this section; and
    (B) The lesser of the amount of the distribution to the partner that 
would not have been made but for the funding of the partnership and the 
amount of the obligation (as determined under Sec. 1.956-1(e)).
    (ii) Deemed treatment. (A) For purposes of applying paragraph 
(c)(3)(i) of

[[Page 407]]

this section, in the case of a distribution of liquid assets by a 
foreign partnership to a partner, the foreign partnership is treated as 
if it would not have made the distribution of liquid assets to the 
partner but for the funding of the partnership through an obligation or 
obligations held (or treated as held) by the controlled foreign 
corporation to the extent the foreign partnership does not have 
sufficient liquid assets to make the distribution immediately prior to 
the distribution, without taking into account the obligation or 
obligations.
    (B) If the controlled foreign corporation holds (or is treated as 
holding) multiple obligations of the foreign partnership, paragraph 
(c)(3)(ii)(A) of this section applies to the obligations in reverse 
chronological order starting with the obligation that was acquired (or 
the obligation with respect to which a pledge or guarantee was entered 
into) closest in time to the distribution. Paragraph (c)(3)(ii)(A) of 
this section applies to an obligation only to the extent that the full 
amount of the distribution is not otherwise treated, pursuant to 
paragraph (c)(3)(ii)(A) of this section, as if it would not have been 
made but for the funding of the partnership through one or more other 
obligations.
    (C) For purposes of paragraph (c)(3)(ii) of this section, a 
significant modification, within the meaning of Sec. 1.1001-3(e), of an 
obligation constitutes an acquisition of the obligation on or after that 
date, and a pledgor or guarantor is treated as entering into a pledge or 
guarantee when there is a significant modification, within the meaning 
of Sec. 1.1001-3(e), of an obligation with respect to which it is a 
pledgor or guarantor.
    (D) For purposes of paragraph (c)(3)(ii) of this section, liquid 
assets means cash or cash equivalents, marketable securities within the 
meaning of section 453(f)(2), or an obligation owed by a related person 
(within the meaning of section 954(d)(3)).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c):

    Example 1. (i) Facts. USP, a domestic corporation, wholly owns FS, a 
controlled foreign corporation, and owns an interest in FPRS, a foreign 
partnership. At the close of quarter 1 of year 1, the liquidation value 
percentage, as determined under paragraph (b)(2)(i) of this section, for 
USP with respect to FPRS is 90%. X, a foreign person that is unrelated 
to USP or FS, owns the remaining interest in FPRS. FPRS borrows $100x 
from FS. FS's basis in the FPRS obligation is $100x.
    (ii) Result. Under paragraph (c)(1) of this section, for purposes of 
section 956, the obligation of FPRS is treated as obligations of its 
partners (USP and X) in proportion to each partner's liquidation value 
percentage with respect to FPRS. Because USP, a partner in FPRS, is 
related to FS within the meaning of section 954(d)(3), the exception in 
paragraph (c)(2) of this section does not apply. Based on its 
liquidation value percentage, USP's share of the FPRS obligation is 
$90x. Accordingly, for purposes of section 956, $90x of the FPRS 
obligation held by FS is treated as an obligation of USP and is United 
States property within the meaning of section 956(c). Therefore, on the 
date the loan is made, FS is treated as holding United States property 
of $90x.
    Example 2. (i) Facts. The facts are the same as in Example 1 of this 
paragraph (c)(4), except that USP owns 40% of the stock of FS and is not 
a related person (as defined in section 954(d)(3)) with respect to FS. 
Y, a United States person that is unrelated to USP or X, owns the 
remaining 60% of the stock of FS.
    (ii) Result. Because neither FS nor any person related to FS within 
the meaning of section 954(d)(3) is a partner in FPRS, the exception in 
paragraph (c)(2) of this section applies to treat the FPRS obligation as 
an obligation of a foreign partnership and not an obligation of a United 
States person. Therefore, paragraph (c)(1) of this section does not 
apply, and FS is not treated as holding United States property.
    Example 3. (i) Facts. USP, a domestic corporation, wholly owns FS, a 
controlled foreign corporation. USP and FS own interests in FPRS, a 
foreign partnership. USP's liquidation value percentage with respect to 
FPRS is 60%, and FS's liquidation value percentage with respect to FPRS 
is 30%. USP2, a domestic corporation that is unrelated to USP and FS, 
also owns an interest in FPRS; its liquidation value percentage is 10%. 
FPRS borrows $100x from an unrelated person. FS guarantees the FPRS 
obligation.
    (ii) Result. Under paragraph (c)(1) of this section, for purposes of 
section 956, the obligation of FPRS is treated as obligations of its 
partners (USP, FS, and USP2) in proportion to each partner's liquidation 
value percentage. Because USP, a partner in FPRS, is related to FS 
within the meaning of section 954(d)(3), and because FS is a partner in 
FPRS, the exception in paragraph (c)(2) of this section does not apply. 
Based on their liquidation value percentages, USP's share of

[[Page 408]]

the FPRS obligation is $60x, and USP2's share of the FPRS obligation is 
$10x. For purposes of section 956, $60x of the FPRS obligation is 
treated as an obligation of USP, and $10x of the FPRS obligation is 
treated as an obligation of USP2. Under Sec. 1.956-2(c)(1), FS is 
treated as holding the obligations of USP and USP2 that FS guaranteed. 
All of the exceptions to the definition of United States property 
contained in section 956 and Sec. 1.956-2 must be considered to 
determine whether the obligations of USP and USP2 that are treated as 
held by FS constitute United States property. Accordingly, the 
obligation of USP2 is not United States property under section 
956(c)(2)(F) and Sec. 1.956-2(b)(1)(viii). The obligation of USP, 
however, is United States property within the meaning of section 956(c). 
Therefore, on the date the guarantee is made, FS is treated as holding 
United States property of $60x.
    Example 4. (i) Facts. USP, a domestic corporation, wholly owns FS, a 
controlled foreign corporation. USP owns an interest in FPRS, a foreign 
partnership; its liquidation value percentage with respect to FPRS is 
70%. A domestic corporation that is unrelated to USP and FS owns the 
remaining interest in FPRS; its liquidation value percentage is 30%. 
FPRS borrows $100x from FS and makes a distribution of $80x to USP. FPRS 
would not have made the distribution to USP but for the funding of FPRS 
by FS.
    (ii) Result. Because USP, a partner in FPRS, is related to FS within 
the meaning of section 954(d)(3), the exception in paragraph (c)(2) of 
this section does not apply. Moreover, an obligation of USP held by FS 
would be United States property. USP's share of the FPRS obligation as 
determined under paragraph (c)(1) of this section in accordance with 
USP's liquidation value percentage is $70x. Under paragraph (c)(3) of 
this section, USP's share of the FPRS obligation is the greater of (i) 
USP's attributable share of the obligation, $70x, or (ii) the lesser of 
the amount of the distribution, $80x, or the amount of the obligation, 
$100x. For purposes of section 956, therefore, $80x of the FPRS 
obligation is treated as an obligation of USP and is United States 
property within the meaning of section 956(c). Thus, on the date the 
loan is made, FS is treated as holding United States property of $80x.

    (d) Limitation on a partner's indirect pledge or guarantee. For 
purposes of section 956 and Sec. 1.956-2(c), a controlled foreign 
corporation that is a partner in a partnership is not considered a 
pledgor or guarantor of the portion of an obligation of the partnership 
attributed to its partners that are United States persons under 
paragraph (c) of this section solely as a result of the attribution of a 
portion of the partnership's assets to the controlled foreign 
corporation under paragraph (b) of this section.
    (e) Obligations of a domestic partnership. For purposes of section 
956, an obligation of a domestic partnership is an obligation of a 
United States person. See section 956(c)(2)(L) for an exception from the 
treatment of such an obligation as United States property.
    (f) Effective/applicability dates. (1) Paragraph (b) of this section 
applies to taxable years of controlled foreign corporations ending on or 
after November 3, 2016, and taxable years of United States shareholders 
in which or with which such taxable years end, with respect to property 
acquired on or after November 3, 2016. For purposes of this paragraph 
(f)(1), a deemed exchange of property pursuant to section 1001 on or 
after November 3, 2016, constitutes an acquisition of the property on or 
after that date. See Sec. 1.956-2(a)(3), as contained in 26 CFR part 1 
revised as of April 1, 2016, for the rules applicable to taxable years 
of a controlled foreign corporation beginning on or after July 23, 2002, 
and ending before November 3, 2016, and with respect to property 
acquired before November 3, 2016, to taxable years of a controlled 
foreign corporation beginning on or after July 23, 2002.
    (2) Except as otherwise provided in this paragraph (f)(2), paragraph 
(c) of this section applies to taxable years of controlled foreign 
corporations ending on or after November 3, 2016, and taxable years of 
United States shareholders in which or with which such taxable years 
end, with respect to obligations acquired, or pledges or guarantees 
entered into, on or after September 1, 2015, and, for purposes of 
paragraph (c)(3) of this section, in the case of distributions made on 
or after September 1, 2015. Paragraph (c)(3)(ii) of this section applies 
to taxable years of controlled foreign corporations ending on or after 
November 3, 2016, and taxable years of United States shareholders in 
which or with which such taxable years end, with respect to obligations 
acquired, or pledges or guarantees entered into, on or after September 
1, 2015, and distributions made

[[Page 409]]

on or after November 3, 2016. For purposes of this paragraph (f)(2), a 
significant modification, within the meaning of Sec. 1.1001-3(e), of an 
obligation on or after September 1, 2015 constitutes an acquisition of 
the obligation on or after that date. Furthermore, for purposes of this 
paragraph (f)(2), a pledgor or guarantor is treated as entering into a 
pledge or guarantee when there is a significant modification, within the 
meaning of Sec. 1.1001-3(e), of an obligation with respect to which it 
is a pledgor or guarantor on or after September 1, 2015. See Sec. 
1.956-1T(b)(5), as contained in 26 CFR part 1 revised as of April 1, 
2016, for rules applicable to taxable years of controlled foreign 
corporations ending on or after September 1, 2015, and before November 
3, 2016, and to taxable years of United States shareholders in which or 
with which such taxable years end, in the case of distributions made on 
or after September 1, 2015.
    (3) Paragraph (d) of this section applies to taxable years of 
controlled foreign corporations ending on or after November 3, 2016, and 
taxable years of United States shareholders in which or with which such 
taxable years end, with respect to pledges or guarantees entered into on 
or after September 1, 2015. For purposes of this paragraph (f)(3), a 
pledgor or guarantor is treated as entering into a pledge or guarantee 
when there is a significant modification, within the meaning of Sec. 
1.1001-3(e), of an obligation with respect to which it is a pledgor or 
guarantor on or after September 1, 2015.
    (4) Paragraph (e) of this section applies to taxable years of 
controlled foreign corporations ending on or after November 3, 2016, and 
to taxable years of United States shareholders in which or with which 
such taxable years end, with respect to obligations held on or after 
November 3, 2016.

[T.D. 9792, 81 FR 76509, Nov. 3, 2016; 81 FR 95471, Dec. 28, 2016]



Sec. 1.957-1  Definition of controlled foreign corporation.

    (a) In general. The term controlled foreign corporation means any 
foreign corporation of which more than 50 percent (or such lesser amount 
as is provided in section 957(b) or section 953(c)) of either--
    (1) The total combined voting power of all classes of stock of the 
corporation entitled to vote; or
    (2) The total value of the stock of the corporation, is owned within 
the meaning of section 958(a), or (except for purposes of section 
953(c)) is considered as owned by applying the rules of section 958(b) 
and Sec. 1.958-2, by United States shareholders on any day during the 
taxable year of such foreign corporation. For the definition of the term 
United States shareholder, see sections 951(b) and 953(c)(1)(A). For the 
definition of the term foreign corporation, see Sec. 301.7701-5 of this 
chapter (Procedure and Administration Regulations). For the treatment of 
associations as corporations, see section 7701(a)(3) and Sec. Sec. 
301.7701-1 and 301.7701-2 of this chapter. For the definition of the 
term stock, see sections 958(a)(3) and 7701(a)(7). For the 
classification of a member in an association, joint stock company or 
insurance company as a shareholder, see section 7701(a)(8).
    (b) Percentage of total combined voting power owned by United States 
shareholders--(1) Meaning of combined voting power. In determining for 
purposes of paragraph (a) of this section whether United States 
shareholders own the requisite percentage of total combined voting power 
of all classes of stock entitled to vote, consideration will be given to 
all the facts and circumstances of each case. In all cases, however, 
United States shareholders of a foreign corporation will be deemed to 
own the requisite percentage of total combined voting power with respect 
to such corporation--
    (i) If they have the power to elect, appoint, or replace a majority 
of that body of persons exercising, with respect to such corporation, 
the powers ordinarily exercised by the board of directors of a domestic 
corporation;
    (ii) If any person or persons elected or designated by such 
shareholders have the power, where such shareholders have the power to 
elect exactly one-half of the members of such governing body of such 
foreign corporation, either to cast a vote deciding an evenly divided 
vote of such body or, for the duration of any deadlock which

[[Page 410]]

may arise, to exercise the powers ordinarily exercised by such governing 
body; or
    (iii) If the powers which would ordinarily be exercised by the board 
of directors of a domestic corporation are exercised with respect to 
such foreign corporation by a person whom such shareholders have the 
power to elect, appoint, or replace.
    (2) Shifting of formal voting power. Any arrangement to shift formal 
voting power away from United States shareholders of a foreign 
corporation will not be given effect if in reality voting power is 
retained. The mere ownership of stock entitled to vote does not by 
itself mean that the shareholder owning such stock has the voting power 
of such stock for purposes of section 957. For example, if there is any 
agreement, whether express or implied, that any shareholder will not 
vote his stock or will vote it only in a specified manner, or that 
shareholders owning stock having not more than 50 percent of the total 
combined voting power will exercise voting power normally possessed by a 
majority of stockholders, then the nominal ownership of the voting power 
will be disregarded in determining which shareholders actually hold such 
voting power, and this determination will be made on the basis of such 
agreement. Moreover, where United States shareholders own shares of one 
or more classes of stock of a foreign corporation which has another 
class of stock outstanding, the voting power ostensibly provided such 
other class of stock will be deemed owned by any person or persons on 
whose behalf it is exercised or, if not exercised, will be disregarded 
if the percentage of voting power of such other class of stock is 
substantially greater than its proportionate share of the corporate 
earnings, if the facts indicate that the shareholders of such other 
class of stock do not exercise their voting rights independently or fail 
to exercise such voting rights, and if a principal purpose of the 
arrangement is to avoid the classification of such foreign corporation 
as a controlled foreign corporation under section 957.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Foreign corporation R has two classes of capital stock 
outstanding, 60 shares of class A stock, and 40 shares of class B stock. 
Each share of each class of stock has one vote for all purposes. E, a 
United States person, owns 51 shares of class A stock. Corporation R is 
a controlled foreign corporation.
    Example 2. Foreign corporation S has three classes of capital stock 
outstanding, consisting of 60 shares of class A stock, 40 shares of 
class B stock, and 200 shares of class C stock. The owners of a majority 
of class A stock are entitled to elect 6 of the 10 corporate directors, 
and the owners of a majority of the class B stock are entitled to elect 
the other 4 of the 10 directors. Class C stock has no voting rights. D, 
a United States person, owns all of the shares of the class C stock. He 
also owns 31 shares of class A stock and as such an owner can elect 6 
members of the board of directors. None of the remaining shares of class 
A stock, or the 40 shares of class B stock, is owned, or considered as 
owned, within the meaning of section 958, by a United States person. 
Since, as owner of 31 shares of the class A stock, D has sufficient 
voting power to elect 6 directors, D has more than 50 percent of the 
total combined voting power of all classes of stock entitled to vote, 
and S Corporation is a controlled foreign corporation.
    Example 3. M, a United States person, owns a 51-percent interest in 
R Company, a foreign company of which he is a member. The company, if it 
were domestic, would be taxable as a corporation. The remaining interest 
of 49 percent in the company is owned by seven other members none of 
whom is a United States person. The memorandum of association of R 
Company provides for only one manager, who with respect to the company 
exercises the powers ordinarily exercised by a board of directors of a 
domestic corporation. The manager is to be elected by unanimous 
agreement of all the members. Since M owns 51 percent of the company, he 
will be deemed to own more than 50 percent of the total combined voting 
power of all classes of stock of R Company entitled to vote, 
notwithstanding that he has power to elect a manager only with the 
agreement of the other members. Company R is a controlled foreign 
corporation.
    Example 4. Domestic corporation M owns a 49-percent interest in S 
Company, a foreign company of which it is a member. The company, if it 
were domestic, would be taxable as a corporation. Company S is formed 
under the laws of foreign country Y. The remaining interest of 51 
percent in S Company is owned by persons who are not United States 
persons. The organization contract of S Company provides for one 
manager, B, a citizen and resident of country Y who is an officer of

[[Page 411]]

M Corporation in charge of its foreign operations in such country, or 
any person M Corporation may at any time appoint to succeed B in such 
capacity. The manager has the sole authority with respect to S Company 
to exercise powers ordinarily exercised by a board of directors of a 
domestic corporation. Since M Corporation has the discretionary power to 
replace B and to appoint his successor as manager of S Company, the 
company is a controlled foreign corporation.
    Example 5. N, a United States person, owns 50 percent of the 
outstanding shares of the only class of capital stock of foreign 
corporation R. An additional 48 percent of the outstanding shares is 
owned by foreign corporation S. The remaining 2 percent of shares is 
owned by P, a citizen and resident of foreign country T, who regularly 
acts as attorney for N in the conduct of N's business affairs in country 
T. All of the shares of the outstanding capital stock of R Corporation 
are bearer shares. At the time of the issuance of the shares to him, P 
places the certificates for such shares in a depository to which N has 
access. On several occasions N, with P's acquiescence, has taken such 
shares from the depository and, on one such occasion, used the shares as 
collateral in borrowing funds on a loan. Although dividends, when paid, 
are paid to P on his shares, his charges to N for legal fees are reduced 
by the amount of the dividends paid on such shares. Although P votes his 
shares at meetings of shareholders, the facts set forth above indicate 
an implied agreement between P and N that N is really to retain dominion 
over the stock. N is deemed to own the voting rights ostensibly attached 
to the stock owned by P, and R Corporation is a controlled foreign 
corporation.
    Example 6. M, a domestic corporation which manufactures in the 
United States and distributes all of its production for foreign 
consumption through N, a person other than a related person or a United 
States person, forms foreign corporation S to purchase products from M 
Corporation and sell them to N. Corporations S and M have common 
directors. The outstanding capital stock of S Corporation consists of 
10,000 shares of $100 par value class A stock, which has no voting 
rights except to vote for dissolution of the corporation on a share-for-
share basis, and 500 shares of no par class B stock which has full 
voting rights. Each class of the outstanding stock is to participate on 
a share for share basis in any dividend. The class A stock has a 
preference as to assets on dissolution of the corporation to the extent 
of its par value as well as the right to participate with the class B 
stock in all other assets on a share for share basis. All of the shares 
of class A stock are issued to M Corporation in return for property 
having a value of $1 million. Of the class B stock, 300 of the shares 
are issued to N in return for $3,000 in cash and 200 shares are issued 
to M Corporation for $2,000 in cash. At stockholder meetings N never 
votes in opposition to M Corporation on important issues. Corporation S 
has average annual earnings of $200,000, all of which will be subpart F 
income if S Corporation is held to be a controlled foreign corporation. 
All such earnings are accumulated. Although N ostensibly has 60 percent 
of the voting power of S Corporation by virtue of his ownership of 300 
shares of class B stock, he has the right to only approximately 3 
percent of any dividends which may be paid by S Corporation; in 
addition, upon liquidation of S Corporation, N is entitled to share in 
the assets only after M Corporation has received the par value of its 
10,000 shares of class A stock, or $1 million. Thus, the voting power 
owned by N is substantially greater than its proportionate share of the 
earnings of S Corporation. In addition, the facts set forth above 
indicate that N is not exercising his voting rights independently and 
that a principal purpose of the capitalization arrangement is to avoid 
classification of S Corporation as a controlled foreign corporation. For 
these reasons, the voting power ostensibly provided the class B stock 
will be deemed owned by M Corporation, and S Corporation is a controlled 
foreign corporation.
    Example 7. Foreign corporation A, authorized to issue 100 shares of 
one class of capital stock, issues, for $1,000 per share, 45 shares to 
domestic corporation M, 45 shares to foreign corporation B, and 10 
shares to foreign corporation C. Corporation C, a bank, lends $3 million 
to finance the operations of A Corporation. In the course of negotiating 
these financial arrangements, D, an officer of C Corporation, and E, an 
officer of M Corporation, orally agree that C Corporation will vote its 
stock as M Corporation directs. By virtue of such oral agreement M 
Corporation possesses the voting power ostensibly owned by C 
Corporation, and A Corporation is a controlled foreign corporation.
    Example 8. For its prior taxable year, JV, a foreign corporation, 
had outstanding 1000 shares of class A stock, which is voting common, 
and 1000 shares of class B stock, which is nonvoting preferred. DP, a 
domestic corporation, and FP, a foreign corporation, each owned 
precisely 500 shares of both class A and class B stock, and each elected 
5 of the 10 members of JV's board of directors. The other facts and 
circumstances were such that JV was not a controlled foreign corporation 
on any day of the prior taxable year. On the first day of the current 
taxable year, DP purchased one share of class B stock from FP. JV was a 
controlled foreign corporation on the following day because over 50 
percent of the total value in the corporation was held by a person that 
was a United States shareholder under section 951(b). See Sec. 1.951-
1(f).

[[Page 412]]

    Example 9. The facts are the same as in Example 8 except that the 
stock of FP was publicly traded, FP had one class of stock, and on the 
first day of the current taxable year DP purchased one share of FP stock 
on the foreign stock exchange instead of purchasing one share of JV 
stock from FP. JV became a controlled foreign corporation on the 
following day because over 50 percent of the total value in the 
corporation was held by a person that was a United States shareholder 
under section 951(b).
    Example 10. X, a foreign corporation, is incorporated under the laws 
of country Y. Under the laws of country Y, X is considered a mutual 
insurance company. X issues insurance policies that provide the 
policyholder with the right to vote for directors of the corporation, 
the right to a share of the assets upon liquidation in proportion to 
premiums paid, and the right to receive policyholder dividends in 
proportion to premiums paid. Only policyholders are provided with the 
right to vote for directors, share in assets upon liquidation, and 
receive distributions. United States policyholders contribute 25 percent 
of the premiums and have 25 percent of the outstanding rights to vote 
for the board of directors. Based on these facts, the United States 
policyholders are United States shareholders owning the requisite 
combined voting power and value. Thus, X is a controlled foreign 
corporation for purposes of taking into account related person insurance 
income under section 953(c).

    (d) Effective date. Paragraphs (a) and (c) Examples 8 through 10 of 
this section are effective for taxable years of a controlled foreign 
corporation beginning after November 6, 1995.

[T.D. 6688, 28 FR 11631, Oct. 31, 1963, as amended by T.D. 8216, 53 FR 
27510, July 21, 1988; T.D. 8618, 60 FR 46529, Sept. 7, 1995; 60 FR 
62026, Dec. 4, 1995; T.D. 8704, 62 FR 21, Jan. 2, 1997]



Sec. 1.957-2  Controlled foreign corporation deriving income from 
insurance of United States risks.

    (a) In general. For purposes of taking into account only the income 
derived from the insurance of United States risks under Sec. 1.953-1, 
the term ``controlled foreign corporation'' means any foreign 
corporation of which more than 25 percent, but not more than 50 percent, 
of the total combined voting power of all classes of stock entitled to 
vote is owned within the meaning of section 958(a), or is considered as 
owned by applying the rules of ownership of section 958(b), by United 
States shareholders on any day of the taxable year of such foreign 
corporation, but only if the gross amount of premiums received by such 
foreign corporation during such taxable year which are attributable to 
the reinsuring and the issuing of insurance and annuity contracts in 
connection with United States risks, as defined in Sec. 1.953-2 or 
1.953-3, exceeds 75 percent of the gross amount of all premiums received 
by such foreign corporation during such year which are attributable to 
the reinsuring and the issuing of insurance and annuity contracts in 
connection with all risks. The subpart F income for a taxable year of a 
foreign corporation which is a controlled foreign corporation for such 
taxable year within the meaning of this paragraph shall, subject to the 
provisions of section 952(b), (c), and (d), and Sec. 1.952-1, include 
only the income derived from the insurance of United States risks, as 
determined under Sec. 1.953-1.
    (b) Gross amount of premiums defined. For a foreign corporation 
which is engaged in the business of reinsuring or issuing insurance or 
annuity contracts and which, if it were a domestic corporation engaged 
only in such business, would be taxable as--
    (1) A life insurance company to which part I (sections 801 through 
820) of subchapter L of the Code applies,
    (2) A mutual insurance company to which part II (sections 821 
through 826) of subchapter L of the Code applies, or
    (3) A mutual marine insurance or other insurance company to which 
part III (sections 831 and 832) of subchapter L of the Code applies,


the term ``gross amount of premiums'' means, for purposes of paragraph 
(a) of this section, the gross amount of premiums and other 
consideration which are taken into account by a life insurance company 
under section 809(c)(1). Determinations for purposes of this paragraph 
shall be made without regard to section 501(a).

[T.D. 6795, 30 FR 942, Jan. 29, 1965]



Sec. 1.957-3  United States person defined.

    (a) Basic rule--(1) In general. The term United States person has 
the same meaning for purposes of sections 951 through 965 that it has 
under section 7701(a)(30) and the regulations under that section,

[[Page 413]]

except as provided in paragraphs (b) and (c) of this section, which 
provide, with respect to corporations organized in possessions of the 
United States, that certain residents of such possessions are not United 
States persons. The effect of determining that an individual is not a 
United States person for such purposes is to exclude such individual in 
determining whether a foreign corporation created or organized in, or 
under the laws of, a possession of the United States is a controlled 
foreign corporation. See Sec. 1.957-1 for the definition of the term 
``controlled foreign corporation.''
    (2) Special provisions applicable to possessions of the United 
States. For purposes of this section--
    (i) The term possession of the United States means Puerto Rico or 
any section 931 possession;
    (ii) The term section 931 possession has the same meaning that it 
has under Sec. 1.931-1(c)(1);
    (iii) The rules of Sec. 1.937-1 will apply for determining whether 
an individual is a bona fide resident of a possession of the United 
States;
    (iv) Except as provided in paragraph (b)(2) of this section, the 
rules of Sec. 1.937-2 will apply for determining whether income is from 
sources within a possession of the United States; and
    (v) The rules of Sec. 1.937-3 will apply for determining whether 
income is effectively connected with the conduct of a trade or business 
in a possession of the United States.
    (b) Puerto Rico corporation and resident. An individual (who, 
without regard to this paragraph (b), is a United States person) will 
not be considered a United States person with respect to a foreign 
corporation created or organized in, or under the laws of, Puerto Rico 
for the taxable year of such corporation that ends with or within the 
taxable year of such individual if--
    (1) Such individual is a bona fide resident of Puerto Rico during 
his entire taxable year in which or with which the taxable year of such 
foreign corporation ends; and
    (2) A dividend received by such individual from such corporation 
during the taxable year of such corporation would, for purposes of 
section 933(1), be treated as income derived from sources within Puerto 
Rico. For purposes of this paragraph (b)(2), the rules of Sec. 1.937-
2(g)(1) will not apply.
    (c) Section 931 possession corporation and resident. An individual 
(who, without regard to this paragraph (c), is a United States person) 
will not be considered a United States person with respect to a foreign 
corporation created or organized in, or under the laws of, a section 931 
possession for the taxable year of such corporation that ends with or 
within the taxable year of such individual if--
    (1) Such individual is a bona fide resident of such section 931 
possession during his entire taxable year in which or with which the 
taxable year of such foreign corporation ends; and
    (2) Such corporation satisfies the following conditions--
    (i) 80 percent or more of its gross income for the 3-year period 
ending at the close of the taxable year (or for such part of such period 
as such corporation or any predecessor has been in existence) was 
derived from sources within section 931 possessions or was effectively 
connected with the conduct of a trade or business in section 931 
possessions; and
    (ii) 50 percent or more of its gross income for such period (or 
part) was derived from the active conduct of a trade or business within 
section 931 possessions.
    (d) Effective/applicability date. This section applies to taxable 
years ending after April 9, 2008.

[T.D. 9391, 73 FR 19375, Apr. 9, 2008]



Sec. 1.958-1  Direct and indirect ownership of stock.

    (a) In general. Section 958(a) provides that, for purposes of 
sections 951 to 964 (other than sections 955(b)(1)(A) and (B) and 
955(c)(2)(A)(ii) (as in effect before the enactment of the Tax Reduction 
Act of 1975), and 960(a)(1)), stock owned means--
    (1) Stock owned directly; and
    (2) Stock owned with the application of paragraph (b) of this 
section.


The rules of section 958(a) and this section provide a limited form of 
stock attribution primarily for use in determining the amount taxable to 
a United States shareholder under section 951(a).

[[Page 414]]

These rules also apply for purposes of other provisions of the Code and 
regulations which make express reference to section 958(a).
    (b) Stock ownership through foreign entities. For purposes of 
paragraph (a)(2) of this section, stock owned, directly or indirectly, 
by or for a foreign corporation, foreign partnership, foreign trust 
(within the meaning of section 7701(a)(31)) described in sections 671 
through 679, or other foreign trust or foreign estate (within the 
meaning of section 7701(a)(31)) shall be considered as being owned 
proportionately by its shareholders, partners, grantors or other persons 
treated as owners under sections 671 through 679 of any portion of the 
trust that includes the stock, or beneficiaries, respectively. Stock 
considered to be owned by reason of the application of this paragraph 
shall, for purposes of reapplying this paragraph, be treated as actually 
owned by such person. Thus, this rule creates a chain of ownership; 
however, since the rule applies only to stock owned by a foreign entity, 
attribution under the rule stops with the first United States person in 
the chain of ownership running from the foreign entity. The application 
of this paragraph may be illustrated by the following example:

    Example. Domestic corporation M owns 75 percent of the one class of 
stock in foreign corporation R, which in turn owns 80 percent of the one 
class of stock in foreign corporation S, which in turn owns 90 percent 
of the one class of stock in foreign corporation T. Under this 
paragraph, R Corporation is considered as owning 80 percent of the 90 
percent of the stock which S Corporation owns in T Corporation, or 72 
percent. Corporation M is considered as owning 75 percent of such 72 
percent of the stock in T Corporation, or 54 percent. Since M 
Corporation is a domestic corporation, the attribution under this 
paragraph stops with M Corporation, even though, illustratively, such 
corporation is wholly owned by domestic corporation N.

    (c) Rules of application--(1) Special rule for mutual insurance 
companies. For purposes of applying paragraph (a) of this section in the 
case of a foreign mutual insurance company, the term ``stock'' shall 
include any certificate entitling the holder to voting power in the 
corporation.
    (2) Amount of interest in foreign corporation, foreign partnership, 
foreign trust, or foreign estate. The determination of a person's 
proportionate interest in a foreign corporation, foreign partnership, 
foreign trust, or foreign estate will be made on the basis of all the 
facts and circumstances in each case. Generally, in determining a 
person's proportionate interest in a foreign corporation, the purpose 
for which the rules of section 958(a) and this section are being applied 
will be taken into account. Thus, if the rules of section 958(a) are 
being applied to determine the amount of stock owned for purposes of 
section 951(a), a person's proportionate interest in a foreign 
corporation will generally be determined with reference to such person's 
interest in the income of such corporation. If the rules of section 
958(a) are being applied to determine the amount of voting power owned 
for purposes of section 951(b) or 957, a person's proportionate interest 
in a foreign corporation will generally be determined with reference to 
the amount of voting power in such corporation owned by such person. 
However, any arrangement which artificially decreases a United States 
person's proportionate interest will not be recognized. See Sec. Sec. 
1.951-1 and 1.957-1.
    (d) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. United States persons A and B own 25 percent and 50 
percent, respectively, of the one class of stock in foreign corporation 
M. Corporation M owns 80 percent of the one class of stock in foreign 
corporation N, and N Corporation owns 60 percent of the one class of 
stock in foreign corporation P. Under paragraph (b) of this section, M 
Corporation is considered to own 48 percent (80 percent of 60 percent) 
of the stock in P Corporation; such 48 percent is treated as actually 
owned by M Corporation for the purpose of again applying paragraph (b) 
of this section. Thus, A and B are considered to own 12 percent (25 
percent of 48 percent) and 24 percent (50 percent of 48 percent), 
respectively, of the stock in P Corporation.
    Example 2. United States person C is a 60-percent partner in foreign 
partnership X. Partnership X owns 40 percent of the one class of stock 
in foreign corporation Q. Corporation Q is a 50-percent partner in 
foreign partnership Y, and partnership Y owns 100 percent of the one 
class of stock in foreign corporation R. By the application of paragraph 
(b) of this section, C is considered to own 12 percent (60 percent of 40 
percent of 50

[[Page 415]]

percent of 100 percent) of the stock in R Corporation.
    Example 3. Foreign trust Z was created for the benefit of United 
States persons D, E, and F. Under the terms of the trust instrument, the 
trust income is required to be divided into three equal shares. Each 
beneficiary's share of the income may either be accumulated for him or 
distributed to him in the discretion of the trustee. In 1970, the trust 
is to terminate and there is to be paid over to each beneficiary the 
accumulated income applicable to his share and one-third of the corpus. 
The corpus of trust Z is composed of 90 percent of the one class of 
stock in foreign corporation S. By the application of this section, each 
of D, E, and F is considered to own 30 percent (\1/3\ of 90 percent) of 
the stock in S Corporation.
    Example 4. Among the assets of foreign estate W are Blackacre and a 
block of stock, consisting of 75 percent of the one class of stock of 
foreign corporation T. Under the terms of the will governing estate W, 
Blackacre is left to G, a nonresident alien, for life, remainder to H, a 
nonresident alien, and the block of stock is left to United States 
person K. By the application of this section, K is considered to own the 
75 percent of the stock of T Corporation, and G and H are not considered 
to own any of such stock.

[T.D. 6889, 31 FR 9455, July 12, 1966, as amended by T.D. 7893, 48 FR 
22509, May 19, 1983; T.D. 8955, 66 FR 37897, July 20, 2001]



Sec. 1.958-2  Constructive ownership of stock.

    (a) In general. Section 958(b) provides that, for purposes of 
sections 951(b), 954(d)(3), 956(b)(2), and 957, the rules of section 
318(a) as modified by section 958(b) and this section shall apply to the 
extent that the effect is to treat a United States person as a United 
States shareholder within the meaning of section 951(b), to treat a 
person as a related person within the meaning of section 954(d)(3), to 
treat the stock of a domestic corporation as owned by a United States 
shareholder of a controlled foreign corporation under section 956(b)(2), 
or to treat a foreign corporation as a controlled foreign corporation 
under section 957. The rules contained in this section also apply for 
purposes of other provisions of the Code and regulations which make 
express reference to section 958(b).
    (b) Members of family--(1) In general. Except as provided in 
subparagraph (3) of this paragraph, an individual shall be considered as 
owning the stock owned, directly or indirectly, by or for--
    (i) His spouse (other than a spouse who is legally separated from 
the individual under a decree of divorce or separate maintenance); and
    (ii) His children, grandchildren, and parents.
    (2) Effect of adoption. For purposes of subparagraph (1)(ii) of this 
paragraph, a legally adopted child of an individual shall be treated as 
a child of such individual by blood.
    (3) Stock owned by nonresident alien individual. For purposes of 
this paragraph, stock owned by a nonresident alien individual (other 
than a foreign trust or foreign estate) shall not be considered as owned 
by a United States citizen or a resident alien individual. However, this 
limitation does not apply for purposes of determining whether the stock 
of a domestic corporation is owned or considered as owned by a United 
States shareholder under section 956(b)(2) and Sec. 1.956-
2(b)(1)(viii). See section 958(b)(1).
    (c) Attribution from partnerships, estates, trusts, and 
corporations--(1) In general. Except as provided in subparagraph (2) of 
this paragraph--
    (i) From partnerships and estates. Stock owned, directly or 
indirectly, by or for a partnership or estate shall be considered as 
owned proportionately by its partners or beneficiaries.
    (ii) From trusts--(a) To beneficiaries. Stock owned, directly or 
indirectly, by or for a trust (other than an employees' trust described 
in section 401(a) which is exempt from tax under section 501(a)) shall 
be considered as owned by its beneficiaries in proportion to the 
actuarial interest of such beneficiaries in such trust.
    (b) To owner. Stock owned, directly or indirectly, by or for any 
portion of a trust of which a person is considered the owner under 
sections 671 to 679 (relating to grantors and others treated as 
substantial owners) shall be considered as owned by such person.
    (iii) From corporations. If 10 percent or more in value of the stock 
in a corporation is owned, directly or indirectly, by or for any person, 
such person shall be considered as owning the stock owned, directly or 
indirectly, by or for such corporation, in that proportion which

[[Page 416]]

the value of the stock which such person so owns bears to the value of 
all the stock in such corporation. See section 958(b)(3).
    (2) Rules of application. For purposes of subparagraph (1) of this 
paragraph, if a partnership, estate, trust, or corporation owns, 
directly or indirectly, more than 50 percent of the total combined 
voting power of all classes of stock entitled to vote in a corporation, 
it shall be considered as owning all the stock entitled to vote. See 
section 958(b)(2).
    (d) Attribution to partnerships, estates, trusts, and corporations. 
(1) Except as otherwise provided in paragraph (d)(2) of this section and 
Sec. 1.954-1(f)--
    (i) To partnerships and estates. Stock owned, directly or 
indirectly, by or for a partner or a beneficiary of an estate shall be 
considered as owned by the partnership or estate.
    (ii) To trusts--(a) From beneficiaries. Stock owned, directly or 
indirectly, by or for a beneficiary of a trust (other than an employees' 
trust described in section 401(a) which is exempt from tax under section 
501(a)) shall be considered as owned by the trust, unless such 
beneficiary's interest in the trust is a remote contingent interest. For 
purposes of the preceding sentence, a contingent interest of a 
beneficiary in a trust shall be considered remote if, under the maximum 
exercise of discretion by the trustee in favor of such beneficiary, the 
value of such interest, computed actuarially, is 5 percent or less of 
the value of the trust property.
    (b) From owner. Stock owned, directly or indirectly, by or for a 
person who is considered the owner of any portion of a trust under 
sections 671 to 678 (relating to grantors and others treated as 
substantial owners) shall be considered as owned by the trust.
    (iii) To corporations. If 50 percent or more in value of the stock 
in a corporation is owned, directly or indirectly, by or for any person, 
such corporation shall be considered as owning the stock owned, directly 
or indirectly, by or for such person. This subdivision shall not be 
applied so as to consider a corporation as owning its own stock.
    (2) [Reserved]
    (e) Options. Except as otherwise provided in Sec. 1.954-1(f), if 
any person has an option to acquire stock, such stock shall be 
considered as owned by such person. For purposes of the preceding 
sentence, an option to acquire such an option, and each one of a series 
of such options, shall be considered as an option to acquire such stock.
    (f) Rules of application. For purposes of this section--
    (1) Stock treated as actually owned--(i) In general. Except as 
provided in subdivisions (ii) and (iii) of this subparagraph, stock 
constructively owned by a person by reason of the application of 
paragraphs (b), (c), (d), and (e) of this section shall, for purposes of 
applying such paragraphs, be considered as actually owned by such 
person.
    (ii) Members of family. Stock constructively owned by an individual 
by reason of the application of paragraph (b) of this section shall not 
be considered as owned by him for purposes of again applying such 
paragraph in order to make another the constructive owner of such stock.
    (iii) Partnerships, estates, trusts, and corporation. Stock 
constructively owned by a partnership, estate, trust, or corporation by 
reason of the application of paragraph (d) of this section shall not be 
considered as owned by it for purposes of applying paragraph (c) of this 
section in order to make another the constructive owner of such stock.
    (iv) Option rule in lieu of family rule. For purposes of this 
subparagraph, if stock may be considered as owned by an individual under 
paragraph (b) or (e) of this section, it shall be considered as owned by 
him under paragraph (e).
    (2) Coordination of different attribution rules. For purposes of any 
one determination, stock which may be owned under more than one of the 
rules of Sec. 1.958-1 and this section, or by more than one person, 
shall be owned under that attribution rule which imputes to the person, 
or persons, concerned the largest total percentage of such stock. The 
application of this subparagraph may be illustrated by the following 
examples:

    Example 1. (a) United States persons A and B, and domestic 
corporation M, own 9 percent, 32 percent, and 10 percent, respectively, 
of the one class of stock in foreign corporation R. A also owns 10 
percent of the one

[[Page 417]]

class of stock in M Corporation. For purposes of determining whether A 
is a United States shareholder with respect to R Corporation, 10 percent 
of the 10-percent interest of M Corporation in R Corporation is 
considered as owned by A. See paragraph (c)(1)(iii) of this section. 
Thus, A owns 10 percent (9 percent plus 10 percent of 10 percent) of the 
stock in R Corporation and is a United States shareholder with respect 
to such corporation. Corporation M and B, by reason of owning 10 percent 
and 32 percent, respectively, of the stock in R Corporation are United 
States shareholders with respect to such corporation.
    (b) For purposes of determining whether R Corporation is a 
controlled foreign corporation, the 1 percent of the stock in R 
Corporation directly owned by M Corporation and considered as owned by A 
cannot be counted twice. Therefore, the total amount of stock in R 
Corporation owned by United States shareholders is 51 percent, 
determined as follows:

                    Stock Ownership in R Corporation
                                [percent]
A..............................................................        9
B..............................................................       32
M Corporation..................................................       10
                                                                --------
  Total........................................................       51
 

    Example 2. United States person C owns 10 percent of the one class 
of stock in foreign corporation N, which owns 60 percent of the one 
class of stock in foreign corporation S. Under paragraph (a)(2) of Sec. 
1.958-1, C is considered as owning 6 percent (10 percent of 60 percent) 
of the stock in S Corporation. Under paragraph (c)(1)(iii) and (2) of 
this section N Corporation is considered as owning 100 percent of the 
stock in S Corporation and C is considered as owning 10 percent of such 
100 percent, or 10 percent of the stock in S Corporation. Thus, for 
purposes of determining whether C is a United States shareholder with 
respect to S Corporation, the attribution rules of paragraph (c)(1)(iii) 
and (2) of this section are used inasmuch as C owns a larger total 
percentage of the stock of S Corporation under such rules.

    (g) Illustration. The application of this section may be illustrated 
by the following examples:
    (1) Example 1. United States persons A and B own 5 percent and 25 
percent, respectively, of the one class of stock in foreign corporation 
M. Corporation M owns 60 percent of the one class of stock in foreign 
corporation N. Under paragraph (a)(2) of Sec. 1.958-1, A and B are 
considered as owning 3 percent (5 percent of 60 percent) and 15 percent 
(25 percent of 60 percent), respectively, of the stock in N Corporation. 
Under paragraph (c)(2) of this section, M Corporation is treated as 
owning all the stock in N Corporation, and, under paragraph (c)(1)(iii) 
of this section, B is considered as owning 25 percent of such 100 
percent, or 25 percent of the stock in N Corporation. Inasmuch as A owns 
less than 10 percent of the stock in M Corporation, he is not considered 
as owning, under paragraph (c)(1)(iii) of this section, any of the stock 
in N Corporation owned by M Corporation. Thus, the attribution rules of 
paragraph (a)(2) of Sec. 1.958-1 are used with respect to A inasmuch as 
he owns a larger total percentage of the stock of N Corporation under 
such rules; and the attribution rules of paragraphs (c)(1)(iii) and 
(c)(2) of this section are used with respect to B inasmuch as he owns a 
larger total percentage of the stock of N Corporation under such rules.
    (2) Example 2. United States person C owns 60 percent of the one 
class of stock in domestic corporation P; corporation P owns 60 percent 
of the one class of stock in foreign corporation Q; and corporation Q 
owns 60 percent of the one class of stock in foreign corporation R. 
Under paragraph (a)(2) of Sec. 1.958-1, P Corporation is considered as 
owning 36 percent (60 percent of 60 percent) of the stock in R 
Corporation, and C is considered as owning none of the stock in R 
Corporation inasmuch as the chain of ownership stops at the first United 
States person and P Corporation is such a person. Under paragraph (c)(2) 
of this section, Q Corporation is treated as owning 100 percent of the 
stock in R Corporation, and under paragraph (c)(1)(iii) of this section, 
P Corporation is considered as owning 60 percent of such 100 percent, or 
60 percent of the stock in R Corporation. For purposes of determining 
the amount of stock in R Corporation which C is considered as owning, P 
Corporation is treated under paragraph (c)(2) of this section as owning 
100 percent of the stock in R Corporation; therefore, C is considered as 
owning 60 percent of the stock in R Corporation. Thus, the attribution 
rules of paragraphs (c)(1)(iii) and (c)(2) of this section are used with 
respect to C and P Corporation inasmuch as they each own a larger total

[[Page 418]]

percentage of the stock of R Corporation under such rules.
    (3) Example 3. United States person D owns 25 percent of the one 
class of stock in foreign corporation S. D is also a 40-percent partner 
in domestic partnership X, which owns 50 percent of the one class of 
stock in domestic corporation T. Under paragraph (d)(1)(i) of this 
section, the 25 percent of the stock in S Corporation owned by D is 
considered as being owned by partnership X; since such stock is treated 
as actually owned by partnership X under paragraph (f)(1)(i) of this 
section, such stock is in turn considered as being owned by T 
Corporation under paragraph (d)(1)(iii) of this section. Thus, under 
paragraphs (d)(1) and (f)(1)(i) of this section, T Corporation is 
considered as owning 25 percent of the stock in S Corporation.
    (4) Example 4. Foreign corporation U owns 100 percent of the one 
class of stock in domestic corporation V and also 100 percent of the one 
class of stock in foreign corporation W. Because more than 50 percent in 
value of the stock of V Corporation is owned by its sole shareholder, U 
Corporation, V Corporation is considered under paragraph (d)(1)(iii) of 
this section as owning the stock owned by U Corporation in W 
Corporation, and accordingly is a United States shareholder of W 
Corporation.
    (5) Example 5. United States citizen E owns 15 percent of the one 
class of stock in foreign corporation Y, and United States citizen F, 
E's spouse, owns 5 percent of such stock. E and F's four nonresident 
alien grandchildren each own 20 percent of the stock in Y Corporation. 
Under paragraph (b)(1) of this section, E is considered as owning the 
stock owned by F in Y Corporation; however, by virtue of paragraph 
(b)(3) of this section, E may not be considered under paragraph (b)(1) 
of this section as owning any of the stock in Y Corporation owned by 
such grandchildren.
    (6) Example 6. United States person F owns 10 percent of the one 
class of stock in foreign corporation Z; corporation Z owns 10 percent 
of the one class of stock in foreign corporation K; and corporation K 
owns 100 percent of the one class of stock in foreign corporation L. 
United States person G, F's spouse, owns 9 percent of the stock in K 
Corporation. Under paragraph (c)(1)(iii) of this section or paragraph 
(a)(2) of Sec. 1.958-1, F is considered as owning 1 percent (10 percent 
of 10 percent of 100 percent) of the stock in L Corporation by reason of 
his ownership of stock in Z Corporation, and, under paragraph (b)(1) of 
this section, G is considered as owning such 1 percent of the stock in L 
Corporation. Under paragraph (a)(2) of Sec. 1.958-1, G is considered as 
owning 9 percent (9 percent of 100 percent) of the stock in L 
Corporation by reason of her ownership of stock in K Corporation, and, 
under paragraph (b)(1) of this section, F is considered as owning such 9 
percent of the stock in L Corporation. Thus, for the purpose of 
determining whether F or G is a United States shareholder with respect 
to L Corporation, each of F and G is considered as owning a total of 10 
percent of the stock in L Corporation by applying the rules of paragraph 
(a)(2) of Sec. 1.958-1 and paragraphs (b)(1) and (c)(1)(iii) of this 
section.
    (h) Applicability date. Paragraphs (d)(1) and (e) of this section 
apply for taxable years of controlled foreign corporations ending on or 
after November 19, 2019, and for the taxable years of United States 
shareholders in which or with which such taxable years end. Paragraphs 
(d)(2) and (g)(4) of this section apply to taxable years of foreign 
corporations ending on or after October 1, 2019, and taxable years of 
United States shareholders in which or with which such taxable years of 
foreign corporations end. For taxable years of foreign corporations 
ending before October 1, 2019, and taxable years of United States 
shareholders in which or with which such taxable years of foreign 
corporations end, a taxpayer may apply such provisions to the last 
taxable year of a foreign corporation beginning before January 1, 2018, 
and each subsequent taxable year of the foreign corporation, and to 
taxable years of United States shareholders in which or with which such 
taxable years of the foreign corporation end, provided that the taxpayer 
and United States persons that are related (within the meaning of 
section 267 or 707) to the taxpayer consistently apply such

[[Page 419]]

provisions with respect to all foreign corporations. For taxable years 
of foreign corporations ending before October 1, 2019, and taxable years 
of United States shareholders in which or with which such taxable years 
of foreign corporations end, where the taxpayer does not apply the 
provisions of paragraphs (d)(2) and (g)(4) of this section, see 
paragraph (d)(2) and (g)(4) of this section as in effect and contained 
in 26 CFR part 1, as revised April 1, 2020.

[T.D. 6889, 31 FR 9455, July 12, 1966, as amended by T.D. 7712, 45 FR 
52375, Aug. 7, 1980; T.D. 8955, 66 FR 37897, July 20, 2001; T.D. 9883, 
84 FR 63804, Nov. 19, 2019; T.D. 9908, 85 FR 59435, Sept. 22, 2020]



Sec. 1.959-1  Exclusion from gross income of United States persons 
of previously taxed earnings and profits.

    (a) In general. Sections 951 through 964 provide that certain types 
of income of controlled foreign corporations will be subject to United 
States income tax even though such amounts are not currently distributed 
to the United States shareholders of such corporations. The amounts so 
taxed to certain United States shareholders are described as subpart F 
income, previously excluded subpart F income withdrawn from investment 
in less developed countries, previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations, 
and increases in earnings invested in United States property. Section 
959 provides that amounts taxed as subpart F income, as previously 
excluded subpart F income withdrawn from investment in less developed 
countries, or as previously excluded subpart F income withdrawn from 
investment in foreign base company shipping operations are not taxed 
again as increases in earnings invested in United States property. 
Section 959 also provides an exclusion whereby none of the amounts so 
taxed are taxed again when actually distributed directly, or indirectly 
through a chain of ownership described in section 958(a), to United 
States shareholders or to such shareholders' successors in interest. The 
exclusion also applies to amounts taxed to United States shareholders as 
income of one controlled foreign corporation and later distributed to 
another controlled foreign corporation in such a chain of ownership 
where such amounts would otherwise be again included in the income of 
such shareholders or their successors in interest as subpart F income of 
the controlled foreign corporation to which they are distributed. 
Section 959 also provides rules for the allocation of distributions to 
earnings and profits and for the non-dividend treatment of actual 
distributions which are excluded from gross income.
    (b) Actual distributions to United States persons. The earnings and 
profits for a taxable year of a foreign corporation attributable to 
amounts which are, or have been, included in the gross income of a 
United States shareholder of such corporation under section 951(a) shall 
not, when such amounts are distributed to such shareholder directly, or 
indirectly through a chain of ownership described in section 958(a), be 
again included in the gross income of such United States shareholder. 
See section 959(a)(1). Thus, earnings and profits attributable to 
amounts which are, or have been, included in the gross income of a 
United States shareholder of a foreign corporation under section 951 
(a)(1)(A)(i) as subpart F income, under section 951(a)(1)(A)(ii) as 
previously excluded subpart F income withdrawn from investment in less 
developed countries, under section 951(a)(1)(A)(iii) as previously 
excluded subpart F income withdrawn from investment in foreign base 
company shipping operations, or under section 951(a)(1)(B) as earnings 
invested in United States property, shall not be again included in the 
gross income of such shareholder when such amounts are actually 
distributed, directly or indirectly, to such shareholder. See paragraph 
(d) of this section for exclusion applicable to such shareholder's 
successor in interest. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of R Corporation, a corporation organized on January 
1, 1963, which is a controlled foreign corporation throughout the period 
here involved. Both A and R Corporation use the calendar year as a 
taxable year.
    (b) During 1964, R Corporation derives $100 of subpart F income, and 
A includes such

[[Page 420]]

amount in his gross income under section 951(a)(1)(A)(i). Corporation 
R's current and accumulated earnings and profits (before taking into 
account distributions made during 1964) are $150. Also, during 1964, R 
Corporation distributes $50 to A. The $50 distribution is excludable 
from A's gross income for 1964 under this paragraph and Sec. 1.959-3 
because such distribution represents earnings and profits attributable 
to amounts which are included in A's gross income for such year under 
section 951(a).
    (c) If instead of deriving the $100 of subpart F income in 1964, R 
Corporation derives such amount during 1963 and has earnings and profits 
for 1963 in excess of $100, A must include $100 in his gross income for 
1963 under section 951(a)(1)(A)(i). However, the $50 distribution made 
by R Corporation to A during 1964 is excludable from A's gross income 
for such year under this paragraph and Sec. 1.959-3 because such 
distribution represents earnings and profits attributable to amounts 
which have been included in A's gross income for 1963 under section 
951(a).
    (d) If, with respect to 1964--
    (1) Instead of owning the stock of R Corporation directly, A owns 
such stock through a chain of ownership described in section 958(a), 
that is, A owns 100 percent of M Corporation which owns 100 percent of N 
Corporation which owns 100 percent of R Corporation,
    (2) Both M and N Corporations use the calendar year as a taxable 
year and are controlled foreign corporations throughout the period here 
involved,
    (3) Corporation R derives $100 of subpart F income and has earnings 
and profits in excess of $100,
    (4) Neither M Corporation nor N Corporation has earnings and profits 
or a deficit in earnings and profits, and
    (5) The $50 distribution is from R Corporation to N Corporation to M 
Corporation to A,


A must include $100 in his gross income for 1964 under section 
951(a)(1)(A)(i) by reason of his indirect ownership of R Corporation. 
However, the $50 distribution is excludable from A's gross income for 
1964 under this paragraph and Sec. 1.959-3 because such distribution 
represents earnings and profits attributable to amounts which are 
included in A's gross income for such year under section 951(a) and are 
distributed indirectly to A through a chain of ownership described in 
section 958(a).

    (c) Excludable investment of earnings in United States property. The 
earnings and profits for a taxable year of a foreign corporation 
attributable to amounts which are, or have been, included in the gross 
income of a United States shareholder of such corporation under section 
951(a)(1)(A) shall not, when such amounts would, but for section 
959(a)(2) and this paragraph, be included under section 951(a)(1)(B) in 
the gross income of such shareholder directly, or indirectly through a 
chain of ownership described in section 958(a), be again included in the 
gross income of such United States shareholder. Thus, earnings and 
profits attributable to amounts which are, or have been, included in the 
gross income of a United States shareholder of a foreign corporation 
under section 951(a)(1)(A)(i) as subpart F income, under section 
951(a)(1)(A)(ii) as previously excluded subpart F income withdrawn from 
investment in less developed countries, or under section 
951(a)(1)(A)(iii) as previously excluded subpart F income withdrawn from 
investment in foreign base company shipping operations, may be invested 
in United States property without being again included in such 
shareholder's income under section 951 (a). Moreover, the first amount 
deemed invested in United States property are amounts previously 
included in the gross income of a United States shareholder under 
section 951(a)(1)(A). See paragraph (d) of this section for exclusion 
applicable to such shareholder's successor in interest. The application 
of this paragraph may be illustrated by the following example:

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of R Corporation, a corporation organized on January 
1, 1963, which is a controlled foreign corporation throughout the period 
here involved. Both A and R Corporation use the calendar year as a 
taxable year.
    (b) During 1964, R Corporation derives $35 of subpart F income, and 
A includes such amount in his gross income under section 
951(a)(1)(A)(i). During 1964, R Corporation also invests $50 in tangible 
property (other than property described in section 956(b)(2)) located in 
the United States. Corporation R makes no distributions during the year, 
and its current earnings and profits are in excess of $50. Of the $50 
investment of earnings in United States property, $35 is excludable from 
A's gross income for 1964 under section 959(a)(2) because such amount 
represents earnings and profits which are attributable to amounts which 
are included in A's gross income for such year under section 
951(a)(1)(A)(i) and therefore may be invested in United States property 
without again being included in A's gross income. The remaining $15 is 
includible in A's gross income for 1964 under section 951(a)(1)(B).

[[Page 421]]

    (c) If, instead of deriving $35 of subpart F income in 1964, R 
Corporation has no subpart F income for 1964 but derives the $35 of 
subpart F income during 1963 and has earnings and profits for such year 
in excess of $35, A must include $35 in his gross income for 1963 under 
section 951(a)(1)(A)(i). However, of the $50 investment of earnings in 
United States property made by R Corporation during 1964, $35 is 
excludable from A's gross income for 1964 under section 959(a)(2) 
because such amount represents earnings and profits attributable to 
amounts which have been included in A's gross income for 1963 under 
section 951(a)(1)(A)(i). The remaining $15 is includible in A's gross 
income for 1964 under section 951(a)(1)(B).

    (d) Application of exclusions to shareholder's successor in 
interest. If a United States person (as defined in Sec. 1.957-4) 
acquires from any person any portion of the interest in the foreign 
corporation of a United States shareholder referred to in paragraph (b) 
or (c) of this section, the rules of such paragraph shall apply to such 
acquiring person but only to the extent that the acquiring person 
establishes to the satisfaction of the district director his right to 
the exclusion provided by such paragraph. The information to be 
furnished by the acquiring person to the district director with his 
return for the taxable year to support such exclusion shall include:
    (1) The name, address, and taxable year of the foreign corporation 
from which the distribution is received and of all other corporations, 
partnerships, trusts, or estates in any applicable chain of ownership 
described in section 958(a);
    (2) The name, address, and (in the case of information required to 
be furnished after June 20, 1983) taxpayer identification number of the 
person from whom the stock interest was acquired;
    (3) A description of the stock interest acquired and its relation, 
if any, to a chain of ownership described in section 958(a);
    (4) The amount for which an exclusion under section 959(a) is 
claimed; and
    (5) Evidence showing that the earnings and profits for which an 
exclusion is claimed are attributable to amounts which were included in 
the gross income of a United States shareholder under section 951(a), 
that such amounts were not previously excluded from the gross income of 
a United States person, and the identity of the United States 
shareholder including such amounts.


The acquiring person shall also furnish to the district director such 
other information as may be required by the district director in support 
of the exclusion.

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of R Corporation, a corporation organized on January 
1, 1964, and a controlled foreign corporation throughout the period here 
involved. Both A and R Corporation use the calendar year as a taxable 
year.
    (b) During 1964, R Corporation has $100 of subpart F income and 
earnings and profits in excess of $100. A includes $100 in his gross 
income for 1964 under section 951(a)(1)(A)(i). During 1965, A sells 40 
percent of his stock in R Corporation to B, a United States person who 
uses the calendar year as a taxable year. In 1965, R Corporation has no 
earnings and profits and experiences no increase in earnings invested in 
United States property. Corporation R distributes $40 to B on December 
1, 1965. If B establishes his right to the exclusion to the satisfaction 
of the district director, he may exclude $40 from his gross income for 
1965 under section 959(a)(1).
    (c) If, instead of selling his 40-percent interest directly to B, A 
sells on February 1, 1965, 40 percent of his stock in R Corporation to 
C, a nonresident alien, and on October 1, 1965, B acquires the 40-
percent interest in R Corporation from C, the result is the same as in 
paragraph (b) of this example, if B establishes his right to the 
exclusion to the satisfaction of the district director.
    (d) If, instead of acquiring 40 percent, B acquires only 5 percent 
of A's stock in R Corporation and R Corporation distributes $5 to B 
during 1965, B is not a United States shareholder (within the meaning of 
section 951(b)) with respect to R Corporation since he owns only 5 
percent of the stock of R Corporation. Notwithstanding, B may exclude 
the $5 distribution from his gross income for 1965 under section 
959(a)(1) if he establishes his right to the exclusion to the 
satisfaction of the district director.
    (e) If the facts are assumed to be the same as in paragraphs (a) and 
(b) of this example except that--
    (1) A owns the stock of R Corporation indirectly through a chain of 
ownership described in section 958(a), that is, A owns 100 percent of M 
Corporation which owns 100 percent of N Corporation which owns 100 
percent of R Corporation,
    (2) B acquires from N Corporation 40 percent of the stock in R 
Corporation,

[[Page 422]]

    (3) Both M Corporation and N Corporation are controlled foreign 
corporations which use the calendar year as a taxable year,
    (4) Neither M Corporation nor N Corporation has any amount in 1964 
or 1965 which is includible in gross income of United States 
shareholders under section 951(a), and
    (5) Neither M Corporation nor N Corporation has a deficit in 
earnings and profits for 1964;


the result is the same as in paragraph (b) of this example if B 
establishes his right to the exclusion to the satisfaction of the 
district director.

[T.D. 6795, 30 FR 943, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22509, May 19, 1983]



Sec. 1.959-2  Exclusion from gross income of controlled foreign 
corporations of previously taxed earnings and profits.

    (a) Applicable rule. The earnings and profits for a taxable year of 
a controlled foreign corporation attributable to amounts which are, or 
have been, included in the gross income of a United States shareholder 
under section 951(a) shall not, when distributed through a chain of 
ownership described in section 958(a), be also included in the gross 
income of another controlled foreign corporation in such chain for 
purposes of the application of section 951(a) to such other controlled 
foreign corporation with respect to such United States shareholder. See 
section 959(b). The exclusion from the income of such other foreign 
corporation also applies with respect to any other United States 
shareholder who acquires from such United States shareholder or any 
other person any portion of the interest of such United States 
shareholder in the controlled foreign corporation, but only to the 
extent the acquiring shareholder establishes to the satisfaction of the 
district director his right to such exclusion. An acquiring shareholder 
claiming the exclusion under section 959(b) shall furnish to the 
district director with his return for the taxable year the information 
required under paragraph (d) of Sec. 1.959-1 to support the exclusion 
under this paragraph.
    (b) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of M Corporation which in turn owns 100 percent of 
the only class of stock of N Corporation. A and corporations M and N use 
the calendar year as a taxable year and corporations M and N are 
controlled foreign corporations throughout the period here involved.
    (b) During 1963, N Corporation invests $100 in tangible property 
(other than property described in section 956(b)(2)) located in the 
United States and has earnings and profits in excess of $100. A is 
required to include $100 in his gross income for 1963 under section 
951(a)(1)(B) by reason of his indirect ownership of the stock of N 
Corporation. During 1963, M Corporation has no income or investments 
other than the income derived from a distribution of $100 from N 
Corporation. Corporation M has earnings and profits of $100 for 1963. 
Under paragraph (a) of Sec. 1.954-2, the $100 distribution received by 
M Corporation from N Corporation would otherwise constitute subpart F 
income of M Corporation; however, by reason of section 959(b) and this 
section, this amount does not constitute gross income of M Corporation 
for purposes of determining amounts includible in A's gross income under 
section 951(a)(1)(A)(i).
    (c) During 1964, N Corporation derives $100 of subpart F income and 
distributes $100 to M Corporation which has no subpart F income for 1964 
but which invests the $100 distribution in tangible property (other than 
property described in section 956(b)(2)) located in the United States. 
Corporation N's earnings and profits for 1964 are in excess of $100, and 
M Corporation's current and accumulated earnings and profits (before 
taking into account distributions made during 1964) are in excess of 
$100. A is required with respect to N Corporation to include $100 in his 
gross income for 1964 under section 951(a)(1)(A)(i) by reason of his 
indirect ownership of the stock of N Corporation. The investment by M 
Corporation in United States property would otherwise constitute an 
investment of earnings in United States property to which section 956 
applies; however, by reason of section 959(b) and this section, such 
amount does not constitute gross income of M Corporation for purposes of 
determining amounts includible in A's gross income under section 
951(a)(1)(B).
    (d) If during 1965, N Corporation invests $100 in tangible property 
(other than property described in section 956(b)(2)) located in the 
United States and has earnings and profits in excess of $100, A will be 
required with respect to N Corporation to include $100 in his gross 
income for 1965 under section 951(a)(1)(B), because the $100 of earnings 
and profits for 1964 attributable to N Corporation's subpart F income 
which was taxed to A in 1964 was distributed to M Corporation in such 
year.
    (e) If, with respect to 1966--

[[Page 423]]

    (1) Corporation N owns 100 percent of the only class of stock of R 
Corporation,
    (2) Corporation R derives $100 of subpart F income, has earnings and 
profits in excess of $100, and makes no distributions to N Corporation,
    (3) Corporation N invests $25 in tangible property (other than 
property described in section 956(b)(2)) located in the United States 
and has current and accumulated earnings and profits in excess of $25, 
and
    (4) Corporation M has no income or investments and does not have a 
deficit in earnings and profits,


the $100 of subpart F income derived by R Corporation is includible in 
A's gross income for 1966 under section 951(a)(1)(A)(i) and the $25 
investment of earnings in United States property by N Corporation is 
includible in A's gross income for 1966 under section 951(a)(1)(B).
    (f) If, however, the facts are the same as in paragraph (e) of this 
example except that--
    (1) During 1966, R Corporation distributes $20 to N Corporation, and
    (2) Corporation N makes no distributions during such year to M 
Corporation,

of the $25 investment in United States property by N Corporation, $20 is 
not includible in A's gross income for 1966 because such amount 
represents earnings and profits which are attributable to amounts 
included in A's gross income for such year under section 951(a)(1)(A)(i) 
with respect to R Corporation and which have been distributed to N 
Corporation by R Corporation. By reason of section 959(B) and this 
section, such $20 distribution to N Corporation does not constitute 
gross income of N Corporation for purposes of determining amounts 
includible in A's gross income under section 951(a)(1)(B); however, the 
remaining $5 of investment of earnings in United States property by N 
Corporation in 1966 is includible in A's gross income for such year 
under section 951(a)(1)(B).

[T.D. 6795, 30 FR 944, Jan. 29, 1965]



Sec. 1.959-3  Allocation of distributions to earnings and profits
of foreign corporations.

    (a) In general. For purposes of Sec. Sec. 1.959-1 and 1.959-2, the 
source of the earnings and profits from which distributions are made by 
a foreign corporation as between earnings and profits attributable to 
increases in earnings invested in United States property, previously 
taxed subpart F income, previously excluded subpart F income withdrawn 
from investment in less developed countries, previously excluded subpart 
F income withdrawn from investment in foreign base company shipping 
operations, and other amounts shall be determined in accordance with 
section 959(c) and paragraphs (b) through (e) of this section.
    (b) Applicability of section 316(a). For purposes of this section, 
section 316(a) shall be applied, in determining the source of 
distributions from the earnings and profits of a foreign corporation, by 
first applying section 316(a)(2) and then by applying section 
316(a)(1)--
    (1) First, as provided by section 959 (c)(1), to earnings and 
profits attributable to amounts included in gross income of a United 
States shareholder under section 951(a)(1)(B) (or which would have been 
so included but for section 959(a)(2) and paragraph (c) of Sec. 1.959-
1),
    (2) Secondly, as provided by section 959(c)(2), to earnings and 
profits attributable to amounts included in gross income of a United 
States shareholder under section 951(a)(1)(A) (but reduced by amounts 
not included in such gross income under section 951(a)(1)(B) because of 
the exclusion provided by section 959(a)(2) and paragraph (c) of Sec. 
1.959-1), and
    (3) Finally, as provided by section 959(c)(3), to other earnings and 
profits. Thus, distributions shall be considered first attributable to 
amounts, if any, described in subparagraph (1) of this paragraph (first 
for the current taxable year and then for prior taxable years beginning 
with the most recent prior taxable year), secondly to amounts, if any, 
described in subparagraph (2) of this paragraph (first for the current 
taxable year and then for prior taxable years beginning with the most 
recent prior taxable year), and finally to the amounts, if any, 
described in subparagraph (3) of this paragraph (first for the current 
taxable year and then for prior taxable years beginning with the most 
recent prior taxable year). See, however, paragraph (e) of Sec. 1.963-3 
(applied as if section 963 had not been repealed by the Tax Reduction 
Act of 1975) for a special rule for determination of the source of 
distributions counting as minimum distributions. Earnings and profits 
are classified as to year and as to section 959(c) amount in the year in 
which such amounts are included in

[[Page 424]]

gross income of a United States shareholder under section 951(a) and are 
reclassified as to section 959(c) amount in the year in which such 
amounts would be so included but for the provisions of section 
959(a)(2); any subsequent distribution of such amounts to a higher tier 
in a chain of ownership described in section 958(a) does not of itself 
change such classifications. For example, earnings and profits of a 
foreign corporation attributable to amounts of previously excluded 
subpart F income withdrawn from investment in less developed countries 
(or from investments in export trade assets or foreign base company 
shipping operations) shall be reclassified as amounts to which 
subparagraph (2), rather than subparagraph (3), of this paragraph 
applies for purposes of determining priority of distribution, and such 
earnings and profits shall be considered attributable to the taxable 
year in which the withdrawal occurs. This paragraph shall apply to 
distributions by one foreign corporation to another foreign corporation 
and by a foreign corporation to a United States person. The application 
of this paragraph may be illustrated by the following example:

    Example. (a) M, a controlled foreign corporation, is organized on 
January 1, 1963, and is 100-percent owned by A, a United States 
shareholder. Both A and M Corporation use the calendar year as a taxable 
year, and M Corporation is a controlled foreign corporation throughout 
the period here involved. As of December 31, 1966, M Corporation's 
accumulated earnings and profits of $450 (before taking into account 
distributions made in 1966) applicable to A's interest in such 
corporation are classified for purposes of section 959(c) as follows:

------------------------------------------------------------------------
                                        Classification of earnings and
                                        profits for purposes of section
                Year                                  959
                                     -----------------------------------
                                        (c)(1)      (c)(2)      (c)(3)
------------------------------------------------------------------------
1963................................        $100
1964................................         100         $75
1965................................  ..........          75         $50
1966................................  ..........  ..........          50
------------------------------------------------------------------------

    (b) During 1966, M Corporation makes three separate distributions to 
A of $150 each, and the source of such distributions under section 
959(c) is as follows:

------------------------------------------------------------------------
                                                           Allocation of
                                                           distributions
                                         Amount     Year   under section
                                                                959
------------------------------------------------------------------------
Distribution No. 1...................       $100     1964        (c)(1)
                                              50     1963        (c)(1)
                                      -----------
                                             150
                                      ===========
Distribution No. 2...................         50     1963        (c)(1)
                                              75     1965        (c)(2)
                                              25     1964        (c)(2)
                                      -----------
                                             150
                                      ===========
Distribution No. 3...................         50     1964        (c)(2)
                                              50     1966        (c)(3)
                                              50     1965        (c)(3)
                                      -----------
                                             150  .......  .............
------------------------------------------------------------------------

    (c) If, in addition to the above facts--
    (1) M Corporation owns throughout the period here involved 100 
percent of the only class of stock of N Corporation, a controlled 
foreign corporation which uses the calendar year as a taxable year,
    (2) Corporation N derives $60 of subpart F income for 1963 which A 
includes in his gross income for such year under section 
951(a)(1)(A)(i),
    (3) Corporation N has earnings and profits for 1963 of $60 but has 
neither earnings or profits nor a deficit in earnings and profits for 
1964, 1965, or 1966, and
    (4) During 1966, N Corporation invests $20 in tangible property (not 
described in section 956(b)(2)) located in the United States and 
distributes $45 to M Corporation,


the $20 investment of earnings in United States property is excludable 
from A's gross income for 1966, under section 959(a)(2) and paragraph 
(c) of Sec. 1.959-1, with respect to N Corporation and the $45 dividend 
received by M Corporation does not, under section 959(b) and Sec. 
1.959-2, constitute gross income of M Corporation for 1966 for purposes 
of determining amounts includible in A's gross income under section 
951(a)(1)(A)(i) with respect to M Corporation. However, the $45 dividend 
paid by N Corporation to M Corporation is allocated under section 959(c) 
and this paragraph to the earnings and profits of N Corporation as 
follows: $20 to 1963 earnings described in section 959(c)(1) and $25 to 
1963 earnings described in section 959(c)(2). In such case, M 
Corporation's earnings and profits of $495 (before taking into account 
distributions made in 1966) would be classified as follows for purposes 
of section 959(c):

------------------------------------------------------------------------
                                        Classification of earnings and
                                        profits for purposes of section
                Year                                  959
                                     -----------------------------------
                                        (c)(1)      (c)(2)      (c)(3)
------------------------------------------------------------------------
1963................................        $120         $25
1964................................         100          75
1965................................  ..........          75         $50

[[Page 425]]

 
1966................................  ..........  ..........          50
------------------------------------------------------------------------

    (d) The three distributions to A in 1966 of $150 each would then 
have the following source under section 959(c):

------------------------------------------------------------------------
                                                           Allocation of
                                                           distributions
                                         Amount     Year   under section
                                                                959
------------------------------------------------------------------------
Distribution No. 1...................       $100     1964        (c)(1)
                                              50     1963        (c)(1)
                                      -----------
                                             150
                                      ===========
Distribution No. 2...................         70     1963        (c)(1)
                                              75     1965        (c)(2)
                                               5     1964        (c)(2)
                                      -----------
                                             150
                                      ===========
Distribution No. 3...................         70     1964        (c)(2)
                                              25     1963        (c)(2)
                                              50     1966        (c)(3)
                                               5     1965        (c)(3)
 
                                      -----------
                                             150  .......  .............
------------------------------------------------------------------------

    (c) Treatment of deficits in earnings and profits. For purposes of 
this section, a United States shareholder's pro rata share (determined 
in accordance with the principles of paragraph (e) of Sec. 1.951-1) of 
a foreign corporation's deficit in earnings and profits, determined 
under section 964(a) and Sec. 1.964-1, for any taxable year shall be 
applied only to earnings and profits described in paragraph (b)(3) of 
this section.
    (d) Treatment of certain foreign taxes. For purposes of this 
section, any amount described in subparagraph (1), (2), or (3) of 
paragraph (b) of this section which is distributed by a foreign 
corporation through a chain of ownership described in section 958(a)(2) 
shall be reduced by any income, war profits, or excess profits taxes 
imposed on or with respect to such distribution by any foreign country 
or possession of the United States.

    Example. (a) Domestic corporation M owns 100 percent of the only 
class of stock of foreign corporation A, which is incorporated under the 
laws of foreign country X and which, in turn, owns 100 percent of the 
only class of stock of foreign corporation B, which is incorporated 
under the laws of foreign country Y. All corporations use the calendar 
year as a taxable year and corporations A and B are controlled foreign 
corporations throughout the period here involved.
    (b) During 1963, B Corporation (a less developed country corporation 
for 1963 within the meaning of Sec. 1.955-5) derives $90 of subpart F 
income, after incurring $10 of foreign income tax allocable to such 
income under paragraph (c) of Sec. 1.954-1, has earnings and profits in 
excess of $90, and makes no distributions. Corporation M must include 
$90 in its gross income for 1963 under section 951(a)(1)(A)(i). As of 
December 31, 1963, with respect to M Corporation, B Corporation has 
earnings and profits for 1963 described in section 959(c)(2) of $90.
    (c) During 1964, B Corporation has neither earnings and profits nor 
a deficit in earnings and profits but distributes $90 to A Corporation, 
and, by reason of section 959(b) and Sec. 1.959-2, such amount is not 
includible in the gross income of M Corporation for 1964 under section 
951(a) with respect to A Corporation. Corporation A incurs a withholding 
tax of $13.50 on the $90 dividend distributed from B Corporation (15 
percent of $90) and an additional foreign income tax of 10 percent or 
$7.65 by reason of the inclusion of the net distribution of $76.50 ($90 
minus $13.50) in its taxable income for 1964. As of December 31, 1964, 
with respect to M Corporation, B Corporation's earnings and profits for 
1963 described in section 959(c)(2) amount to zero ($90 minus $90); and 
A Corporation's earnings and profits for 1963 described in section 
959(c)(2) amount to $68.85 ($90 minus $13.50 minus $7.65).

    (e) Determination of foreign tax credit. For purposes of applying 
section 902 and section 960 in determining the foreign tax credit 
allowable under section 901 in a case in which distributions are made by 
a second-tier corporation or a first-tier corporation, as the case may 
be, from its earnings and profits for a taxable year which are 
attributable to an amount included in the gross income of a U.S. 
shareholder under section 951(a) or which are attributable to amounts 
excluded from the gross income of such foreign corporation under section 
959(b) and Sec. 1.959-2 with respect to a U.S. shareholder, the rules 
of paragraph (b) of this section shall apply except that in applying 
subparagraph (1) or (2) of such paragraph--
    (1) Distributions from the earnings and profits for such taxable 
year of the second-tier corporation shall be considered first 
attributable to its earnings and profits attributable to distributions 
from the earnings and profits of the foreign corporation, if any, next

[[Page 426]]

lower in the chain of ownership described in section 958(a), to the 
extent of such earnings and profits of the second-tier corporation, and 
then to the other earnings and profits of such second-tier corporation, 
and
    (2) Distributions from the earnings and profits for such taxable 
year of the first-tier corporation shall be considered first 
attributable to its earnings and profits attributable to distributions 
from the earnings and profits of the second-tier corporation, to the 
extent of such earnings and profits of the first-tier corporation, and 
then to the other earnings and profits of such first-tier corporation. 
For purposes of this paragraph, a second-tier corporation is a foreign 
corporation referred to in section 960(a)(1)(B), and a first-tier 
corporation is a foreign corporation referred to in section 960 
(a)(1)(A). The application of this paragraph may be illustrated by the 
following examples:

    Example 1. (a) Domestic corporation A, a United States shareholder, 
owns 100 percent of the only class of stock of foreign corporation R 
which, in turn, owns 100 percent of the only class of stock of foreign 
corporation S. All corporations use the calendar year as a taxable year, 
and corporations R and S are controlled foreign corporations throughout 
the period here involved.
    (b) Neither R Corporation nor S Corporation has subpart F income for 
1963. During 1963, S Corporation increases by $100 its investment in 
tangible property (not described in section 956(b)(2)) located in the 
United States, makes no distributions, and has earnings and profits of 
$100. Corporation A must include $100 in its gross income for 1963 under 
section 951(a)(1)(B) with respect to S Corporation. During 1963, R 
Corporation also increases by $100 its investment in tangible property 
(not described in section 956(b)(2)) located in the United States, makes 
no distributions, and has earnings and profits of $100. Corporation A 
must include $100 in its gross income for 1963 under section 
951(a)(1)(B) with respect to R Corporation.
    (c) During 1964, S Corporation distributes $100 to R Corporation, 
and R Corporation distributes $100 to A Corporation. Neither corporation 
has any earnings or profits or deficit in earnings and profits for such 
year. On December 31, 1964, R Corporation has earnings and profits 
(computed before distributions to A Corporation made for the year) of 
$200, consisting of $100 of section 959(c)(1) amounts of R Corporation 
for 1963 and of $100 of section 959(c)(1) amounts of S Corporation for 
1963. For purposes of determining the foreign tax credit under section 
960 and the regulations thereunder, the $100 distribution by R 
Corporation shall be considered attributable to S Corporation's earnings 
and profits for 1963 described in section 959(c)(1).
    Example 2. (a) Domestic corporation A, a United States shareholder, 
owns 100 percent of the only class of stock of foreign corporation T 
which, in turn, owns 100 percent of the only class of stock of foreign 
corporation U. All corporations use the calendar year as a taxable year, 
and corporations T and U are controlled foreign corporations throughout 
the period here involved.
    (b) During 1964, T Corporation invests $100 in tangible property 
(not described in section 956(b)(2)) located in the United States. For 
1964, T Corporation has no subpart F income and makes no distributions; 
A must include $100 in its gross income for 1964 under section 
951(a)(1)(B) with respect to T Corporation. For 1964, U Corporation has 
no subpart F income or investment of earnings in United States property 
but U Corporation has $100 of earnings and profits which it distributes 
to T Corporation. At December 31, 1964, T Corporation has earnings and 
profits of $300, consisting of operating income of $100 for each of the 
years 1963 and 1964 and $100 in dividends received from the earnings and 
profits of U Corporation for 1964. These earnings and profits are 
classified as follows under section 959(c): $100 of section 959(c)(1) 
amounts of T Corporation for 1964, $100 of section 959(c)(3) amounts of 
U Corporation for 1964, and $100 of section 959(c)(3) amounts of T 
Corporation for 1963.
    (c) During 1965 neither T Corporation nor U Corporation has any 
earnings and profits or deficit in earnings and profits or investment of 
earnings in U.S. property, but T Corporation distributes $100 to A 
Corporation. For purposes of determining the foreign tax credit under 
section 960 and the regulations thereunder, the $100 distribution of T 
Corporation shall be considered attributable to T Corporation's earnings 
and profits for 1964 described in section 959(c)(1).

    (f) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) M, a controlled foreign corporation is organized on 
January 1, 1963, and is wholly owned by A, a United States shareholder. 
Both A and Corporation M use the calendar year as a taxable year.
    (b) Corporation M's earnings and profits (before distributions) for 
1963 are $200, $100, of which is attributable to subpart F income. 
Corporation M's earnings and profits for such year also include $25 
attributable to subpart F income which is excluded from M Corporation's 
foreign base company income under section 954(b)(1) as dividends, 
interest, and gains invested in qualified investments in less developed 
countries. Corporation M's

[[Page 427]]

increase in earnings invested in tangible property (not described in 
section 956(b)(2)) located in the United States for 1963, is $50, and M 
Corporation makes a distribution of such property during such year of 
$20. For purposes of section 959, A's interest in M Corporation's 
earnings and profits as of December 31, 1963, determined after the 
distributions of $20, is classified as follows:

Section 959(c)(1) amounts:
  Earnings for 1963 attributable to increased               $50
   investment in U.S. property which would have been
   included in A's gross income but for application of
   section 959(a)(2) and Sec. 1.959-1(c)............
  Less: Distribution for 1963 allocated under section        20      $30
   959(c)(1) and paragraph (b)(1) of this section to
   such amounts.......................................
                                              ---------
Section 959(c)(2) amounts:
  Earnings for 1963 attributable to subpart F income        100
   included in A's gross income under section
   951(a)(1)(A)(i)....................................
  Less: Earnings for 1963 attributable to increased          50       50
   investment in U.S. property which would have been
   included in A's gross income but for application of
   section 959(a)(2) and Sec. 1.959-1(c)............
                                              ---------
Section 959(c)(3) amounts:
  Predistribution earnings for 1963...................      200
  Less: Earnings for 1963 classified as:
    Section 959(c)(1) amounts................      $50
    Section 959(c)(2) amounts................       50      100      100
                                              --------------------------
A's total interest in M Corporation's          .......  .......      180
 earnings and profits........................
------------------------------------------------------------------------
 


For 1963, A is required to include $100 of subpart F income in his gross 
income under section 951(a)(1)(A)(i). He would have been required to 
include $50 in his gross income under section 951(a)(1)(B) as M 
Corporation's increase in earnings invested in United States property, 
except that section 959(a)(2) and paragraph (c) of Sec. 1.959-1 provide 
in effect that earnings and profits taxed to A under section 
951(a)(1)(A) with respect to M Corporation (whether in the current 
taxable year or in prior years) may be invested in United States 
property without again being included in gross income under section 
951(a). The $20 dividend from M Corporation is excluded from A's gross 
income under section 959(a)(1) and paragraph (b) of Sec. 1.959-1, since 
such distribution is allocated under section 959(c)(1) and paragraph 
(b)(1) of this section to amounts described in section 959(c)(1).
    (c) During 1964, M Corporation's earnings and profits (before 
distributions) are $300, $75 of which is attributable to subpart F 
income. Corporation M has no change in investments in United States 
property during such year and withdraws $15 of previously excluded 
subpart F income from investment in less developed countries. 
Corporation M makes a cash distribution of $250 to A during 1964. For 
purposes of section 959, A's interest in M Corporation's earnings and 
profits as of December 31, 1964, determined after the distribution of 
$250, is classified as follows:

Section 959 (c)(1) amounts:
  Section 959(c)(1) net amount for 1963 (as determined      $30
   under paragraph (b) of this example)...............
  Less: Distribution for 1964 allocated under section        30
   959(c)(1) and paragraph (b)(1) of this section to
   such amount........................................
                                     =========
Section 959(c)(2) amounts:
  Section 959(c)(2) net amount for 1963 (as determined       50
   under paragraph (b) of this example)...............
  Plus: Earnings for 1964 attributable to:
    Subpart F income for 1964 included in A's gross          75
     income under section 951(a)(1)(A)(i).............
    Previously excluded subpart F income withdrawn in        15
     1964 from investment in less developed countries
     and included in A's gross income under section
     951(a)(1)(A)(ii).................................
                                     ---------
                                                            140
  Less: Distribution for 1964 allocated under section       140
   959(c)(2) and paragraph (b)(2) of this section to
   such amounts.......................................
                                     =========
Section 959(c)(3) amounts:
  Section 959(c)(3) net amount for 1963 (as determined      100
   under paragraph (b) of this example)...............
  Plus: Section 959(c)(3) net amount
   for 1964:
    Predistribution earnings for      .......     $300
     1964...........................
    Less:
      Earnings for 1964 classified        $90
       as section 959(c)(1) amounts
       ($0) and as section 959(c)(2)
       amounts ($75 + $15)..........
      Distributions for 1964               80      170      130     $230
       allocated under section
       959(c)(3) and paragraph
       (b)(3) of this section.......
                                     -----------------------------------

[[Page 428]]

 
A's total interest in M               .......  .......  .......      230
 Corporation's earnings and profits.
------------------------------------------------------------------------
 

For 1964, A is required to include in his gross income under section 
951(a)(1)(A)(i) $75 of subpart F income, and under section 951 
(a)(1)(A)(ii) $15 of previously excluded subpart F income withdrawn from 
investment in less developed countries. Of the $250 cash distribution, A 
may exclude $170 from his gross income under section 959(a)(1) and 
paragraph (b) of Sec. 1.959-1 and $80 is includible in his gross income 
as a dividend.
    (d) The source under section 959(c) of the 1964 distribution of $250 
to A is as follows:

------------------------------------------------------------------------
                                                           Allocation of
                                                           distribution
                  Year                        Amount       under section
                                                                959
------------------------------------------------------------------------
1963....................................             $30         (c)(1).
1964....................................              90         (c)(2).
1963....................................              50         (c)(2).
1964....................................              80         (c)(3).
                                         ----------------
                                                     250  ..............
------------------------------------------------------------------------


[T.D. 6795, 30 FR 945, Jan. 29, 1965, as amended by T.D. 7334, 39 FR 
44211, Dec. 23, 1974; T.D. 7545, 43 FR 19652, May 8, 1978; T.D. 7893, 48 
FR 22510, May 19, 1983]



Sec. 1.959-4  Distributions to United States persons not counting
as dividends.

    Except as provided in section 960(a)(3) and Sec. 1.960-2, any 
distribution to a United States person which is excluded from the gross 
income of such person under section 959(a)(1) and Sec. 1.959-1 shall be 
treated for purposes of chapter 1 (relating to normal taxes and 
surtaxes) of subtitle A (relating to income taxes) of the Code as a 
distribution which is not a dividend. However, see paragraph (b)(1) of 
Sec. 1.956-1, relating to the dividend limitation on the amount of a 
controlled foreign corporation's investment of earnings in United States 
property.

[T.D. 7120, 36 FR 10860, June 4, 1971]



Sec. 1.960-1  Overview, definitions, and computational rules for 
determining foreign income taxes deemed paid under section 960(a), 
(b), and (d).

    (a) Overview--(1) Scope of Sec. Sec. 1.960-1 through 1.960-3. This 
section and Sec. Sec. 1.960-2 and 1.960-3 provide rules to associate 
foreign income taxes of a controlled foreign corporation with the income 
that a domestic corporation that is a United States shareholder of the 
controlled foreign corporation takes into account in determining a 
subpart F inclusion or GILTI inclusion amount of the domestic 
corporation, as well as to associate foreign income taxes of a 
controlled foreign corporation with distributions of previously taxed 
earnings and profits. This section and Sec. Sec. 1.960-2 and 1.960-3 
provide the exclusive rules for determining the foreign income taxes 
deemed paid by a domestic corporation under section 960. Therefore, only 
foreign income taxes of a controlled foreign corporation that are 
associated under these rules with a subpart F inclusion or GILTI 
inclusion amount of a domestic corporation that is a United States 
shareholder of the controlled foreign corporation, or with previously 
taxed earnings and profits, are eligible to be deemed paid. This section 
provides definitions and computational rules for determining foreign 
income taxes deemed paid under section 960(a), (b), and (d). Section 
1.960-2 provides rules for computing the amount of foreign income taxes 
deemed paid by a domestic corporation that is a United States 
shareholder of a controlled foreign corporation under section 960(a) and 
(d). Section 1.960-3 provides rules for computing the amount of foreign 
income taxes deemed paid by a domestic corporation that is a United 
States shareholder of a controlled foreign corporation, or by a 
controlled foreign corporation, under section 960(b). This section and 
Sec. Sec. 1.960-2 and 1.960-3 also apply for purposes of any provision 
that treats a taxpayer as a domestic corporation that is deemed to pay 
foreign income taxes or treats a foreign corporation as a controlled 
foreign corporation for purposes of section 960. See, for example, 
sections 962(a)(2) and 1293(f).
    (2) Scope of this section. Paragraph (b) of this section provides 
definitions for purposes of this section and Sec. Sec. 1.960-2 and 
1.960-3. Paragraph (c) of this section provides computational rules to 
coordinate the various calculations under this section and Sec. Sec. 
1.960-2 and 1.960-3. Paragraph (d) of this section

[[Page 429]]

provides rules for computing the income in an income group within a 
section 904 category, and for associating foreign income taxes with an 
income group. Paragraph (e) of this section provides a rule for the 
treatment of taxes associated with the residual income group. Paragraph 
(f) of this section provides an example illustrating the application of 
this section.
    (b) Definitions. The following definitions apply for purposes of 
this section and Sec. Sec. 1.960-2 and 1.960-3.
    (1) Annual PTEP account. The term annual PTEP account has the 
meaning set forth in Sec. 1.960-3(c)(1).
    (2) Controlled foreign corporation. The term controlled foreign 
corporation means a foreign corporation described in section 957(a).
    (3) Current taxable year. The term current taxable year means the 
U.S. taxable year of a controlled foreign corporation that is an 
inclusion year, or during which the controlled foreign corporation 
receives a section 959(b) distribution or makes a section 959(a) 
distribution or a section 959(b) distribution.
    (4) Current year tax. The term current year tax means a foreign 
income tax paid or accrued by a controlled foreign corporation in a 
current taxable year (taking into account any adjustments resulting from 
a foreign tax redetermination (as defined in Sec. 1.905-3(a)). A 
foreign income tax accrues when all the events have occurred that 
establish the fact of the liability and the amount of the liability can 
be determined with reasonable accuracy. See Sec. Sec. 1.446-
1(c)(1)(ii)(A) and 1.461-4(g)(6)(iii)(B) (economic performance exception 
for certain foreign taxes). Withholding taxes described in section 
901(k)(1)(B) that are withheld from a payment accrue when the payment is 
made. A foreign income tax calculated on the basis of net income (or a 
base in lieu of net income) for a foreign taxable year accrues on the 
last day of the foreign taxable year. Accordingly, current year taxes 
include foreign withholding taxes that are withheld from payments made 
to the controlled foreign corporation during the current taxable year, 
and foreign income taxes that accrue in the controlled foreign 
corporation's current taxable year in which or with which its foreign 
taxable year ends. Additional payments of foreign income taxes resulting 
from a redetermination of foreign tax liability, including contested 
taxes that accrue when the contest is resolved, ``relate back'' and are 
considered to accrue as of the end of the foreign taxable year to which 
the taxes relate.
    (5) Foreign income tax. The term foreign income tax means each 
separate levy (as defined in Sec. 1.901-2(d)) that is an income, war 
profits, and excess profits tax as defined in Sec. 1.901-2(a), and tax 
included in the term income, war profits, and excess profits tax by 
reason of section 903 and Sec. 1.903-1(a), that is imposed by a foreign 
country or a possession of the United States, including any such tax 
that is deemed paid by a controlled foreign corporation under section 
960(b)(2). Income, war profits, and excess profits taxes do not include 
amounts excluded from the definition of those taxes under section 901. 
See, for example, section 901(f), (g), and (i). Foreign income tax also 
does not include taxes paid by a controlled foreign corporation for 
which a credit is disallowed at the level of the controlled foreign 
corporation. See, for example, sections 245A(e)(3), 901(k)(1), (l), and 
(m), 909, and 6038(c)(1)(B). Foreign income tax, however, includes tax 
that may be deemed paid but for which a credit is reduced or disallowed 
at the level of the United States shareholder. See, for example, 
sections 901(e), 901(j), 901(k)(2), 908, 965(g), and 6038(c)(1)(A).
    (6) Foreign taxable year. The term foreign taxable year has the 
meaning set forth in section 7701(a)(23), applied by substituting 
``under foreign law'' for the phrase ``under subtitle A.''
    (7) Foreign taxable income. The term foreign taxable income means 
the base upon which a current year tax is imposed that comprises the 
items included in gross income under foreign law and the deductions 
allowed under foreign law. In the case of a current year tax that is 
imposed with respect to a taxable period, foreign taxable income 
includes all of the items taken into account under foreign law with 
respect to that period. See paragraph (d)(3)(ii)(A) of this section for 
rules for apportioning current year tax to section 904 categories or 
income groups on the basis of foreign taxable income.

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    (8) GILTI inclusion amount. The term GILTI inclusion amount has the 
meaning set forth in Sec. 1.951A-1(c)(1) (or, in the case of a member 
of a consolidated group, Sec. 1.1502-51(b)).
    (9) Gross tested income. The term gross tested income has the 
meaning set forth in Sec. 1.951A-2(c)(1).
    (10) Inclusion percentage. The term inclusion percentage has the 
meaning set forth in Sec. 1.960-2(c)(2).
    (11) Inclusion year. The term inclusion year means the U.S. taxable 
year of a controlled foreign corporation which ends during or with the 
taxable year of a United States shareholder of the controlled foreign 
corporation in which the United States shareholder includes an amount in 
income under section 951(a)(1) or 951A(a) with respect to the controlled 
foreign corporation.
    (12) Income group. The term income group means a group of income 
described in paragraph (d)(2)(ii) of this section.
    (13) Partnership CFC. The term partnership CFC means, with respect 
to a U.S. shareholder partnership, a controlled foreign corporation 
stock of which is owned (within the meaning of section 958(a)) by the 
U.S. shareholder partnership.
    (14) Passive category. The term passive category means the separate 
category of income described in section 904(d)(1)(C) and Sec. 1.904-
4(b).
    (15) Previously taxed earnings and profits. The term previously 
taxed earnings and profits means earnings and profits described in 
section 959(c)(1) or (2), including earnings and profits described in 
section 959(c)(2) by reason of section 951A(f)(1) and Sec. 1.951A-
5(b)(1).
    (16) PTEP group. The term PTEP group has the meaning set forth in 
Sec. 1.960-3(c)(2).
    (17) PTEP group taxes. The term PTEP group taxes has the meaning set 
forth in Sec. 1.960-3(d)(1).
    (18) Recipient controlled foreign corporation. The term recipient 
controlled foreign corporation has the meaning set forth in Sec. 1.960-
3(b)(2).
    (19) Reclassified previously taxed earnings and profits. The term 
reclassified previously taxed earnings and profits has the meaning set 
forth in Sec. 1.960-3(c)(4).
    (20) Reclassified PTEP group. The term reclassified PTEP group has 
the meaning set forth in Sec. 1.960-3(c)(4).
    (21) Residual income group. The term residual income group has the 
meaning set forth in paragraph (d)(2)(ii)(D) of this section.
    (22) Section 904 category. The term section 904 category means a 
separate category of income described in Sec. 1.904-5(a)(4)(v).
    (23) Section 951A category. The term section 951A category means the 
separate category of income described in section 904(d)(1)(A) and Sec. 
1.904-4(g).
    (24) Section 959 distribution. The term section 959 distribution 
means a section 959(a) distribution or a section 959(b) distribution.
    (25) Section 959(a) distribution. The term section 959(a) 
distribution means a distribution excluded from the gross income of a 
United States shareholder under section 959(a).
    (26) Section 959(b) distribution. The term section 959(b) 
distribution means a distribution excluded from the gross income of a 
controlled foreign corporation for purposes of section 951(a) under 
section 959(b).
    (27) Section 959(c)(2) PTEP group. The term section 959(c)(2) PTEP 
group has the meaning set forth in Sec. 1.960-3(c)(4).
    (28) Subpart F inclusion. The term subpart F inclusion has the 
meaning set forth in Sec. 1.960-2(b)(1).
    (29) Subpart F income. The term subpart F income has the meaning set 
forth in section 952 and Sec. 1.952-1(a).
    (30) Subpart F income group. The term subpart F income group has the 
meaning set forth in paragraph (d)(2)(ii)(B)(1) of this section.
    (31) Tested foreign income taxes. The term tested foreign income 
taxes has the meaning set forth in Sec. 1.960-2(c)(3).
    (32) Tested income. The term tested income means the amount with 
respect to a controlled foreign corporation that is described in section 
951A(c)(2)(A) and Sec. 1.951A-2(b)(1).
    (33) Tested income group. The term tested income group has the 
meaning set forth in paragraph (d)(2)(ii)(C) of this section.
    (34) United States shareholder. The term United States shareholder 
has the meaning set forth in section 951(b).

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    (35) U.S. shareholder partner. The term U.S. shareholder partner 
means, with respect to a U.S. shareholder partnership and a partnership 
CFC of the U.S. shareholder partnership, a United States person that is 
a partner in the U.S. shareholder partnership and that is also a United 
States shareholder (as defined in section 951(b)) of the partnership 
CFC.
    (36) U.S. shareholder partnership. The term U.S. shareholder 
partnership means a domestic partnership (within the meaning of section 
7701(a)(4)) that is a United States shareholder of one or more 
controlled foreign corporations.
    (37) U.S. taxable year. The term U.S. taxable year has the same 
meaning as that of the term taxable year set forth in section 
7701(a)(23).
    (c) Computational rules--(1) In general. For purposes of computing 
foreign income taxes deemed paid by either a domestic corporation that 
is a United States shareholder with respect to a controlled foreign 
corporation under Sec. 1.960-2 or Sec. 1.960-3 or by a controlled 
foreign corporation under Sec. 1.960-3 for the current taxable year, 
the following rules apply in the following order, beginning with the 
lowest-tier controlled foreign corporation in a chain with respect to 
which the domestic corporation is a United States shareholder:
    (i) First, items of gross income of the controlled foreign 
corporation for the current taxable year other than a section 959(b) 
distribution are assigned to section 904 categories and included in 
income groups within those section 904 categories under the rules in 
paragraph (d)(2) of this section. The receipt of a section 959(b) 
distribution by the controlled foreign corporation is accounted for 
under Sec. 1.960-3(c)(3).
    (ii) Second, deductions (other than for current year taxes) of the 
controlled foreign corporation for the current taxable year are 
allocated and apportioned to reduce gross income in the section 904 
categories and the income groups within a section 904 category. See 
paragraph (d)(3)(i) of this section. Additionally, the functional 
currency amounts of current year taxes of the controlled foreign 
corporation for the current taxable year are allocated and apportioned 
to reduce gross income in the section 904 categories and the income 
groups within a section 904 category, and to reduce earnings and profits 
in any PTEP groups that were increased as provided in paragraph 
(c)(1)(i) of this section. See paragraph (d)(3)(ii) of this section. For 
purposes of computing foreign taxes deemed paid, current year taxes 
allocated and apportioned to income groups and PTEP groups in the 
section 904 categories are translated into U.S. dollars in accordance 
with section 986(a). See paragraph (c)(3) of this section.
    (iii) Third, current year taxes deemed paid under section 960(a) and 
(d) by the domestic corporation with respect to income of the controlled 
foreign corporation are computed under the rules of Sec. 1.960-2. In 
addition, foreign income taxes deemed paid under section 960(b)(2) with 
respect to the receipt of a section 959(b) distribution by the 
controlled foreign corporation are computed under the rules of Sec. 
1.960-3(b).
    (iv) Fourth, any previously taxed earnings and profits of the 
controlled foreign corporation resulting from subpart F inclusions and 
GILTI inclusion amounts with respect to the controlled foreign 
corporation's current taxable year are separated from other earnings and 
profits of the controlled foreign corporation and added to an annual 
PTEP account, and a PTEP group within the PTEP account, under the rules 
of Sec. 1.960-3(c).
    (v) Fifth, paragraphs (c)(1)(i) through (iv) of this section are 
repeated for each next higher-tier controlled foreign corporation in the 
chain.
    (vi) Sixth, with respect to the highest-tier controlled foreign 
corporation in a chain that is owned directly (or indirectly through a 
partnership) by the domestic corporation, foreign income taxes that are 
deemed paid under section 960(b)(1) in connection with the receipt of a 
section 959(a) distribution by the domestic corporation are computed 
under the rules of Sec. 1.960-3(b).
    (2) Inclusion of current year items. For a current taxable year, the 
items of income and deductions (including for taxes), and the U.S. 
dollar amounts of current year taxes, that are included in the 
computations described in this section and assigned to income groups and 
PTEP groups for the taxable year are the items that the controlled 
foreign

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corporation accrues and takes into account during the current taxable 
year. An item of income with respect to a current taxable year does not 
include an amount included as subpart F income of a controlled foreign 
corporation by reason of the recharacterization of a recapture account 
established in a prior U.S. taxable year (and the corresponding earnings 
and profits) of the controlled foreign corporation under section 
952(c)(2) and Sec. 1.952-1(f).
    (3) Functional currency and translation. The computations described 
in this paragraph (c) that relate to income and earnings and profits are 
made in the functional currency of the controlled foreign corporation 
(as determined under section 985), and references to taxes deemed paid 
are to U.S. dollar amounts (translated in accordance with section 
986(a)).
    (d) Computing income in a section 904 category and an income group 
within a section 904 category--(1) Scope. This paragraph (d) provides 
rules for assigning gross income (including gains) of a controlled 
foreign corporation for the current taxable year to a section 904 
category and income group within a section 904 category, and for 
allocating and apportioning deductions (including losses and current 
year taxes) and the U.S. dollar amount of current year taxes of the 
controlled foreign corporation for the current taxable year among the 
section 904 categories, income groups within a section 904 category, and 
PTEP groups. For rules regarding maintenance of previously taxed 
earnings and profits in an annual PTEP account, and assignment of those 
previously taxed earnings and profits to PTEP groups, see Sec. 1.960-3.
    (2) Assignment of gross income to section 904 categories and income 
groups within a category--(i) Assigning items of gross income to section 
904 categories. Items of gross income of the controlled foreign 
corporation for the current taxable year are first assigned to a section 
904 category of the controlled foreign corporation under Sec. Sec. 
1.904-4 and 1.904-5, and under Sec. 1.960-3(c)(1) in the case of gross 
income relating to a section 959(b) distribution received by the 
controlled foreign corporation. Income of a controlled foreign 
corporation, other than gross income relating to a section 959(b) 
distribution, cannot be assigned to the section 951A category. See Sec. 
1.904-4(g).
    (ii) Grouping gross income within a section 904 category--(A) In 
general. Gross income within a section 904 category is assigned to an 
income group under the rules of this paragraph (d)(2)(ii), or to a PTEP 
group under the rules of Sec. 1.960-3(c)(3). Gross income other than a 
section 959(b) distribution is assigned to a subpart F income group, 
tested income group, or residual income group.
    (B) Subpart F income groups--(1) In general. The term subpart F 
income group means an income group within a section 904 category that 
consists of income that is described in paragraph (d)(2)(ii)(B)(2) of 
this section. Gross income that is treated as a single item of income 
under Sec. 1.954-1(c)(1)(iii) is in a separate subpart F income group 
under paragraph (d)(2)(ii)(B)(2)(i) of this section. Items of gross 
income that give rise to income described in paragraph 
(d)(2)(ii)(B)(2)(ii) of this section are aggregated and treated as gross 
income in a separate subpart F income group. Similarly, items of gross 
income that give rise to income described in each one of paragraphs 
(d)(2)(ii)(B)(2)(iii) through (v) of this section are aggregated and 
treated as gross income in a separate subpart F income group.
    (2) Income in subpart F income groups. The income included in 
subpart F income groups is:
    (i) Items of foreign base company income treated as a single item of 
income under Sec. 1.954-1(c)(1)(iii);
    (ii) Insurance income described in section 952(a)(1);
    (iii) Income subject to the international boycott factor described 
in section 952(a)(3);
    (iv) Income from certain bribes, kickbacks and other payments 
described in section 952(a)(4); and
    (v) Income subject to section 901(j) described in section 952(a)(5).
    (C) Tested income groups. The term tested income group means an 
income group that consists of tested income within a section 904 
category. Items of gross tested income in each section 904 category are 
aggregated and treated as gross income in a separate tested income 
group.

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    (D) Residual income group. The term residual income group means the 
income group within a section 904 category that consists of income that 
is not in a subpart F income group, tested income group, or PTEP group.
    (E) Examples. The following examples illustrate the application of 
this paragraph (d)(2)(ii).
    (1) Example 1: Subpart F income groups--(i) Facts. CFC, a controlled 
foreign corporation, is incorporated in Country X. CFC uses the ``u'' as 
its functional currency. At all relevant times, 1u = $1x. CFC earns from 
sources outside of Country X portfolio dividend income of 100,000u, 
portfolio interest income of 1,500,000u, and 70,000u of royalty income 
that is not derived from the active conduct of a trade or business. CFC 
also earns 50,000u from the sale of personal property to a related 
person for use outside of Country X that gives rise to foreign base 
company sales income under section 954(d). Finally, CFC earns 45,000u 
for performing consulting services outside of Country X for related 
persons that gives rise to foreign base company services income under 
section 954(e). None of the income is taxed by Country X. The dividend 
income is subject to a 15 percent third-country withholding tax after 
application of the applicable income tax treaty. The interest income and 
the royalty income are subject to no third-country withholding tax. CFC 
incurs no expenses.
    (ii) Analysis. Under paragraph (d)(2)(i) of this section and Sec. 
1.904-4, the interest income, dividend income, and royalty income are 
passive category income and the sales and consulting income are general 
category income. Under paragraph (d)(2)(ii)(B) of this section, CFC has 
a separate subpart F income group within the passive category with 
respect to the 100,000u of dividend income, which is foreign personal 
holding company income described in Sec. 1.954-1(c)(1)(iii)(A)(1)(i) 
(dividends, interest, rents, royalties and annuities) that falls within 
a single group of income under Sec. 1.904-4(c)(3)(i) for passive income 
that is subject to withholding tax of fifteen percent or greater. CFC 
also has a separate subpart F income group within the passive category 
with respect to the 1,500,000u of interest income and the 70,000u of 
royalty income (in total 1,570,000u) which together are foreign personal 
holding company income described in Sec. 1.954-1(c)(1)(iii)(A)(1)(i) 
(dividends, interest, rents, royalties and annuities) that falls within 
a single group of income under Sec. 1.904-4(c)(3)(iii) for passive 
income that is subject to no withholding tax or other foreign tax. With 
respect to its 50,000u of sales income, CFC has a separate subpart F 
income group with respect to foreign base company sales income described 
in Sec. 1.954-1(c)(1)(iii)(A)(2)(i) within the general category. With 
respect to its 45,000u of services income, CFC has a separate subpart F 
income group with respect to foreign base company services income 
described in Sec. 1.954-1(c)(1)(iii)(A)(2)(ii) within the general 
category.
    (2) Example 2: Tested income groups--(i) Facts. CFC, a controlled 
foreign corporation, is incorporated in Country X. CFC uses the ``u'' as 
its functional currency. At all relevant times, 1u = $1x. CFC earns 500u 
from the sale of goods to unrelated parties. CFC also earns 75u for 
performing consulting services for unrelated parties. All of its income 
is gross tested income. CFC incurs no deductions.
    (ii) Analysis. Under paragraph (d)(2)(i) of this section and section 
904 and Sec. 1.904-4, the sales income and services income are both 
general category income. Under paragraph (d)(2)(ii)(C) of this section, 
with respect to the 500u of sales income and 75u services income (in 
total 575u), CFC has one tested income group within the general 
category.
    (3) Allocation and apportionment of deductions among section 904 
categories, income groups within a section 904 category, and certain 
PTEP groups--(i) In general. Gross income of the controlled foreign 
corporation in each income group within each section 904 category is 
reduced by deductions (including losses) of the controlled foreign 
corporation for the current taxable year under the rules in this 
paragraph (d)(3)(i). No deductions of the controlled foreign corporation 
for the current taxable year other than a deduction for current year 
taxes imposed solely by reason of the receipt of

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a section 959(b) distribution are allocated or apportioned to reduce 
earnings and profits in a PTEP group.
    (A) First, the rules of sections 861 through 865 and 904(d) (taking 
into account the rules of section 954(b)(5) and Sec. 1.954-1(c), and 
section 951A(c)(2)(A)(ii) and Sec. 1.951A-2(c)(3), as appropriate) 
apply to allocate and apportion to reduce gross income (or create a 
loss) in each section 904 category and income group within a section 904 
category any deductions of the controlled foreign corporation that are 
definitely related to less than all of the controlled foreign 
corporation's gross income as a class. See paragraph (d)(3)(ii) of this 
section for special rules for allocating and apportioning current year 
taxes to section 904 categories, income groups, and PTEP groups.
    (B) Second, related person interest expense is allocated to and 
apportioned among the subpart F income groups within the passive 
category under the principles of Sec. Sec. 1.904-5(c)(2) and 1.954-
1(c)(1)(i).
    (C) Third, any remaining deductions are allocated and apportioned to 
reduce gross income (or create a loss) in the section 904 categories and 
income groups within each section 904 category under the rules 
referenced in paragraph (d)(3)(i)(A) of this section.
    (ii) Allocation and apportionment of a current year tax--(A) In 
general. A current year tax is allocated and apportioned among the 
section 904 categories under the rules of Sec. 1.904-6. An amount of 
the current year tax that is allocated and apportioned to a section 904 
category is then allocated and apportioned among the income groups 
within the section 904 category under Sec. 1.861-20 (as modified by 
Sec. 1.904-6(c)) by treating each income group as a statutory grouping 
and treating the residual income group as the residual grouping. 
Therefore, foreign gross income attributable to a base difference is 
assigned to the residual income grouping under Sec. 1.861-
20(d)(2)(ii)(B). See, however, paragraph (d)(3)(ii)(B) of this section 
for special rules for applying Sec. 1.861-20 in the case of PTEP 
groups. For purposes of determining foreign income taxes deemed paid 
under the rules in Sec. Sec. 1.960-2 and 1.960-3, the U.S. dollar 
amount of a current year tax is assigned to the section 904 categories, 
income groups, and PTEP groups (to the extent provided in paragraph 
(d)(3)(ii)(B) of this section) to which the current year tax is 
allocated and apportioned.
    (B) Foreign taxable income that includes previously taxed earnings 
and profits. For purposes of allocating and apportioning a current year 
tax under this paragraph (d)(3)(ii), a PTEP group that is increased 
under Sec. 1.960-3(c)(3) as a result of the receipt of a section 959(b) 
distribution in the current taxable year of the controlled foreign 
corporation is treated as an income group within the section 904 
category. In such case, under Sec. 1.861-20, the portion of the foreign 
gross income (as defined in Sec. 1.861-20(b)(5)) that is characterized 
under Federal income tax principles as a distribution of previously 
taxed earnings and profits that results in the increase in the PTEP 
group in the current taxable year is assigned to that PTEP group. If a 
PTEP group is not treated as an income group under the first sentence of 
this paragraph (d)(3)(ii)(B), and the rules of Sec. 1.861-20 would 
otherwise apply to assign foreign gross income to a PTEP group, that 
foreign gross income is instead assigned to the subpart F income group 
or tested income group to which the income that gave rise to the 
previously taxed earnings and profits would be assigned if the income 
were recognized by the recipient controlled foreign corporation under 
Federal income tax principles in the current taxable year. For example, 
a net basis or withholding tax imposed on a controlled foreign 
corporation's receipt of a section 959(b) distribution is allocated or 
apportioned to a PTEP group. In contrast, a withholding tax imposed on a 
disregarded payment from a disregarded entity to its controlled foreign 
corporation owner is never treated as related to a PTEP group, even if 
all of the controlled foreign corporation's earnings are previously 
taxed earnings and profits, because the payment that gives rise to the 
foreign gross income from which the tax was withheld does not constitute 
a section 959(b) distribution in the current taxable year. That foreign 
gross income, however, may be

[[Page 435]]

assigned to a subpart F income group or tested income group.
    (e) No deemed paid credit for current year taxes related to residual 
income group. Current year taxes paid or accrued by a controlled foreign 
corporation that are allocated and apportioned under paragraph 
(d)(3)(ii) of this section to a residual income group cannot be deemed 
paid under section 960 for any taxable year.
    (f) Example. The following example illustrates the application of 
this section and Sec. 1.960-3.
    (1) Facts--(i) Income of CFC1 and CFC2. CFC1, a controlled foreign 
corporation, conducts business in Country X. CFC1 uses the ``u'' as its 
functional currency. At all relevant times, 1u=$1x. CFC1 owns all of the 
stock of CFC2, a controlled foreign corporation. CFC1 and CFC2 both use 
the calendar year as their U.S. and foreign taxable years. In 2019, CFC1 
earns 2,000,000u of gross income that is foreign oil and gas extraction 
income, within the meaning of section 907(c)(1), and 2,000,000u of 
interest income from unrelated persons, for both U.S. and Country X tax 
law purposes. Country X exempts interest income from tax. In 2019, CFC1 
also receives a section 959(b) distribution from CFC2 of 4,000,000u of 
previously taxed earnings and profits attributable to an inclusion under 
section 965(a) for CFC2's 2017 U.S. taxable year. The inclusion under 
section 965(a) was income in the general category. There are no PTEP 
group taxes associated with the previously taxed earnings and profits 
distributed by CFC2 at the level of CFC2. The section 959(b) 
distribution is treated as a dividend taxable to CFC1 under Country X 
law. In 2019, CFC2 earns no gross income and receives no distributions.
    (ii) Pre-tax deductions of CFC1 and CFC2. For both U.S. and Country 
X tax purposes, in 2019, CFC1 incurs 1,500,000u of deductible expenses 
other than current year taxes that are allocable to all gross income. 
For U.S. tax purposes, under Sec. Sec. 1.861-8 through 1.861-14T, 
750,000u of such deductions are apportioned to each of CFC1's foreign 
oil and gas extraction income and interest income. Under Country X law, 
1,000,000u of deductions are allocated and apportioned to the 4,000,000u 
treated as a dividend, and 500,000u of deductions are allocated and 
apportioned to the 2,000,000u of foreign oil and gas extraction income. 
Under Country X law, no deductions are allocable to the interest income. 
Country X imposes tax of 900,000u on a base of 4,500,000u (6,000,000u 
gross income-1,500,000u deductions) consisting of 3,000,000u 
(4,000,000u-1,000,000u) attributable to CFC1's section 959(b) 
distribution and 1,500,000u (2,000,000u-500,000u) attributable to CFC1's 
foreign oil and gas extraction income. In 2019, CFC2 has no expenses 
(including current year taxes).
    (iii) United States shareholders of CFC1. All of the stock of CFC1 
is owned (within the meaning of section 958(a)) by corporate United 
States shareholders that use the calendar year as their U.S. taxable 
year. In 2019, the United States shareholders of CFC1 include in gross 
income subpart F inclusions in the passive category totaling $1,250,000x 
with respect to 1,250,000u of subpart F income of CFC1.
    (2) Analysis--(i) CFC2. Under paragraph (c)(1) of this section, the 
computational rules of paragraph (c)(1) of this section are applied 
beginning with CFC2. However, CFC2 has no gross income or expenses in 
2019 (the ``current taxable year''). Accordingly, the computational 
rules described in paragraphs (c)(1)(i) through (iv) of this section are 
not relevant with respect to CFC2. Under paragraph (c)(1)(v) of this 
section, the rules in paragraph (c)(1)(i) through (iv) of this section 
are then applied to CFC1.
    (ii) CFC1--(A) Step 1. Under paragraph (c)(1)(i) of this section, 
CFC1's items of gross income for the current taxable year are assigned 
to section 904 categories and included in income groups within those 
section 904 categories. In addition, CFC1's receipt of a section 959(b) 
distribution is assigned to a PTEP group. Under paragraph (d)(2)(i) of 
this section and Sec. 1.904-4, the interest income is passive category 
income and the foreign oil and gas extraction income is general category 
income. Under paragraph (d)(2)(ii) of this section, the 2,000,000u of 
interest income is assigned to a subpart F income group (the ``subpart F 
income group'') within the passive category because it

[[Page 436]]

is foreign personal holding company income described in Sec. 1.954-
1(c)(1)(iii)(A)(1)(i) that falls within a single group of income under 
Sec. 1.904-4(c)(3)(iii) for passive income that is subject to no 
withholding tax or other foreign tax. The 2,000,000u of foreign oil and 
gas extraction income is assigned to the residual income group within 
the general category. Under Sec. 1.960-3(c), the 4,000,000u section 
959(b) distribution is assigned to the PTEP group described in Sec. 
1.960-3(c)(2)(vii) within the 2017 annual PTEP account (the ``PTEP 
group'') within the general category.
    (B) Step 2--(1) Allocation and apportionment of deductions for 
expenses other than taxes. Under paragraph (c)(1)(ii) of this section, 
CFC1's deductions for the current taxable year are allocated and 
apportioned among the section 904 categories, income groups within a 
section 904 category, and any PTEP groups that were increased as 
provided in paragraph (c)(1)(i) of this section. Under paragraph 
(d)(3)(i) of this section and Sec. Sec. 1.861-8 through 1.861-14T, 
750,000u of deductions are allocated and apportioned to the residual 
income group within the general category, and 750,000u of deductions are 
allocated and apportioned to the subpart F income group within the 
passive category. Therefore, CFC1 has 1,250,000u (2,000,000u-750,000u) 
of pre-tax income attributable to the residual income group within the 
general category and 1,250,000u (2,000,000u-750,000u) of pre-tax income 
attributable to the subpart F income group within the passive category. 
For U.S. tax purposes, no deductions other than current year taxes are 
allocated and apportioned to the 4,000,000u in CFC1's PTEP group.
    (2) Allocation and apportionment of current year taxes. Under 
paragraph (c)(1)(ii) of this section, CFC1's current year taxes are 
allocated and apportioned among the section 904 categories, income 
groups within a section 904 category, and any PTEP groups that were 
increased as provided in paragraph (c)(1)(i) of this section. Under 
paragraphs (d)(3)(i) and (ii) of this section, for purposes of 
allocating and apportioning taxes to reduce the income in a section 904 
category, an income group, or PTEP group, Sec. 1.904-6(a)(1) and (ii) 
are applied to determine the amount of foreign taxable income, computed 
under Country X law but characterized under Federal income tax law, in 
each section 904 category, income group, and PTEP group that is included 
in the Country X tax base. For Country X purposes, 1,000,000u of 
deductions are apportioned to CFC1's PTEP group within the general 
category, 500,000u of deductions are apportioned to the residual income 
group within the general category, and no deductions are apportioned to 
the subpart F income group in the passive category. Therefore, for 
Country X purposes, CFC1 has 3,000,000u of foreign taxable income 
attributable to the PTEP group within the general category, 1,500,000u 
of foreign taxable income attributable to the residual income group 
within the general category, and no income attributable to the subpart F 
income group within the passive category. Under paragraph (d)(3)(ii) of 
this section, 600,000u (3,000,000u/4,500,000u x 900,000u) of the 
900,000u current year taxes paid by CFC1 are related to the PTEP group 
within the general category, and 300,000u (1,500,000u/4,500,000u x 
900,000u) are related to the residual income group within the general 
category. No current year taxes are allocated or apportioned to the 
subpart F income group within the passive category because the interest 
expense is exempt from Country X tax. Thus, for U.S. tax purposes, CFC1 
has 3,400,000u of previously taxed earnings and profits (4,000,000u-
600,000u) in the PTEP group within the general category, 1,250,000u of 
income in the subpart F income group within the passive category, and 
950,000u of income (1,250,000u-300,000u) in the residual income group 
within the general category. For purposes of determining foreign taxes 
deemed paid under section 960, CFC1 has $600,000x of foreign income 
taxes in the PTEP group within the general category and $300,000x of 
current year taxes in the residual income group within the general 
category. Under paragraph (e) of this section, the United States 
shareholders of CFC1 cannot claim a credit with respect to the $300,000x 
of taxes on CFC1's income in the residual income group.

[[Page 437]]

    (C) Step 3. Under paragraph (c)(1)(iii) of this section, the United 
States shareholders of CFC1 compute current year taxes deemed paid under 
section 960(a) and (d) and the rules of Sec. 1.960-2. None of the 
Country X tax is allocated to CFC1's subpart F income group. Therefore, 
there are no current year taxes deemed paid by CFC1's United States 
shareholders with respect to their passive category subpart F 
inclusions. See Sec. 1.960-2(b)(5) and (c)(7) for examples of the 
application of section 960(a) and (d) and the rules in Sec. 1.960-2. 
Additionally, under paragraph (c)(1)(iii) of this section, foreign 
income taxes deemed paid under section 960(b)(2) by CFC1 are determined 
with respect to the section 959(b) distribution from CFC2 under the 
rules of Sec. 1.960-3. There are no PTEP group taxes associated with 
the previously taxed earnings and profits distributed by CFC2 in the 
hands of CFC2. Therefore, there are no foreign income taxes deemed paid 
by CFC1 under section 960(b)(2) with respect to the section 959(b) 
distribution from CFC2. See Sec. 1.960-3(e) for examples of the 
application of section 960(b) and the rules in Sec. 1.960-3.
    (D) Step 4. Under paragraph (c)(1)(iv) of this section, previously 
taxed earnings and profits resulting from subpart F inclusions and GILTI 
inclusion amounts with respect to CFC1's current taxable year are 
separated from CFC1's other earnings and profits and added to an annual 
PTEP account and PTEP group within the PTEP account, under the rules of 
Sec. 1.960-3(c). The United States shareholders of CFC1 include in 
gross income subpart F inclusions totaling $1,250,000x with respect to 
1,250,000u of subpart F income of CFC1, and the subpart F inclusions are 
passive category income. Therefore, under Sec. 1.960-3(c)(2), 
1,250,000u of previously taxed earnings and profits resulting from the 
subpart F inclusions is added to CFC1's section 951(a)(1)(A) PTEP within 
the 2019 annual PTEP account within the passive category.
    (E) Step 5. Paragraph (c)(1)(v) of this section does not apply 
because CFC1 is the highest-tier controlled foreign corporation in the 
chain.
    (F) Step 6. Paragraph (c)(1)(vi) of this section does not apply 
because CFC1 did not make a section 959(a) distribution.

[T.D. 9882, 84 FR 69107, Dec. 17, 2019, as amended by T.D. 9922, 85 FR 
72071, Nov. 12, 2020]



Sec. 1.960-2  Foreign income taxes deemed paid under sections 960(a)
and (d).

    (a) Scope. Paragraph (b) of this section provides rules for 
computing the amount of foreign income taxes deemed paid by a domestic 
corporation that is a United States shareholder of a controlled foreign 
corporation under section 960(a). Paragraph (c) of this section provides 
rules for computing the amount of foreign income taxes deemed paid by a 
domestic corporation that is a United States shareholder of a controlled 
foreign corporation under section 960(d).
    (b) Foreign income taxes deemed paid under section 960(a)--(1) In 
general. If a domestic corporation that is a United States shareholder 
of a controlled foreign corporation includes in gross income under 
section 951(a)(1)(A) its pro rata share of the subpart F income of the 
controlled foreign corporation (a subpart F inclusion), the domestic 
corporation is deemed to have paid the amount of the controlled foreign 
corporation's foreign income taxes that are properly attributable to the 
items of income in a subpart F income group of the controlled foreign 
corporation that give rise to the subpart F inclusion of the domestic 
corporation that is attributable to the subpart F income group. For each 
section 904 category, the domestic corporation is deemed to have paid 
foreign income taxes equal to the sum of the controlled foreign 
corporation's foreign income taxes that are properly attributable to the 
items of income in the subpart F income groups to which the subpart F 
inclusion is attributable. See Sec. 1.904-6(b)(1) for rules on 
assigning the foreign income tax to a section 904 category. No foreign 
income taxes are deemed paid under section 960(a) with respect to an 
inclusion under section 951(a)(1)(B).
    (2) Properly attributable. The amount of the controlled foreign 
corporation's foreign income taxes that are properly attributable to the 
items of income in the subpart F income group of the controlled foreign 
corporation to which a

[[Page 438]]

subpart F inclusion is attributable equals the domestic corporation's 
proportionate share of the current year taxes of the controlled foreign 
corporation that are allocated and apportioned under Sec. 1.960-
1(d)(3)(ii) to the subpart F income group. No other foreign income taxes 
are considered properly attributable to an item of income of the 
controlled foreign corporation.
    (3) Proportionate share--(i) In general. A domestic corporation's 
proportionate share of the current year taxes of a controlled foreign 
corporation that are allocated and apportioned under Sec. 1.960-
1(d)(3)(ii) to a subpart F income group within a section 904 category of 
the controlled foreign corporation is equal to the total U.S. dollar 
amount of current year taxes that are allocated and apportioned under 
Sec. 1.960-1(d)(3)(ii) to the subpart F income group multiplied by a 
fraction (not to exceed one), the numerator of which is the portion of 
the domestic corporation's subpart F inclusion that is attributable to 
the subpart F income group and the denominator of which is the total net 
income in the subpart F income group, both determined in the functional 
currency of the controlled foreign corporation. If the numerator or 
denominator of the fraction is zero or less than zero, then the 
proportionate share of the current year taxes that are allocated and 
apportioned under Sec. 1.960-1(d)(3)(ii) to the subpart F income group 
is zero.
    (ii) Effect of qualified deficits. Neither an accumulated deficit 
nor any prior year deficit in the earnings and profits of a controlled 
foreign corporation reduces its net income in a subpart F income group. 
Accordingly, any such deficit does not affect the denominator of the 
fraction described in paragraph (b)(3)(i) of this section. However, the 
first sentence of this paragraph (b)(3)(ii) does not affect the 
application of section 952(c)(1)(B) for purposes of determining the 
domestic corporation's subpart F inclusion. Any reduction to the 
domestic corporation's subpart F inclusion under section 952(c)(1)(B) is 
reflected in the numerator of the fraction described in paragraph 
(b)(3)(i) of this section.
    (iii) Effect of current year E&P limitation or chain deficit. To the 
extent that an amount of income in a subpart F income group is excluded 
from the subpart F income of the controlled foreign corporation under 
section 952(c)(1)(A) or (C), the net income in the subpart F income 
group that is the denominator of the fraction described in paragraph 
(b)(3)(i) of this section is reduced (but not below zero) by the amount 
excluded. The domestic corporation's subpart F inclusion that is the 
numerator of the fraction described in paragraph (b)(3)(i) of this 
section is based on the controlled foreign corporation's subpart F 
income computed with the application of section 952(c)(1)(A) and (C). 
See Sec. 1.960-1(c)(2) for a rule regarding the treatment of an 
increase in the subpart F income of a controlled foreign corporation by 
reason of the recharacterization of a recapture account and the 
corresponding accumulated earnings and profits under section 952(c) and 
Sec. 1.952-1(f).
    (4) Domestic partnerships. For purposes of applying this paragraph 
(b), in the case of a domestic partnership that is a U.S. shareholder 
partnership with respect to a partnership CFC, the distributive share of 
a U.S. shareholder partner of the U.S. shareholder partnership's subpart 
F inclusion with respect to the partnership CFC is treated as a subpart 
F inclusion of the U.S. shareholder partner with respect to the 
partnership CFC.
    (5) Example. The following example illustrates the application of 
this paragraph (b).
    (i) Facts. USP, a domestic corporation, owns 80% of the stock of 
CFC, a controlled foreign corporation. The remaining portion of the 
stock of CFC is owned by an unrelated person. USP and CFC both use the 
calendar year as their U.S. taxable year, and CFC also uses the calendar 
year as its foreign taxable year. CFC uses the ``u'' as its functional 
currency. At all relevant times, 1u=$1x. For its U.S. taxable year 
ending December 31, 2018, after the application of the rules in Sec. 
1.960-1(d) the income of CFC after foreign taxes is assigned to the 
following income groups: 1,000,000u of dividend income in a subpart F 
income group within the passive category (``subpart F income group 1''); 
2,400,000u of gain from commodities transactions in a subpart F income 
group within the passive category

[[Page 439]]

(``subpart F income group 2''); and 1,800,000u of foreign base company 
services income in a subpart F income group within the general category 
(``subpart F income group 3''). CFC has current year taxes, translated 
into U.S. dollars, of $740,000x that are allocated and apportioned as 
follows: $50,000x to subpart F income group 1; $240,000x to subpart F 
income group 2; and $450,000x to subpart F income group 3. USP has a 
subpart F inclusion with respect to CFC of 4,160,000u = $4,160,000x, of 
which 800,000u is attributable to subpart F income group 1, 1,920,000u 
to subpart F income group 2, and 1,440,000u to subpart F income group 3.
    (ii) Analysis--(A) Passive category. Under paragraphs (b)(2) and (3) 
of this section, the amount of CFC's current year taxes that are 
properly attributable to items of income in subpart F income group 1 to 
which a subpart F inclusion is attributable equals USP's proportionate 
share of the current year taxes that are allocated and apportioned under 
Sec. 1.960-1(d)(3)(ii) to subpart F income group 1, which is $40,000x 
($50,000x x 800,000u/1,000,000u). Under paragraphs (b)(2) and (3) of 
this section, the amount of CFC's current year taxes that are properly 
attributable to items of income in subpart F income group 2 to which a 
subpart F inclusion is attributable equals USP's proportionate share of 
the current year taxes that are allocated and apportioned under Sec. 
1.960-1(d)(3)(ii) to subpart F income group 2, which is $192,000x 
($240,000x x 1,920,000u/2,400,000u). Accordingly, under paragraph (b)(1) 
of this section, USP is deemed to have paid $232,000x ($40,000x + 
$192,000x) of passive category foreign income taxes of CFC with respect 
to its $2,720,000x subpart F inclusion in the passive category.
    (B) General category. Under paragraphs (b)(2) and (3) of this 
section, the amount of CFC's current year taxes that are properly 
attributable items of income in subpart F income group 3 to which a 
subpart F inclusion is attributable equals USP's proportionate share of 
the foreign income taxes that are allocated and apportioned under Sec. 
1.960-1(d)(3)(ii) to subpart F income group 3, which is $360,000x 
($450,000x x 1,440,000u/1,800,000u). CFC has no other subpart F income 
groups within the general category. Accordingly, under paragraph (b)(1) 
of this section, USP is deemed to have paid $360,000x of general 
category foreign income taxes of CFC with respect to its $1,440,000x 
subpart F inclusion in the general category.
    (c) Foreign income taxes deemed paid under section 960(d)--(1) In 
general. If a domestic corporation that is a United States shareholder 
of one or more controlled foreign corporations includes an amount in 
gross income under section 951A(a) and Sec. 1.951A-1(b), the domestic 
corporation is deemed to have paid an amount of foreign income taxes 
equal to 80 percent of the product of its inclusion percentage 
multiplied by the sum of all tested foreign income taxes in the tested 
income group within each section 904 category of the controlled foreign 
corporation or corporations.
    (2) Inclusion percentage. The term inclusion percentage means, with 
respect to a domestic corporation that is a United States shareholder of 
one or more controlled foreign corporations, the domestic corporation's 
GILTI inclusion amount divided by the aggregate amount described in 
section 951A(c)(1)(A) and Sec. 1.951A-1(c)(2)(i) with respect to the 
United States shareholder.
    (3) Tested foreign income taxes. The term tested foreign income 
taxes means, with respect to a domestic corporation that is a United 
States shareholder of a controlled foreign corporation, the amount of 
the controlled foreign corporation's foreign income taxes that are 
properly attributable to tested income taken into account by the 
domestic corporation under section 951A and Sec. 1.951A-1.
    (4) Properly attributable. The amount of the controlled foreign 
corporation's foreign income taxes that are properly attributable to 
tested income taken into account by the domestic corporation under 
section 951A(a) and Sec. 1.951A-1(b) equals the domestic corporation's 
proportionate share of the current year taxes of the controlled foreign 
corporation that are allocated and apportioned under Sec. 1.960-
1(d)(3)(ii) to the tested income group within each section 904 category 
of the controlled foreign corporation. No other foreign income taxes are

[[Page 440]]

considered properly attributable to tested income.
    (5) Proportionate share. A domestic corporation's proportionate 
share of current year taxes of a controlled foreign corporation that are 
allocated and apportioned under Sec. 1.960-1(d)(3)(ii) to a tested 
income group within a section 904 category of the controlled foreign 
corporation is the U.S. dollar amount of current year taxes that are 
allocated and apportioned under Sec. 1.960-1(d)(3)(ii) to a tested 
income group within a section 904 category of the controlled foreign 
corporation multiplied by a fraction (not to exceed one), the numerator 
of which is the portion of the tested income of the controlled foreign 
corporation in the tested income group within the section 904 category 
that is included in computing the domestic corporation's aggregate 
amount described in section 951A(c)(1)(A) and Sec. 1.951A-1(c)(2)(i), 
and the denominator of which is the income in the tested income group 
within the section 904 category, both determined in the functional 
currency of the controlled foreign corporation. If the numerator or 
denominator of the fraction is zero or less than zero, the domestic 
corporation's proportionate share of the current year taxes allocated 
and apportioned under Sec. 1.960-1(d)(3)(ii) to the tested income group 
is zero.
    (6) Domestic partnerships. See Sec. 1.951A-1(e) for rules regarding 
the determination of the GILTI inclusion amount of a U.S. shareholder 
partner.
    (7) Examples. The following examples illustrate the application of 
this paragraph (c).
    (i) Example 1: Directly owned controlled foreign corporation--(A) 
Facts. USP, a domestic corporation, owns 100% of the stock of a number 
of controlled foreign corporations, including CFC1. USP and CFC1 each 
use the calendar year as their U.S. taxable year. CFC1 uses the ``u'' as 
its functional currency. At all relevant times, 1u=$1x. For its U.S. 
taxable year ending December 31, 2018, after application of the rules in 
Sec. 1.960-1(d), the income of CFC1 is assigned to a single income 
group: 2,000u of income from the sale of goods in a tested income group 
within the general category (``tested income group''). CFC1 has current 
year taxes, translated into U.S. dollars, of $400x that are all 
allocated and apportioned to the tested income group. For its U.S. 
taxable year ending December 31, 2018, USP has a GILTI inclusion amount 
determined by reference to all of its controlled foreign corporations, 
including CFC1, of $6,000x, and an aggregate amount described in section 
951A(c)(1)(A) and Sec. 1.951A-1(c)(2)(i) of $10,000x. All of the income 
in CFC1's tested income group is included in computing USP's aggregate 
amount described in section 951A(c)(1)(A) and Sec. 1.951A-1(c)(2)(i).
    (B) Analysis. Under paragraph (c)(5) of this section, USP's 
proportionate share of the current year taxes that are allocated and 
apportioned under Sec. 1.960-1(d)(3)(ii) to CFC1's tested income group 
is $400x ($400x x 2,000u/2,000u). Therefore, under paragraph (c)(4) of 
this section, the amount of current year taxes properly attributable to 
tested income taken into account by USP under section 951A(a) and Sec. 
1.951A-1(b) is $400x. Under paragraph (c)(3) of this section, USP's 
tested foreign income taxes with respect to CFC1 are $400x. Under 
paragraph (c)(2) of this section, USP's inclusion percentage is 60% 
($6,000x/$10,000x). Accordingly, under paragraph (c)(1) of this section, 
USP is deemed to have paid $192 of the foreign income taxes of CFC1 (80% 
x 60% x $400x).
    (ii) Example 2: Controlled foreign corporation owned through 
domestic partnership--(A) Facts. (1) US1, a domestic corporation, owns 
95% of PRS, a domestic partnership. The remaining 5% of PRS is owned by 
US2, a domestic corporation that is unrelated to US1. PRS owns all of 
the stock of CFC1, a controlled foreign corporation. In addition, US1 
owns all of the stock of CFC2, a controlled foreign corporation. US1, 
US2, PRS, CFC1, and CFC2 all use the calendar year as their taxable 
year. CFC1 and CFC2 both use the ``u'' as their functional currency. At 
all relevant times, 1u=$1x. For its U.S. taxable year ending December 
31, 2018, after application of the rules in Sec. 1.960-1(d), the income 
of CFC1 is assigned to a single income group: 300u of income from the 
sale of goods in a tested income group within the general category 
(``CFC1's tested income group'').

[[Page 441]]

CFC1 has current year taxes, translated into U.S. dollars, of $100x that 
are all allocated and apportioned to CFC1's tested income group. The 
income of CFC2 is also assigned to a single income group: 200u of income 
from the sale of goods in a tested income group within the general 
category (``CFC2's tested income group''). CFC2 has current year taxes, 
translated into U.S. dollars, of $20x that are allocated and apportioned 
to CFC2's tested income group.
    (2) Under Sec. 1.951A-1(e)(1), for purposes of determining the 
GILTI inclusion amount of US1 and US2, PRS is not treated as owning 
(within the meaning of section 958(a)) the stock of CFC1; instead, PRS 
is treated in the same manner as a foreign partnership for purposes of 
determining the stock of CFC1 owned by US1 and US2 under section 
958(a)(2). Therefore, only US1 is a United States shareholder of CFC1. 
Taking into account both CFC1 and CFC2, US1 has a GILTI inclusion amount 
in the general category of $485x, and an aggregate amount described in 
section 951A(c)(1)(A) and Sec. 1.951A-1(c)(2)(i) within the general 
category of $485x. 285u (95% x 300u) of the income in CFC1's tested 
income group and 200u of the income in CFC2's tested income group is 
included in computing US1's aggregate amount described in section 
951A(c)(1)(A) and Sec. 1.951A-1(c)(2)(i) within the general category. 
Because US2 is not a U.S. shareholder with respect to CFC1, US2 does not 
take into account CFC1's tested income in determining its GILTI 
inclusion amount.
    (B) Analysis--(1) US1--(i) CFC1. Under paragraphs (c)(5) and (6) of 
this section, US1's proportionate share of the current year taxes that 
are allocated and apportioned under Sec. 1.960-1(d)(3)(ii) to CFC1's 
tested income group is $95x ($100x x 285u/300u). Therefore, under 
paragraph (c)(4) of this section, the amount of the current year taxes 
properly attributable to tested income taken into account by US1 under 
section 951A(a) and Sec. 1.951A-1(b) is $95x. Under paragraph (c)(3) of 
this section, US1's tested foreign income taxes with respect to CFC1 are 
$95x. Under paragraph (c)(2) of this section, US1's inclusion percentage 
is 100% ($485x/$485x). Accordingly, under paragraph (c)(1) of this 
section, US1 is deemed to have paid $76x of the foreign income taxes of 
CFC1 (80% x 100% x $95x).
    (ii) CFC2. Under paragraph (c)(5) of this section, US1's 
proportionate share of the foreign income taxes that are allocated and 
apportioned under Sec. 1.960-1(d)(3)(ii) to CFC2's tested income group 
is $20x ($20x x 200u/200u). Therefore, under paragraph (c)(4) of this 
section, the amount of foreign income taxes properly attributable to 
tested income taken into account by US1 under section 951A(a) and Sec. 
1.951A-1(b) is $20x. Under paragraph (c)(3) of this section, US1's 
tested foreign income taxes with respect to CFC2 are $20. Under 
paragraph (c)(2) of this section, US1's inclusion percentage is 100% 
($485x/$485x). Accordingly, under paragraph (c)(1) of this section, US1 
is deemed to have paid $16 of the foreign income taxes of CFC2 (80% x 
100% x $20x).
    (2) US2. US2 is not a United States shareholder of CFC1 or CFC2. 
Accordingly, under paragraph (c)(1) of this section, US2 is not deemed 
to have paid any of the foreign income taxes of CFC1 or CFC2.

[T.D. 9882, 84 FR 69112, Dec. 17, 2019, as amended by T.D. 9922, 85 FR 
72071, Nov. 12, 2020]



Sec. 1.960-3  Foreign income taxes deemed paid under section 960(b).

    (a) Scope. Paragraph (b) of this section provides rules for 
computing the amount of foreign income taxes deemed paid by a domestic 
corporation that is a United States shareholder of a controlled foreign 
corporation, or by a controlled foreign corporation, under section 
960(b). Paragraph (c) of this section provides rules for the 
establishment and maintenance of PTEP groups within an annual PTEP 
account. Paragraph (d) of this section defines the term PTEP group 
taxes. Paragraph (e) of this section provides examples illustrating the 
application of this section.
    (b) Foreign income taxes deemed paid under section 960(b)--(1) 
Foreign income taxes deemed paid by a domestic corporation with respect 
to a section 959(a) distribution. If a controlled foreign corporation 
makes a distribution to a domestic corporation that is a United

[[Page 442]]

States shareholder with respect to the controlled foreign corporation 
and that distribution is, in whole or in part, a section 959(a) 
distribution with respect to a PTEP group within a section 904 category, 
the domestic corporation is deemed to have paid the amount of the 
foreign corporation's foreign income taxes that are properly 
attributable to the section 959(a) distribution with respect to the PTEP 
group and that have not been deemed to have been paid by a domestic 
corporation under section 960 for the current taxable year or any prior 
taxable year. See Sec. 1.965-5(c)(1)(iii) for rules disallowing credits 
in relation to a distribution of certain previously taxed earnings and 
profits resulting from the application of section 965. For each section 
904 category, the domestic corporation is deemed to have paid foreign 
income taxes equal to the sum of the controlled foreign corporation's 
foreign income taxes that are properly attributable to section 959(a) 
distributions with respect to all PTEP groups within the section 904 
category. See Sec. 1.904-6(b)(2) for rules on assigning the foreign 
income tax to a section 904 category.
    (2) Foreign income taxes deemed paid by a controlled foreign 
corporation with respect to a section 959(b) distribution. If a 
controlled foreign corporation (distributing controlled foreign 
corporation) makes a distribution to another controlled foreign 
corporation (recipient controlled foreign corporation) and the 
distribution is, in whole or in part, a section 959(b) distribution from 
a PTEP group within a section 904 category, the recipient controlled 
foreign corporation is deemed to have paid the amount of the 
distributing controlled foreign corporation's foreign income taxes that 
are properly attributable to the section 959(b) distribution from the 
PTEP group and that have not been deemed to have been paid by a domestic 
corporation under section 960 for the current taxable year or any prior 
taxable year. See Sec. 1.904-6(b)(3) for rules on assigning the foreign 
income tax to a section 904 category.
    (3) Properly attributable. The amount of foreign income taxes that 
are properly attributable to a section 959 distribution from a PTEP 
group within a section 904 category equals the domestic corporation's or 
recipient controlled foreign corporation's proportionate share of the 
PTEP group taxes with respect to the PTEP group within the section 904 
category. No other foreign income taxes are considered properly 
attributable to a section 959 distribution.
    (4) Proportionate share. A domestic corporation's or recipient 
controlled foreign corporation's proportionate share of the PTEP group 
taxes with respect to a PTEP group within a section 904 category is 
equal to the total amount of the PTEP group taxes with respect to the 
PTEP group multiplied by a fraction (not to exceed one), the numerator 
of which is the amount of the section 959 distribution from the PTEP 
group, and the denominator of which is the total amount of previously 
taxed earnings and profits in the PTEP group, both determined in the 
functional currency of the controlled foreign corporation. If the 
numerator or denominator of the fraction is zero or less than zero, then 
the proportionate share of the PTEP group taxes with respect to the PTEP 
group is zero.
    (5) Domestic partnerships. For purposes of applying this paragraph 
(b), in the case of a domestic partnership that is a U.S. shareholder 
partnership with respect to a partnership CFC, the distributive share of 
a U.S. shareholder partner of a U.S. shareholder partnership's section 
959(a) distribution from the partnership CFC is treated as a section 
959(a) distribution received by the U.S. shareholder partner from the 
partnership CFC.
    (c) Accounting for previously taxed earnings and profits--(1) 
Establishment of annual PTEP account. A separate, annual account (annual 
PTEP account) must be established for the previously taxed earnings and 
profits of the controlled foreign corporation to which inclusions under 
section 951(a) and GILTI inclusion amounts of United States shareholders 
of the CFC are attributable. Each account must correspond to the 
inclusion year of the previously taxed earnings and profits and to the 
section 904 category to which the inclusions under section 951(a) or 
GILTI inclusion amounts were assigned at the level of the United States 
shareholders.

[[Page 443]]

Accordingly, a controlled foreign corporation may have an annual PTEP 
account in the section 951A category or a treaty category (as defined in 
Sec. 1.861-13(b)(6)), even though income of the controlled foreign 
corporation that gave rise to the previously taxed earnings and profits 
cannot initially be assigned to the section 951A category or a treaty 
category.
    (2) PTEP groups within an annual PTEP account. The amount in an 
annual PTEP account is further assigned to one or more of the following 
groups of previously taxed earnings and profits (each, a PTEP group) 
within the account:
    (i) Earnings and profits described in section 959(c)(1)(A) that were 
initially described in section 959(c)(2) by reason of section 965(a) 
(``reclassified section 965(a) PTEP'');
    (ii) Earnings and profits described in section 959(c)(1)(A) that 
were initially described in section 959(c)(2) by reason of section 
965(b)(4)(A) (``reclassified section 965(b) PTEP'');
    (iii) Earnings and profits described in paragraphs (c)(2)(iii)(A) 
through (C) of this section (which are aggregated into a single PTEP 
group, ``general section 959(c)(1) PTEP''):
    (A) Earnings and profits described in section 959(c)(1)(A) by reason 
of section 951(a)(1)(B) and not by reason of section 959(a)(2);
    (B) Earnings and profits described in section 959(c)(1)(A) that were 
initially described in section 959(c)(2) by reason of section 
951(a)(1)(A) (other than earnings that were initially described in 
paragraphs (c)(2)(vi) through (ix) of this section); and
    (C) Earnings and profits described in section 959(c)(1)(B), 
including by reason of section 959(a)(3) (before its repeal);
    (iv) Earnings and profits described in section 959(c)(1)(A) that 
were initially described in section 959(c)(2) by reason of section 
951A(f)(2) (``reclassified section 951A PTEP'');
    (v) Earnings and profits described in paragraphs (c)(2)(v)(A) 
through (C) of this section (which are aggregated into a single PTEP 
group, ``reclassified section 245A(d) PTEP''):
    (A) Earnings and profits described in section 959(c)(1)(A) that were 
initially described in section 959(c)(2) by reason of section 
245A(e)(2);
    (B) Earnings and profits described in section 959(c)(1)(A) that were 
initially described in section 959(c)(2) by reason of section 959(e); 
and
    (C) Earnings and profits described in section 959(c)(1)(A) that were 
initially described in section 959(c)(2) by reason of section 964(e)(4);
    (vi) Earnings and profits described in section 959(c)(2) by reason 
of section 965(a) (``section 965(a) PTEP'');
    (vii) Earnings and profits described in section 959(c)(2) by reason 
of section 965(b)(4)(A) (``section 965(b) PTEP'');
    (viii) Earnings and profits described in section 959(c)(2) by reason 
of section 951A(f)(2) (``section 951A PTEP'');
    (ix) Earnings and profits described in paragraphs (c)(2)(ix)(A) 
through (C) of this section (which are aggregated into a single PTEP 
group, ``section 245A(d) PTEP''):
    (A) Earnings and profits described in section 959(c)(2) by reason of 
section 245A(e)(2);
    (B) Earnings and profits described in section 959(c)(2) by reason of 
section 959(e); and
    (C) Earnings and profits described in section 959(c)(2) by reason of 
section 964(e)(4); and
    (x) Earnings and profits described in section 959(c)(2) by reason of 
section 951(a)(1)(A) not otherwise described in paragraph (c)(2)(vi) 
through (ix) of this section (``section 951(a)(1)(A) PTEP'').
    (3) Accounting for distributions of previously taxed earnings and 
profits. With respect to a recipient controlled foreign corporation that 
receives a section 959(b) distribution, such distribution amount is 
added to the annual PTEP account, and PTEP group within the annual PTEP 
account, that corresponds to the inclusion year and section 904 category 
of the annual PTEP account, and PTEP group within the annual PTEP 
account, from which the distributing controlled foreign corporation is 
treated as making the distribution under section 959. Similarly, with 
respect to a controlled foreign corporation that makes a section 959 
distribution, such distribution amount reduces the annual PTEP account, 
and PTEP

[[Page 444]]

group within the annual PTEP account, that corresponds to the inclusion 
year and section 904 category of the annual PTEP account, and PTEP group 
within the annual PTEP account, from which the controlled foreign 
corporation is treated as making the distribution under section 959. 
Earnings and profits in a PTEP group are reduced by the amount of 
current year taxes that are allocated and apportioned to the PTEP group 
under Sec. 1.960-1(d)(3)(ii), and the U.S. dollar amount of the taxes 
are added to an account of PTEP group taxes under the rules in paragraph 
(d)(1) of this section.
    (4) Accounting for reclassifications of earnings and profits 
described in section 959(c)(2) to earnings and profits described in 
section 959(c)(1). If an amount of previously taxed earnings and profits 
that is in a PTEP group described in paragraphs (c)(2)(vi) through (x) 
of this section (each, a section 959(c)(2) PTEP group) is reclassified 
as previously taxed earnings and profits described in section 959(c)(1) 
(reclassified previously taxed earnings and profits), the section 
959(c)(2) PTEP group is reduced by the functional currency amount of the 
reclassified previously taxed earnings and profits. This amount is added 
to the corresponding PTEP group described in paragraph (c)(2)(i), (ii), 
(iii) (by reason of paragraph (c)(2)(iii)(B) of this section), (iv) or 
(v) of this section (each, a reclassified PTEP group) in the same 
section 904 category and same annual PTEP account as the reduced section 
959(c)(2) PTEP group.
    (d) PTEP group taxes--(1) In general. The term PTEP group taxes 
means the U.S. dollar amount of foreign income taxes (translated in 
accordance with section 986(a)) that are paid, accrued, or deemed paid 
with respect to an amount in each PTEP group within an annual PTEP 
account. The foreign income taxes that are paid, accrued, or deemed paid 
with respect to a PTEP group within an annual PTEP account of a 
controlled foreign corporation are--
    (i) The sum of--
    (A) The current year taxes paid or accrued by the controlled foreign 
corporation that are allocated and apportioned to the PTEP group under 
Sec. 1.960-1(d)(3)(ii);
    (B) Foreign income taxes that are deemed paid under section 
960(b)(2) and paragraph (b)(2) of this section by the controlled foreign 
corporation with respect to a section 959(b) distribution received by 
the controlled foreign corporation, the amount of which is added to the 
PTEP group under paragraph (c)(3) of this section; and
    (C) In the case of a reclassified PTEP group of the controlled 
foreign corporation, reclassified PTEP group taxes that are attributable 
to the section 959(c)(2) PTEP group that corresponds to the reclassified 
PTEP group.
    (ii) Reduced by--
    (A) Foreign income taxes that were deemed paid under section 
960(b)(2) and paragraph (b)(2) of this section by another controlled 
foreign corporation that received a section 959(b) distribution from the 
controlled foreign corporation, the amount of which is subtracted from 
the controlled foreign corporation's PTEP group under paragraph (c)(3) 
of this section;
    (B) Foreign income taxes that were deemed paid under section 
960(b)(1) and paragraph (b)(1) of this section by a domestic corporation 
that is a United States shareholder of the controlled foreign 
corporation that received a section 959(a) distribution from the 
controlled foreign corporation, the amount of which is subtracted from 
the controlled foreign corporation's PTEP group under paragraph (c)(3) 
of this section; and
    (C) In the case of a section 959(c)(2) PTEP group of the controlled 
foreign corporation, reclassified PTEP group taxes.
    (2) Reclassified PTEP group taxes. Reclassified PTEP group taxes are 
foreign income taxes that are initially included in PTEP group taxes 
with respect to a section 959(c)(2) PTEP group under paragraph 
(d)(1)(i)(A) or (B) of this section multiplied by a fraction, the 
numerator of which is the portion of the previously taxed earnings and 
profits in the section 959(c)(2) PTEP group that become reclassified 
previously taxed earnings and profits, and the denominator of which is 
the total previously taxed earnings and profits in the section 959(c)(2) 
PTEP group.
    (3) Foreign income taxes deemed paid with respect to PTEP groups 
established

[[Page 445]]

for pre-2018 inclusion years. In the case of foreign income taxes paid 
or accrued in a taxable year of the controlled foreign corporation that 
began before January 1, 2018, with respect to an annual PTEP account, 
and a PTEP group within such account, that was established for an 
inclusion year that begins before January 1, 2018, the foreign income 
taxes are treated as PTEP group taxes of a controlled foreign 
corporation for purposes of this section only if those foreign income 
taxes were--
    (i) Not included in a controlled foreign corporation's post-1986 
foreign income taxes (as defined in section 902(c)(2) as in effect on 
December 21, 2017) used to compute foreign taxes deemed paid under 
section 902 (as in effect on December 21, 2017) in any taxable year that 
began before January 1, 2018; and
    (ii) Not treated as deemed paid under section 960(a)(3) (as in 
effect on December 21, 2017) by a domestic corporation that was a United 
States shareholder of the controlled foreign corporation.
    (e) Examples. The following examples illustrate the application of 
this section.
    (1) Example 1: Establishment of PTEP groups and PTEP accounts--(i) 
Facts. USP, a domestic corporation, owns all of the stock of CFC1, a 
controlled foreign corporation. CFC1 owns all of the stock of CFC2, a 
controlled foreign corporation. USP, CFC1, and CFC2 each use the 
calendar year as their U.S. taxable year. CFC1 and CFC2 use the ``u'' as 
their functional currency. At all relevant times, 1u = $1x. With respect 
to CFC2, USP includes in gross income a subpart F inclusion of 
1,000,000u = $1,000,000x for the taxable year ending December 31, 2018. 
The inclusion is with respect to passive category income. In its U.S. 
taxable year ending December 31, 2019, CFC2 distributes 1,000,000u to 
CFC1. CFC2 has no earnings and profits except for the 1,000,000u of 
previously taxed earnings and profits resulting from USP's 2018 taxable 
year subpart F inclusion. CFC2's country of organization, Country X, 
imposes a withholding tax on CFC1 of 300,000u on CFC2's distribution to 
CFC1. Under Sec. 1.960-1(d)(3)(ii), CFC1's 300,000u of current year 
taxes are allocated and apportioned to the PTEP group within the annual 
PTEP account within the section 904 category to which the 1,000,000u of 
previously taxed earnings and profits are assigned.
    (ii) Analysis--(A) Under paragraph (c)(1) of this section, a 
separate annual PTEP account in the passive category for the 2018 
taxable year is established for CFC2 as a result of USP's subpart F 
inclusion. Under paragraph (c)(2) of this section, this account contains 
one PTEP group, section 951(a)(1)(A) PTEP.
    (B) Under paragraph (c)(3) of this section, in the 2019 taxable 
year, the 1,000,000u related to the section 959(b) distribution from 
CFC2 is added to CFC1's annual PTEP account for the 2018 taxable year in 
the passive category and to the section 951(a)(1)(A) PTEP within such 
account. Similarly, CFC2's 2018 taxable year annual PTEP account within 
the passive category, and the section 951(a)(1)(A) PTEP within such 
account, is reduced by the amount of the 1,000,000u section 959(b) 
distribution to CFC1. Additionally, CFC1's annual PTEP account for the 
2018 taxable year in the passive category, and the section 951(a)(1)(A) 
PTEP within such account, is reduced by the 300,000u of withholding tax 
imposed on CFC1 by Country X. Therefore, CFC1's annual PTEP account for 
the 2018 taxable year within the passive category and the section 
951(a)(1)(A) PTEP within such account is 700,000u.
    (C) Under paragraph (d)(1) of this section, the 300,000u of 
withholding tax is translated into U.S. dollars and $300,000x is added 
to the PTEP group taxes with respect to CFC1's section 951(a)(1)(A) PTEP 
within the annual PTEP account for the 2018 taxable year within the 
passive category.
    (2) Example 2: Foreign income taxes deemed paid under section 
960(b)--(i) Facts. USP, a domestic corporation, owns 100% of the stock 
of CFC1, which in turn owns 60% of the stock of CFC2, which in turn owns 
100% of the stock of CFC3. USP, CFC1, CFC2, and CFC3 all use the 
calendar year as their U.S. taxable year. CFC1, CFC2, and CFC3 all use 
the ``u'' as their functional currency. At all relevant times, 1u = $1x. 
On July 1, 2020, CFC2 distributes 600u to CFC1 and the entire 
distribution is a

[[Page 446]]

section 959(b) distribution (``distribution 1''). On October 1, 2020, 
CFC1 distributes 800u to USP and the entire distribution is a section 
959(a) distribution (``distribution 2''). CFC1 and CFC2 make no other 
distributions in the year ending December 31, 2020, earn no other 
income, and incur no taxes on distribution 1 or distribution 2. Before 
taking into account distribution 1, CFC2 has 1,000u of section 
951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable 
year within the general category. The previously taxed earnings and 
profits in CFC2's PTEP group relate to subpart F income of CFC3 that was 
included by USP in 2016. CFC3 distributed the earnings and profits to 
CFC2 before the 2020 taxable year and, solely as a result of the 
distribution of the previously taxed earnings and profits, CFC2 incurred 
withholding and net basis tax, resulting in $150 of PTEP group taxes 
with respect to section 951(a)(1)(A) PTEP. Before taking into account 
distribution 1 and distribution 2, CFC1 has 200u in section 951A PTEP 
within an annual PTEP account for the 2018 taxable year within the 
section 951A category. The previously taxed earnings and profits in 
CFC1's PTEP group relate to the portion of a GILTI inclusion amount that 
was included by USP in 2018 and allocated to CFC2 under section 
951A(f)(2) and Sec. 1.951A-5(b)(2). CFC2 distributed the earnings and 
profits to CFC1 before the 2020 taxable year and, solely as a result of 
the distribution of the previously taxed earnings and profits, CFC1 
incurred withholding and net basis tax, resulting in $25x of PTEP group 
taxes with respect to section 951A PTEP.
    (ii) Analysis--(A) Foreign income taxes deemed paid by CFC1. With 
respect to distribution 1 from CFC2 to CFC1, under paragraph (b)(4) of 
this section CFC1's proportionate share of PTEP group taxes with respect 
to CFC2's section 951(a)(1)(A) PTEP within an annual PTEP account for 
the 2016 taxable year within the general category is $90x ($150x x 600u/
1,000u). Under paragraph (b)(3) of this section, the amount of foreign 
income taxes that are properly attributable to distribution 1 is $90x. 
Accordingly, under paragraph (b)(2) of this section, CFC1 is deemed to 
have paid $90x of general category foreign income taxes of CFC2 with 
respect to its 600u section 959(b) distribution in the general category.
    (B) Adjustments to PTEP accounts of CFC1 and CFC2. Under paragraph 
(c)(3) of this section, the 600u related to distribution 1 is added to 
CFC1's section 951(a)(1)(A) PTEP within an annual PTEP account for the 
2016 taxable year within the general category. Similarly, CFC2's section 
951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable 
year within the general category is reduced by 600u, the amount of the 
section 959(b) distribution to CFC1. Additionally, under paragraph (d) 
of this section, CFC1's PTEP group taxes with respect to its section 
951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable 
year within the general category are increased by $90 and CFC2's PTEP 
group taxes with respect to section 951(a)(1)(A) PTEP within an annual 
PTEP account for the 2016 taxable year within the general category are 
reduced by $90x.
    (C) Foreign income taxes deemed paid by USP. With respect to 
distribution 2 from CFC1 to USP, because CFC1 has PTEP groups in more 
than one section 904 category, this section is applied separately to 
each section 904 category (that is, distribution 2 of 800u is applied 
separately to the 200u of CFC1's section 951A PTEP and 600u of CFC1's 
section 951(a)(1)(A) PTEP).
    (1) Section 951A category. Under paragraph (b)(4) of this section, 
USP's proportionate share of PTEP group taxes with respect to CFC1's 
section 951A PTEP within an annual PTEP account for the 2018 taxable 
year within the section 951A category is $25x ($25x x 200u/200u). Under 
paragraph (b)(3) of this section, the amount of foreign income taxes 
within the section 951A category that are properly attributable to 
distribution 2 is $25x. Accordingly, under paragraph (b)(1) of this 
section USP is deemed to have paid $25x of section 951A category foreign 
income taxes of CFC1 with respect to its 200u section 959(a) 
distribution in the section 951A category.
    (2) General category. Under paragraph (b)(4) of this section, USP's 
proportionate share of PTEP group taxes with respect to CFC1's section

[[Page 447]]

951(a)(1)(A) PTEP within an annual PTEP account for the 2016 taxable 
year within the general category is $90x ($90x x 600u/600u). Under 
paragraph (b)(3) of this section, the amount of foreign income taxes 
that are properly attributable to distribution 2 is $90x. Accordingly, 
under paragraph (b)(1), USP is deemed to have paid $90x of general 
category foreign income taxes of CFC1 with respect to its 600u section 
959(a) distribution in the general category.

[T.D. 9882, 84 FR 69114, Dec. 17, 2019, as amended by T.D. 9922, 85 FR 
72071, Nov. 12, 2020]



Sec. 1.960-4  Additional foreign tax credit in year of receipt of
previously taxed earnings and profits.

    (a) Increase in section 904(a) limitation for the taxable year of 
exclusion--(1) In general. The applicable limitation under section 
904(a) for a taxpayer's taxable year (hereinafter in this section 
referred to as the ``taxable year of exclusion'') in which the taxpayer 
receives an amount which is excluded from gross income under section 
959(a)(1) and which is attributable to a controlled foreign 
corporation's earnings and profits in respect of which an amount was 
required to be included in the gross income of such taxpayer under 
section 951(a) for a taxable year (hereinafter in this section referred 
to as the ``taxable year of inclusion'') previous to the taxable year of 
exclusion shall be increased under section 960(c)(1) by the amount 
described in paragraph (b) of this section if the conditions described 
in paragraph (a)(2) of this section are satisfied. For purposes of this 
section, an amount included in gross income under section 951A(a) is 
treated as an amount included in gross income under section 951(a). The 
amount of the increase in the foreign tax credit limitation allowed by 
this section is determined with regard to each separate category of 
income described in Sec. 1.904-5(a)(4)(v).
    (2) Conditions under which increase in limitation is allowed for the 
taxable year of exclusion. The increase in limitation described in 
subparagraph (1) of this paragraph for the taxable year of exclusion 
shall be made only if the taxpayer--
    (i) For the taxable year of inclusion either chose to claim a 
foreign tax credit as provided in section 901 or did not pay or accrue 
any foreign income taxes,
    (ii) Chooses to claim a foreign tax credit as provided in section 
901 for the taxable year of exclusion, and
    (iii) For the taxable year of exclusion pays, accrues, or is deemed 
to have paid foreign income taxes with respect to the amount, described 
in subparagraph (1) of this paragraph, which is excluded from his gross 
income for such year under section 959(a)(1).
    (b) Amount of increase in limitation for the taxable year of 
exclusion. The amount of increase under section 960 (b)(1) in the 
applicable limitation under section 904(a) for the taxable year of 
exclusion shall be--
    (1) The amount by which the applicable section 904(a) limitation for 
the taxable year of inclusion was increased, determined as provided in 
paragraph (c) of this section, by reason of the inclusion of the amount 
in the taxpayer's income for such year under section 951(a), reduced by
    (2) The amount of foreign income taxes allowed as a credit under 
section 901 for such taxable year of inclusion and which were allowable 
to such taxpayer solely by reason of the inclusion of such amount in his 
gross income under section 951(a), as determined under paragraph (d) of 
this section, and then by
    (3) The additional reduction for such taxable year of inclusion 
arising by reason of increases in limitation under section 960(c)(1) for 
taxable years intervening between such taxable year of inclusion and 
such taxable year of exclusion, as determined under paragraph (e) of 
this section in respect of such inclusion under section 951(a),


except that the amount of increase determined under this paragraph for 
the taxable year of exclusion shall in no case exceed the amount of 
foreign income taxes paid, accrued, or deemed to be paid by such 
taxpayer for such taxable year of exclusion with respect to the amount, 
described in paragraph (a)(1) of this section, which is excluded from 
gross income for such year under section 959(a)(1).

[[Page 448]]

    (c) Determination of increase in limitation for the taxable year of 
inclusion. The amount of the increase in the applicable limitation under 
section 904(a) for the taxable year of inclusion which arises by reason 
of the inclusion of the amount in gross income under section 951(a) 
shall be the amount of the applicable limitation under section 904(a) 
for such year reduced by the amount which would have been the applicable 
limitation under section 904(a) for such year if the amount had not been 
included in gross income for such year under section 951(a).
    (d) Determination of foreign income taxes allowed for taxable year 
of inclusion by reason of section 951(a) amount. The amount of foreign 
income taxes allowed as a credit under section 901 for the taxable year 
of inclusion which were allowable solely by reason of the inclusion of 
the amount in gross income for such year under section 951(a) shall be 
the amount of foreign income taxes allowed as a credit under section 901 
for such year reduced by the amount of foreign income taxes which would 
have been allowed as a credit under section 901 for such year if the 
amount had not been included in gross income for such year under section 
951(a). For purposes of this paragraph (d), the term ``foreign income 
taxes'' includes foreign income taxes paid or accrued, foreign income 
taxes deemed paid or accrued under section 904(c), and foreign income 
taxes deemed paid under section 960 (or section 902 with respect to 
taxable years of foreign corporations beginning before January 1, 2018), 
for the taxable year of inclusion.
    (e) Additional reduction for the taxable year of inclusion arising 
by reason of increases in limitation for intervening years. The amount 
of increase in the applicable limitation under section 904(a) for the 
taxable year of inclusion shall also be reduced, after first deducting 
the foreign income taxes described in paragraph (b)(2) of this section, 
by any increases in limitation which arise under section 960(c)(1)--by 
reason of any earlier exclusions under section 959(a)(1) in respect of 
the same inclusion under section 951(a) for such taxable year of 
inclusion--for the first, second, third, fourth, etc., succeeding 
taxable years of exclusion, in that order, which follow such taxable 
year of inclusion and precede the taxable year of exclusion in respect 
of which the increase in limitation under section 960(c)(1) and 
paragraph (b) of this section is being determined. The amount of any 
increase in limitation which arises under section 960(c)(1) for any such 
succeeding taxable year of exclusion shall be the amount of foreign 
income taxes allowed as a credit under section 901 for each such taxable 
year reduced by the amount of foreign income taxes which would have been 
allowed as a credit under section 901 for each such year if the 
limitation for each such year were not increased under section 
960(c)(1). For any such succeeding taxable year of exclusion for which 
the taxpayer does not choose to claim a foreign tax credit as provided 
in section 901, the same increase in limitation under section 960(c)(1) 
shall be treated as having been made, for purposes of this paragraph, 
which would have been made for such taxable year if the taxpayer had 
chosen to claim the foreign tax credit for such year.
    (f) Examples. The application of this section may be illustrated by 
the following examples:
    (1) Example 1. USP, a domestic corporation, owns all of the one 
class of stock of CFC, a controlled foreign corporation that uses the 
U.S. dollar as its functional currency. CFC, after paying foreign income 
taxes of $10x, has earnings and profits for Year 1 of $90x, all of which 
are attributable to an amount required under section 951(a) to be 
included in USP's gross income for Year 1 because the income is general 
category foreign base company services income of CFC. Both corporations 
use the calendar year as the taxable year. For Year 2 and Year 3, CFC 
has no earnings and profits attributable to an amount required to be 
included in USP's gross income under section 951(a); for each such year 
it makes a distribution of $45x (from its section 951(a)(1)(A) PTEP 
within the annual PTEP account for Year 1) from which a foreign income 
tax of $6x is withheld. For each of Year 1, Year 2, and Year 3, USP 
derives taxable income of $50x from sources within the United States and 
claims a foreign tax credit under section 901, subject to the limitation

[[Page 449]]

under section 904. The U.S. tax payable by USP is determined as follows, 
assuming a corporate tax rate of 21%:

                       Table 1 to Paragraph (f)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
                                 Year 1
------------------------------------------------------------------------
Taxable income of USP:
    U.S. sources........................  ..............         $50.00x
    Sources without the U.S.:
        Amount required to be included           $90.00x
         in USP's gross income under
         section 951(a).................
        Foreign income taxes deemed paid          10.00x         100.00x
         by USP under section 960(a) and
         included in USP's gross income
         under section 78 ($10x x $90x/
         $90x)..........................
                                         -------------------------------
            Total taxable income........  ..............         150.00x
U.S. tax payable for Year 1:
    U.S. tax before credit ($150x x 21%)  ..............          31.50x
    Credit: Foreign income taxes of       ..............          10.00x
     $10x, but not to exceed the
     limitation of $21x for Year 1
     ($100x/$150x x $31.50x)............
    U.S. tax payable....................  ..............          21.50x
------------------------------------------------------------------------


                       Table 2 to Paragraph (f)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
                                 Year 2
------------------------------------------------------------------------
Taxable income of USP, consisting of      ..............         $50.00x
 income from U.S. sources...............
U.S. tax before credit ($50x x 21%).....  ..............          10.50x
Section 904 limitation for Year 2:
Limitation for Year 2 before increase     ..............               0
 under section 960(c)(1) ($10.50x x $0/
 $50x)..................................
    Plus: Increase in limitation for
     Year 2 under sec. 960(c)(1):
        Amount by which Year 1                    21.00x
         limitation was increased by
         reason of inclusion in USP's
         gross income under section
         951(a) for Year 1 ($21x-[($50x
         x 21%) x $0/$50x]).............
        Less: Foreign income taxes                10.00x
         allowed as a credit for Year 1
         which were allowable solely by
         reason of such section 951(a)
         inclusion ($10x-$0)............
                                         -------------------------------
            Balance.....................          11.00x
        But: Such balance not to exceed            6.00x           6.00x
         foreign income taxes paid by
         USP for Year 2 with respect to
         $45x distribution excluded
         under section 959(a)(1) ($6x
         tax withheld)..................
    Limitation for Year 2...............  ..............           6.00x
U.S. tax payable for Year 2:
    U.S. tax before credit ($50x x 21%).  ..............          10.50x
    Credit: Foreign income taxes of $6x,  ..............           6.00x
     but not to exceed limitation of $6x
     for Year 2.........................
    U.S. tax payable....................  ..............           4.50x
------------------------------------------------------------------------


[[Page 450]]


                       Table 3 to Paragraph (f)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
                                 Year 3
------------------------------------------------------------------------
Taxable income of USP, consisting of      ..............         $50.00x
 income from U.S. sources...............
U.S. tax before credit ($50x x 21%).....  ..............          10.50x
Section 904 limitation for Year 3:
    Limitation for Year 3 before          ..............               0
     increase under section 960(c)(1)
     ($10.50x x $0/$50x)................
    Plus: Increase in limitation for
     Year 3 under section 960(c)(1):
        Amount by which Year 1                   $21.00x
         limitation was increased by
         reason of inclusion in USP's
         gross income under section
         951(a) for Year 1 ($21x-[ ($50
         x 21%) x $0/$50x] )............
        Less: Foreign income taxes                10.00x
         allowed as a credit for Year 1
         which were allowable solely by
         reason of such section 951(a)
         inclusion ($10x-$0)............
        Tentative balance...............          11.00x
        Less: Increase in limitation               6.00x
         under section 960(c)(1) for
         Year 2 by reason of such sec.
         951(a) inclusion...............
                                         -------------------------------
            Balance.....................           5.00x
    But: Such balance not to exceed                6.00x           5.00x
     foreign income taxes paid by USP
     for Year 3 with respect to $45x
     distribution excluded under section
     959(a)(1) ($6x tax withheld).......
    Limitation for Year 3...............  ..............           5.00x
U.S. tax payable for Year 3:
    U.S. tax before credit ($50x x 21%).  ..............          10.50x
    Credit: Foreign income taxes of $6,   ..............           5.00x
     but not to exceed section 904(a)
     limitation of $5x..................
    U.S. tax payable....................  ..............           5.50x
------------------------------------------------------------------------

    (2) Example 2. The facts for Year 1 and Year 2 are the same as in 
paragraph (f)(1) of this section (the facts in Example 1), except that 
in Year 0, in which USP also claimed a foreign tax credit under section 
901, USP pays $11x of foreign income taxes in excess of the general 
category limitation and such excess is not absorbed as a carryback to 
the prior year under section 904(c). Therefore, there is no increase 
under section 960(c)(1) in the limitation for Year 2 since the amount 
($21x) by which the Year 1 limitation was increased by reason of the 
inclusion in USP's gross income for Year 1 under section 951(a), less 
the foreign income taxes ($21x) allowed as a credit which were allowable 
solely by reason of such inclusion, is zero. The foreign income taxes so 
allowed as a credit for Year 1 which were allowable solely by reason of 
such section 951(a) inclusion consist of the $10 of foreign income taxes 
deemed paid for Year 1 under section 960(a) and the $11x of foreign 
income taxes for Year 0 carried over and deemed paid for Year 1 under 
section 904(c).

[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 
60089, Oct. 18, 1979; T.D. 9882, 84 FR 69117, Dec. 17, 2019; T.D. 9922, 
85 FR 72071, Nov. 12, 2020]



Sec. 1.960-5  Credit for taxable year of inclusion binding for
taxable year of exclusion.

    (a) Taxes not allowed as a deduction for taxable year of exclusion. 
In the case of any taxpayer who--

[[Page 451]]

    (1) Chooses to claim a foreign tax credit as provided in section 901 
for the taxable year for which he is required to include in gross income 
under section 951(a) or 951A(a) an amount attributable to the earnings 
and profits of a controlled foreign corporation; and
    (2) Does not choose to claim a foreign tax credit as provided in 
section 901 for a taxable year in which he receives an amount which is 
excluded from gross income under section 959(a)(1) and which is 
attributable to such earnings and profits of such controlled foreign 
corporation,


No deduction shall be allowed under section 164 for the taxable year of 
such exclusion for any foreign income taxes paid or accrued on or with 
respect to such excluded amount.
    (b) Example. The application of this section may be illustrated by 
the following example:
    (1) Facts. USP, a domestic corporation, owns all the one class of 
stock of CFC, a controlled foreign corporation. Both corporations use 
the calendar year as the taxable year and the functional currency of CFC 
is the U.S. dollar. All of CFC's earnings and profits of $80x for Year 1 
(after payment of foreign income taxes of $20x on its total income of 
$100x for such year) are attributable to amounts required under section 
951(a) to be included in USP's gross income for Year 1 because such 
income is general category foreign base company services income of CFC. 
For Year 1, USP chooses to claim a foreign tax credit for the $20x of 
foreign income taxes which for such year are paid by CFC and deemed paid 
by USP under section 960(a) and Sec. 1.960-2(b). In Year 2, CFC 
distributes the entire $80x of Year 1 previously taxed earnings and 
profits, from which a foreign income tax of $8x is withheld. Also in 
Year 2, CFC pays $40x of interest to USP, from which a foreign income 
tax of $4x is withheld. For Year 2, USP chooses to claim deductions for 
its creditable foreign income taxes under section 164 rather than a 
foreign tax credit under section 901.
    (2) Analysis. Although USP does not choose to claim a foreign tax 
credit for Year 2, under section 960(c)(4) and paragraph (a) of this 
section it may not deduct the $8x of foreign income taxes under section 
164. USP may, however, deduct under such section the foreign income tax 
of $4x which is withheld from the interest paid by CFC in Year 2.

[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 
60089, Oct. 18, 1979; T.D. 9882, 84 FR 69119, Dec. 17, 2019]



Sec. 1.960-6  Overpayments resulting from increase in limitation 
for taxable year of exclusion.

    (a) Amount of overpayment. If an increase in the limitation under 
section 960(c)(1) and Sec. 1.960-4 for a taxable year of exclusion 
exceeds the tax (determined before allowance of any credits against tax) 
imposed by chapter 1 of the Code for such year, the amount of such 
excess shall be deemed an overpayment of tax for such year and shall be 
refunded or credited to the taxpayer in accordance with chapter 65 
(section 6401 and following) of the Code.
    (b) Example. The application of this section may be illustrated by 
the following example:
    (1) Facts. USP, a domestic corporation, owns all of the one class of 
stock of CFC, a controlled foreign corporation. Both corporations use 
the calendar year as the taxable year, and the functional currency of 
CFC is the U.S. dollar. For Year 1, CFC has total income of $100,000x on 
which it pays foreign income taxes of $20,000x. All of CFC's earnings 
and profits for Year 1 of $80,000x are attributable to an amount which 
is required under section 951(a) to be included in USP's gross income 
for Year 1 because such income is general category foreign base company 
services income of CFC. By reason of such income inclusion USP is deemed 
for Year 1 to have paid under section 960(a), and is required under 
section 78 to include in gross income for such year, the $20,000x 
($20,000x x $80,000x/$80,000x) of foreign income taxes paid by CFC for 
such year. USP also derives $100,000x of taxable income from sources 
within the United States for Year 1. For Year 2, USP has $4,000x of 
taxable income, all of which is derived from sources within the United 
States. No part of CFC's earnings and profits for Year 2 is attributable 
to an amount required under section 951(a) or section 951A(a) to be 
included in USP's gross

[[Page 452]]

income. During Year 2, CFC makes one distribution consisting of its 
$80,000x earnings and profits for Year 1, all of which is excluded under 
section 959(a)(1) from USP's gross income for Year 2, and from which 
distribution foreign income taxes of $1,000x are withheld. For Year 1 
and Year 2, USP claims the foreign tax credit under section 901, subject 
to the limitation of section 904.
    (2) Analysis. The U.S. tax liability of USP is determined as follows 
for such years, assuming a corporate tax rate of 21%:

                       Table 1 to Paragraph (b)(2)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
                                 Year 1
------------------------------------------------------------------------
Taxable income of USP:
    U.S. sources........................  ..............    $100,000.00x
    Sources without the U.S.:
        Amount required to be included       $80,000.00x
         in USP's gross income under
         section 951(a).................
        Foreign income taxes deemed paid      20,000.00x     100,000.00x
         by USP under section 960(a) and
         included in USP's gross income
         under section 78 ($20,000x x
         $80,000x/$80,000x).............
                                         -------------------------------
            Total taxable income........  ..............     200,000.00x
U.S. tax payable for Year 1:
    U.S. tax before credit ( [$200,000x   ..............      42,000.00x
     x 21%] )...........................
    Credit: Foreign income taxes of       ..............      20,000.00x
     $20,000x, but not to exceed
     limitation of $21,000x ($42,000x x
     $100,000x/$200,000x)...............
                                         -------------------------------
        U.S. tax payable................  ..............      22,000.00x
------------------------------------------------------------------------


                       Table 2 to Paragraph (b)(2)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
                                 Year 2
------------------------------------------------------------------------
Taxable income of USP, consisting of      ..............         $4,000x
 income from U.S. sources...............
U.S. tax before credit ($4,000x x 21%)..  ..............            840x
Section 904 limitation for Year 2:
    Limitation for Year 2 before          ..............               0
     increase under section 960(c)(1)
     ($840x x $0/$4,000x)...............
    Plus: Increase in section 904
     limitation for Year 2 under section
     960(c)(1):
        Amount by which Year 1                  $21,000x
         limitation was increased by
         reason of inclusion in USP's
         gross income under section
         951(a) for Year 1 ($21,000x-
         [$21,000x x $0/$100,000x]).....
        Less: Foreign income taxes               20,000x
         allowed as a credit for Year 1
         which were allowable solely by
         reason of such section 951(a)
         inclusion ($20,000x-$0)........
                                         -------------------------------
            Balance.....................          1,000x

[[Page 453]]

 
        But: Such balance not to exceed           1,000x          1,000x
         foreign income taxes paid by
         USP for Year 2 with respect to
         $80,000x distribution excluded
         under section 959(a)(1)
         ($1,000x tax withheld).........
    Limitation for Year 2...............  ..............          1,000x
U.S. tax payable for Year 2:
    U.S. tax before credit ($4,000x x     ..............            840x
     21%)...............................
    Credit: Foreign income taxes of       ..............          1,000x
     $1,000x, but not to exceed
     limitation of $1,000x for Year 2...
    U.S. tax payable....................  ..............            None
Overpayment of tax for Year 2:
    Increase in limitation under section  ..............          1,000x
     960(c)(1) for Year 2...............
    Less: Tax imposed for Year 2 under    ..............            840x
     chapter 1 of the Code..............
    Excess treated as overpayment.......  ..............            160x
------------------------------------------------------------------------


[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 
60089, Oct. 18, 1979; T.D. 9882, 84 FR 69119, Dec. 17, 2019]



Sec. 1.960-7  Applicability dates.

    (a) Except as provided in paragraph (b) of this section, Sec. Sec. 
1.960-1 through 1.960-6 apply to each taxable year of a foreign 
corporation ending on or after December 4, 2018, and to each taxable 
year of a domestic corporation that is a United States shareholder of 
the foreign corporation in which or with which such taxable year of such 
foreign corporation ends.
    (b) Section 1.960-1(c)(2) and (d)(3)(ii) applies to taxable years of 
a foreign corporation beginning after December 31, 2019, and to each 
taxable year of a domestic corporation that is a United States 
shareholder of the foreign corporation in which or with which such 
taxable year of such foreign corporation ends. For taxable years of a 
foreign corporation that end on or after December 4, 2018, and also 
begin before January 1, 2020, see Sec. 1.960-1(c)(2) and (d)(3)(ii) as 
in effect on December 17, 2019.

[T.D. 9922, 85 FR 72072, Nov. 12, 2020]



Sec. 1.961-1  Increase in basis of stock in controlled foreign
corporations and of other property.

    (a) Increase in basis--(1) In general. Except as provided in 
subparagraph (2) of this paragraph, the basis of a United States 
shareholder's--
    (i) Stock in a controlled foreign corporation; or
    (ii) Property (as defined in paragraph (b)(1) of this section) by 
reason of the ownership of which he is considered under section 
958(a)(2) as owning stock in a controlled foreign corporation shall be 
increased under section 961(a), as of the last day in the taxable year 
of such corporation on which it is a controlled foreign corporation, by 
the amount required to be included with respect to such stock or such 
property in such shareholder's gross income under section 951(a) for his 
taxable year in which or with which such taxable year of such 
corporation ends. The increase in basis provided by the preceding 
sentence shall be made only to the extent to which such amount required 
to be included in gross income under section 951(a) was so included in 
gross income.
    (2) Limitation on amount of increase in case of election under 
section 962. In the case of a United States shareholder who makes the 
election under section 962 for the taxable year, the amount of the 
increase in basis provided by subparagraph (1) of this paragraph shall 
not exceed the amount of United States tax paid in accordance with such 
election with respect to the amounts included in such shareholder's 
gross income under section 951(a) for

[[Page 454]]

such year (as determined under Sec. 1.962-1).
    (b) Rules of application--(1) Property defined. The property of a 
United States shareholder referred to in paragraph (a)(1)(ii) of this 
section shall consist of--
    (i) Stock in a foreign corporation;
    (ii) An interest in a foreign partnership; or
    (iii) A beneficial interest in a foreign estate or trust (as defined 
in section 7701(a)(31)).
    (2) Increase with respect to each share of stock. Any increase under 
paragraph (a) of this section in the basis of a United States 
shareholder's stock in a foreign corporation shall be made in the amount 
included in gross income under section 951(a) or in the amount of United 
States tax paid in accordance with an election under section 962, as the 
case may be, with respect to each share of such stock.
    (c) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. Domestic corporation M owns 800 of the 1,000 shares of 
the one class of stock in controlled foreign corporation R which owns 
all of the one class of stock in controlled foreign corporation S. 
Corporations M, R, and S use the calendar year as a taxable year. In 
1964, S Corporation has $100,000 of earnings and profits after the 
payment of $11,250 of foreign income taxes, and $100,000 of subpart F 
income. Corporation R has no earnings and profits. With respect to S 
Corporation, M Corporation is required to include in gross income 
$80,000 (800/1,000 x $100,000) under section 951(a), and $9,000 
($80,000/$100,000 x $11,250) under section 78. On December 31, 1964, M 
Corporation must increase the basis of each share of its stock in R 
Corporation by $100 ($80,000/800).
    Example 2. A, an individual United States shareholder, owns all of 
the 1,000 shares of the one class of stock in controlled foreign 
corporation T. Corporation T and A use the calendar year as a taxable 
year. In 1964, T Corporation has $80,000 of earnings and profits after 
the payment of $20,000 of foreign income taxes, and $80,000 of subpart F 
income. A makes the election under section 962 for 1964 and in 
accordance with such election pays a United States tax of $23,000 with 
respect to the $80,000 included in his gross income under section 
951(a). On December 31, 1964, A must increase the basis of each share of 
his stock in T Corporation by $23 ($23,000/1,000).

[T.D. 6850, 30 FR 11854, Sept. 16, 1965]



Sec. 1.961-2  Reduction in basis of stock in foreign corporations
and of other property.

    (a) Reduction in basis--(1) In general. Except as provided in 
subparagraph (2) of this paragraph, the adjusted basis of a United 
States person's--
    (i) Stock in a foreign corporation;
    (ii) Interest in a foreign partnership; or
    (iii) Beneficial interest in a foreign estate or trust (as defined 
in section 7701(a)(31)),


with respect to which such United States person receives an amount which 
is excluded from gross income under section 959(a), shall be reduced 
under section 961(b), as of the time such person receives such excluded 
amount, by the sum of the amount so excluded and any income, war 
profits, or excess profits taxes imposed by any foreign country or 
possession of the United States on or with respect to the earnings and 
profits attributable to such excluded amount when such earnings and 
profits were actually distributed directly or indirectly through a chain 
of ownership described in section 958(a)(2).
    (2) Limitation on amount of reduction in case of election under 
section 962. In the case of a distribution of earnings and profits 
attributable to amounts with respect to which an election under section 
962 has been made, the amount of the reduction in basis provided by 
subparagraph (1) of this paragraph shall not exceed the sum of--
    (i) The amount of such distribution which is excluded from gross 
income under section 959(a) after the application of section 962(d) and 
Sec. 1.962-3; and
    (ii) Any income, war profits, or excess profits taxes imposed by any 
foreign country or possession of the United States on or with respect to 
the earnings and profits attributable to such excluded amount when such 
earnings and profits were actually distributed directly or indirectly 
through a chain of ownership described in section 958(a)(2).
    (b) Reduction with respect to each share of stock. Any reduction 
under paragraph (a) of this section in the adjusted basis of a United 
States person's stock in a foreign corporation shall be made

[[Page 455]]

with respect to each share of such stock in the sum of--
    (1)(i) The amount excluded from gross income under section 959(a); 
or
    (ii) The amount excluded from gross income under section 959(a) 
after the application of section 962(d) and Sec. 1.962-3; and
    (2) The amount of any income, war profits, or excess profits taxes 
imposed by any foreign country or possession of the United States on or 
with respect to the earnings and profits attributable to such excluded 
amount when such earnings and profits were actually distributed directly 
or indirectly through a chain of ownership described in section 
958(a)(2).
    (c) Amount in excess of basis. To the extent that the amount of the 
reduction in the adjusted basis of property provided by paragraph (a) of 
this section exceeds such adjusted basis, the amount shall be treated as 
gain from the sale or exchange of property.
    (d) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. (a) Domestic corporation M owns all of the 1,000 shares 
of the one class of stock in controlled foreign corporation R, which 
owns all of the 500 shares of the one class of stock in controlled 
foreign corporation S. Each share of M Corporation's stock in R 
Corporation has a basis of $200. Corporations M, R, and S use the 
calendar year as a taxable year. In 1963, S Corporation has $100,000 of 
earnings and profits after the payment of $50,000 of foreign income 
taxes and $100,000 of subpart F income. For 1963, M Corporation includes 
$100,000 in gross income under section 951(a) with respect to S 
Corporation. In accordance with the provisions of Sec. 1.961-1, M 
Corporation increases the basis of each of its 1,000 shares of stock in 
R Corporation to $300 ($200 + $100,000/1,000) as of December 31, 1963.
    (b) On July 31, 1964, M Corporation sells 250 of its shares of stock 
in R Corporation to domestic corporation N at a price of $350 per share. 
Corporation N satisfies the requirements of paragraph (d) of Sec. 
1.959-1 so as to qualify as M Corporation's successor in interest. On 
September 30, 1964, the earnings and profits attributable to the 
$100,000 included in M Corporation's gross income under section 951(a) 
for 1963 are distributed to R Corporation which incurs a withholding tax 
of $10,000 on such distribution (10 percent of $100,000) and an 
additional foreign income tax of 33\1/3\ percent or $30,000 by reason of 
the inclusion of the net distribution of $90,000 ($100,000 minus 
$10,000) in its taxable income for 1964. On June 30, 1965, R Corporation 
distributes the remaining $60,000 of such earnings and profits to 
corporations M and N: Corporation M receives $45,000 (750/1,000 x 
$60,000) and excludes such amount from gross income under section 
959(a); Corporation N receives $15,000 (250/1,000 x $60,000) and, as M 
Corporation's successor in interest, excludes such amount from gross 
income under section 959(a). As of June 30, 1965, M Corporation must 
reduce the adjusted basis of each of its 750 shares of stock in R 
Corporation to $200 ($300 minus ($45,000/750 + $10,000/1,000 + $30,000/
1,000)); and N Corporation must reduce the basis of each of its 250 
shares of stock in R Corporation to $250 ($350 minus ($15,000/250 + 
$10,000/1,000 + $30,000/1,000)).
    Example 2. The facts are the same as in paragraph (a) of example 1, 
except that in addition, on July 31, 1964, R Corporation sells its 500 
shares of stock in S Corporation to domestic corporation P at a price of 
$600 per share. Corporation P satisfies the requirements of paragraph 
(d) of Sec. 1.959-1 so as to qualify as M Corporation's successor in 
interest. On September 30, 1964, S Corporation distributes $100,000 of 
earnings and profits to P Corporation, which earnings and profits are 
attributable to the $100,000 included in M Corporation's gross income 
under section 951(a) for 1963. Corporation P incurs a withholding tax of 
$10,000 on the distribution from S Corporation (10 percent of $100,000). 
As M Corporation's successor in interest, P Corporation excludes the 
$90,000 it receives from gross income under section 959(a). As of 
September 30, 1964, P Corporation must reduce the basis of each of its 
500 shares of stock in S Corporation to $400 ($600 minus ($90,000/500 + 
$10,000/500)).

[T.D. 6850, 30 FR 11854, Sept. 16, 1965]



Sec. 1.962-1  Limitation of tax for individuals on amounts included
in gross income under section 951(a).

    (a) In general. An individual United States shareholder may, in 
accordance with Sec. 1.962-2, elect to have the provisions of section 
962 apply for his taxable year. In such case--
    (1) The tax imposed under chapter 1 of the Internal Revenue Code on 
all amounts which are included in his gross income for such taxable year 
under section 951(a) shall (in lieu of the tax determined under section 
1) be an amount equal to the tax which would be imposed under section 11 
if such amounts were received by a domestic corporation (determined in 
accordance with paragraph (b)(1) of this section), and

[[Page 456]]

    (2) For purposes of applying sections 960(a) and 960(d) (relating to 
foreign tax credit) such amounts shall be treated as if received by a 
domestic corporation (as provided in paragraph (b)(2) of this section).
    (3) Thus, an individual United States shareholder may elect to be 
subject to tax at corporate rates on amounts included in his gross 
income under section 951(a) and to have the benefit of a credit for 
certain foreign taxes paid with respect to the earnings and profits 
attributable to such amounts. Section 962 also provides rules for the 
treatment of an actual distribution of earnings and profits previously 
taxed in accordance with an election of the benefits of this section. 
See Sec. 1.962-3.
    (b) Rules of application. For purposes of this section--
    (1) Application of section 11. For purposes of applying section 11 
for a taxable year as provided in paragraph (a)(1) of this section in 
the case of an electing United States shareholder--
    (i) Determination of taxable income. The term taxable income means 
the excess of--
    (A) The sum of--
    (1) All amounts required to be included in his gross income under 
section 951(a) for the taxable year with respect to a foreign 
corporation of which he is a United States shareholder, including--
    (i) His section 965(a) inclusion amounts (as defined in Sec. 1.965-
1(f)(38)); and
    (ii) His domestic pass-through owner shares (as defined in Sec. 
1.965-1(f)(21)) of section 965(a) inclusion amounts with respect to 
deferred foreign income corporations (as defined in Sec. 1.965-
1(f)(17)) of which he is a United States shareholder; plus
    (2) His GILTI inclusion amount (as defined in Sec. 1.951A-1(c)(1)) 
for the taxable year; plus
    (3) All amounts which would be required to be included in his gross 
income under section 78 for the taxable year with respect to the amounts 
referred to in paragraph (b)(1)(i)(A)(1) and (2) of this section if the 
shareholder were a domestic corporation; over
    (B) The sum of the following deductions, but no other deductions or 
amounts--
    (1) His section 965(c) deduction amount (as defined in Sec. 1.965-
1(f)(42)) for the taxable year;
    (2) His domestic pass-through owner shares of section 965(c) 
deduction amounts corresponding to the amounts referred to in paragraph 
(b)(1)(i)(A)(1)(ii) of this section; and
    (3) The portion of the deduction under section 250 and Sec. 
1.250(a)-1 that would be allowed to a domestic corporation equal to the 
percentage applicable to global intangible low-taxed income for the 
taxable year under section 250(a)(1)(B) (including as modified by 
section 250(a)(3)(B)) multiplied by the sum of the amount described in 
paragraph (b)(1)(i)(A)(2) of this section and the amount described in 
paragraph (b)(1)(i)(A)(3) of this section that is attributable to the 
amount described in paragraph (b)(1)(i)(A)(2) of this section.
    (ii) [Reserved]
    (2) Allowance of foreign tax credit--(i) In general. Subject to the 
applicable limitation of section 904 and to the provisions of this 
paragraph (b)(2), there shall be allowed as a credit against the United 
States tax on the amounts described in paragraph (b)(1)(i) of this 
section the foreign income, war profits, and excess profits taxes deemed 
paid under section 960(a) or section 960(d) by the electing United 
States shareholder with respect to such amounts.
    (ii) Application of sections 960(a) and 960(d). In applying sections 
960(a) and 960(d) for purposes of this paragraph (b)(2) in the case of 
an electing United States shareholder, the term ``domestic corporation'' 
as used in sections 960(a), 960(d), and 78, and the term ``corporation'' 
as used in sections 901 and 960(d)(2)(A) and (B), are treated as 
referring to such shareholder with respect to the amounts described in 
paragraph (b)(1)(i) of this section.
    (iii) Carryback and carryover of excess tax deemed paid. For 
purposes of this paragraph (b)(2), other than with respect to section 
951A category income (as defined in Sec. 1.904-4(g)) (including section 
951A category income that is reassigned to a separate category for 
income resourced under a treaty), any amount by which the foreign 
income,

[[Page 457]]

war profits, and excess profits taxes deemed paid by the electing United 
States shareholder for any taxable year under section 960 exceed the 
limitation determined under paragraph (b)(2)(iv)(A) of this section is 
treated as a carryback and carryover of excess tax paid under section 
904(c), except that in no case will excess tax paid be deemed paid in 
another taxable year under section 904(c) if an election under section 
962 by the shareholder does not apply for such taxable year. Such 
carrybacks and carryovers are applied only against the United States tax 
on amounts described in paragraph (b)(1)(i) of this section.
    (iv) Limitation on credit. For purposes of determining the 
limitation under section 904 on the amount of the credit for foreign 
income, war profits, and excess profits taxes--
    (A) Deemed paid with respect to amounts described in subparagraph 
(1)(i) of this paragraph, the electing United States shareholder's 
taxable income shall be considered to consist only of the amounts 
described in such subparagraph (1)(i), and
    (B) Paid with respect to amounts other than amounts described in 
subparagraph (1)(i) of this paragraph, the electing United States 
shareholder's taxable income shall be considered to consist only of 
amounts other than the amounts described in such subparagraph (1)(i).
    (v) Effect of choosing benefits of sections 901 to 905. The 
provisions of this subparagraph shall apply for a taxable year whether 
or not the electing United States shareholder chooses the benefits of 
subpart A of part III of subchapter N of chapter 1 (sections 901 to 905) 
of the Internal Revenue Code for such year.
    (c) Example. The application of this section may be illustrated by 
the following example.
    (1) Facts. (i) Individual A is a U.S. resident who owns all of the 
shares of the one class of stock in CFC, a controlled foreign 
corporation. A and CFC each use the calendar year as their U.S. and 
foreign taxable years and the U.S. dollar as their functional currency. 
A owns no direct or indirect interest in any other controlled foreign 
corporation.
    (ii) For the 2019 taxable year, CFC has $6,000,000 of pre-foreign 
tax earnings with respect to which it accrues and pays $1,000,000 of 
foreign income tax, leaving $5,000,000 of after-tax net income. Of this 
amount, $3,000,000 is general category tested income as defined in 
section 951A(c)(2), and $2,000,000 is passive category subpart F income 
described in sections 952 and 904(d)(1)(C) that is all in a single 
subpart F income group under Sec. Sec. 1.954-1(c)(1)(iii) and 1.960-
1(d)(2)(ii)(B)(2)(i). Of the $1,000,000 of foreign income taxes paid or 
accrued by CFC, $600,000 is allocated and apportioned to its general 
category tested income group and $400,000 is allocated and apportioned 
to its passive category subpart F income group under Sec. 1.960-
1(d)(3)(ii).
    (iii) For the 2019 taxable year, A includes under section 951A(a) 
all $3,000,000 of the tested income of CFC as A's GILTI inclusion 
amount, as defined in Sec. 1.951A-1(c)(1). In addition, A includes 
under section 951(a)(1) the $2,000,000 of passive category subpart F 
income of CFC.
    (iv) For the 2019 taxable year, A earns $1,000,000 of foreign source 
passive category gross income and $3,000,000 of U.S. source gross 
income. A pays $100,000 of foreign withholding taxes with respect to the 
$1,000,000 of foreign source passive category gross income. A incurs 
$1,000,000 of deductible expenses for the 2019 taxable year that are 
definitely related to all of A's gross income and are properly allocated 
and apportioned under Sec. Sec. 1.861-8(b)(5) and 1.861-8T(c)(1) among 
the section 904 statutory and residual groupings on the basis of the 
relative amounts of gross income in each grouping.
    (v) A elects to apply section 962 and chooses to claim credits under 
section 901 for the 2019 taxable year.
    (2) Analysis with respect to section 962 taxable income. (i) Section 
962(a)(1) and Sec. 1.962-1(a)(1) provide that when an individual United 
States shareholder elects to apply section 962 for a taxable year, the 
U.S. tax imposed with respect to amounts that the individual includes 
under section 951(a) (the ``section 951(a) inclusions'') equals the tax 
that would be imposed under section 11 if the amounts were included by a 
domestic

[[Page 458]]

corporation under section 951(a). For purposes of section 962, an amount 
included under section 951A is treated as an inclusion under section 
951(a). See section 951A(f)(1)(A). Therefore, A has total section 951(a) 
inclusions of $5,000,000: a $2,000,000 passive category subpart F 
inclusion and a $3,000,000 GILTI inclusion amount. A is taxed at the 
corporate rates under section 11 with respect to these inclusions.
    (ii) Section 962(a)(2), Sec. 1.962-1(a)(2), and Sec. 1.962-1(b)(2) 
provide that sections 960(a) and 960(d) apply to the section 951(a) 
inclusions of an electing individual United States shareholder as though 
the inclusions were received by a domestic corporation, and the electing 
individual United States shareholder is allowed a credit against the 
U.S. tax imposed with respect to the section 951(a) inclusions.
    (iii) Section 960(a) deems a domestic corporation that is a United 
States shareholder of a controlled foreign corporation to pay the 
foreign income taxes paid or accrued by the foreign corporation that are 
properly attributable to the foreign corporation's items of income 
included in the domestic corporation's income under section 951(a). The 
foreign income taxes of a CFC that are properly attributable to such 
items are the domestic corporation's proportionate share of the taxes 
that are allocated and apportioned to the relevant subpart F income 
group. See Sec. 1.960-1(c) and Sec. 1.960-2(b). A owns 100 percent of 
CFC, and includes all of its subpart F income, which is in a single 
subpart F income group. Therefore, all of the $400,000 of foreign income 
taxes that are allocable to CFC's subpart F income are properly 
attributable to the section 951(a) inclusion of A, and A is deemed to 
pay these taxes.
    (iv) Section 960(d) provides that a domestic corporation that has an 
inclusion in income under section 951A is deemed to pay an amount of 
foreign income taxes equal to 80 percent of the product of the domestic 
corporation's inclusion percentage multiplied by the sum of all tested 
foreign income taxes. Tested foreign income taxes are the foreign income 
taxes of a controlled foreign corporation that are properly attributable 
to its tested income that the domestic corporation takes into account 
under section 951A. The foreign income taxes that are properly 
attributable to the tested income taken into account by a domestic 
corporation are the domestic corporation's proportionate share of the 
controlled foreign corporation's foreign income taxes that are allocated 
and apportioned to the relevant tested income. See Sec. 1.960-1(c) and 
Sec. 1.960-2(c). Because A owns 100% of CFC and takes all $3,000,000 of 
CFC's tested income into account in computing A's GILTI inclusion 
amount, all $600,000 of the foreign income taxes that are allocated and 
apportioned to the general category tested income group of CFC are 
tested foreign income taxes. A has an inclusion percentage of 100 
percent because A's GILTI inclusion amount equals all of A's share of 
the tested income of CFC. A is therefore deemed to pay under section 
960(d) 80 percent of the $600,000 of tested foreign income taxes of CFC, 
or $480,000 of the tested foreign income taxes.
    (v) Section 1.962-1(b)(1)(i)(A) provides that, for purposes of 
computing taxable income under section 962, gross income includes 
amounts that would be included under section 78 if the shareholder with 
the section 951(a) inclusions were a domestic corporation. Section 78 
requires a domestic corporation to include in its gross income the 
foreign income taxes that it is deemed to pay under section 960, 
computed without regard to the 80 percent limitation under section 
960(d), and to which the benefits of section 901 apply. See section 78. 
A therefore includes in gross income the $600,000 of foreign income 
taxes that A is deemed to pay under section 960(d), computed without 
regard to the 80 percent limitation, and the $400,000 of taxes that A is 
deemed to pay under section 960(a).
    (vi) Section 1.962-1(b)(1)(i)(B)(3) provides that, for purposes of 
computing taxable income under section 962, gross income is reduced only 
by specified deductions, which include the deduction allowed to a 
domestic corporation under section 250 and Sec. 1.250(a)-1 equal to 50 
percent of the sum of the GILTI inclusion amount and the inclusion under 
section 78 with respect to the GILTI inclusion amount. See section

[[Page 459]]

250(a). A is therefore allowed a deduction under section 250 equal to 50 
percent of $3,600,000 (the $3,000,000 GILTI inclusion amount plus the 
$600,000 inclusion under section 78), or $1,800,000.
    (vii) A's taxable income and pre-credit U.S. tax liability with 
respect to the section 951(a) inclusions are computed as follows:

                    Table 1 to Paragraph (c)(2)(vii)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Section 951(a) inclusions with respect to CFC...........      $5,000,000
Section 78 inclusions...................................       1,000,000
Deduction under section 250.............................     (1,800,000)
Taxable income under section 962........................       4,200,000
Pre-credit U.S. tax (0.21 x $4,200,000).................         882,000
------------------------------------------------------------------------

    (viii) Section 962 and Sec. 1.962-1(b)(2) provide that, in 
computing the section 904 limitation on the credit for foreign income 
taxes that an electing individual United States shareholder is deemed to 
pay under sections 960(a) and (d), the individual's taxable income for a 
taxable year is considered to consist only of section 951(a) inclusions 
and the deductions allowed under section 962. Section 904 limits the 
credit that a taxpayer may claim for the taxes that it pays or accrues, 
or is deemed to pay, to the amount of its U.S. tax that is attributable 
to the taxpayer's foreign source income, and applies this limitation 
separately with respect to each separate category of income. The 
limitation amount is computed by multiplying the taxpayer's total pre-
credit U.S. tax by the ratio of the taxpayer's foreign source taxable 
income in a separate category for the taxable year to the taxpayer's 
total taxable income for the taxable year. See section 904(a) and Sec. 
1.904-1(a).
    (ix) A must compute the limitation on the credit for the foreign 
income taxes deemed paid under section 960(d) separately with respect to 
A's taxable income in the separate category described in section 
904(d)(1)(A) (the ``GILTI category''), namely, taxable income 
attributable to the GILTI inclusion amount. The limitation is computed 
using only A's 2019 taxable income under section 962 and the pre-credit 
U.S. tax of $882,000 on this income. A therefore computes the limitation 
by multiplying $882,000 by the ratio of A's foreign source GILTI 
category taxable income under section 962 to A's total taxable income 
under section 962, as follows:

                     Table 2 to Paragraph (c)(2)(ix)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
GILTI inclusion amount..................................      $3,000,000
Section 78 inclusion....................................        $600,000
Section 250 deduction...................................    ($1,800,000)
Total GILTI category taxable income under section 962...      $1,800,000
Ratio of GILTI category taxable income to total taxable           42.86%
 income under section 962 (1,800,000/$4,200,000)........
Limitation amount (pre-credit U.S. tax of $882,000 x            $378,000
 ($1,800,000/$4,200,000))...............................
------------------------------------------------------------------------

    (x) A also must compute the limitation on the credit for the foreign 
income taxes deemed paid under section 960(a) separately with respect to 
the foreign source passive category taxable income under section 962, 
namely, A's taxable income attributable to the subpart F inclusion. A 
computes the limitation by multiplying A's pre-credit U.S. tax of 
$882,000 by the ratio of A's foreign source passive category taxable 
income under section 962 to A's total taxable income under section 962, 
as follows:

                     Table 3 to Paragraph (c)(2)(x)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Subpart F inclusion.....................................      $2,000,000
Section 78 inclusion....................................        $400,000
Total foreign source passive category taxable income....      $2,400,000
Ratio of foreign source passive category taxable income           57.14%
 to total taxable income under section 962 ($2,400,000/
 $4,200,000)............................................
Limitation amount (pre-credit U.S. tax of $882,000 x            $504,000
 ($2,400,000/$4,200,000))...............................
------------------------------------------------------------------------

    (xi) A may claim a foreign tax credit for $378,000 of the $480,000 
of foreign income taxes deemed paid under section 960(d), and a foreign 
tax credit for all $400,000 of the foreign income taxes deemed paid 
under section 960(a), for a

[[Page 460]]

total foreign tax credit of $778,000. The U.S. tax on A's 2019 taxable 
income with respect to CFC under section 962 is reduced from $882,000 to 
$104,000 ($882,000 minus $778,000).
    (3) Analysis with respect to other income. (i) A's taxable income 
and pre-credit U.S. tax liability with respect to A's other income is 
computed as follows:

                     Table 4 to Paragraph (c)(3)(i)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income............................................      $4,000,000
Deductions..............................................       1,000,000
Taxable Income..........................................       3,000,000
Pre-credit U.S. tax computed under section 1(j).........       1,074,988
------------------------------------------------------------------------

    (ii) A must compute a separate limitation on the credit for the 
foreign withholding taxes paid with respect to A's other foreign source 
passive category taxable income. Under Sec. 1.962-1(b)(2)(iv)(B), A's 
section 904 limitation on this income is computed on the basis of A's 
taxable income other than the amounts taken into account under Sec. 
1.962-1(b)(1)(i). Accordingly, $250,000 of A's deductions ($1,000,000 x 
$1,000,000/$4,000,000) are apportioned to A's $1,000,000 of other 
foreign source passive category gross income, and $750,000 of deductions 
($1,000,000 x $3,000,000/$4,000,000) are apportioned to A's $3,000,000 
of U.S. source gross income, resulting in $750,000 of other foreign 
source passive category taxable income and $2,250,000 of U.S. source 
taxable income A computes the limitation by multiplying A's pre-credit 
U.S. tax on A's other income of $1,074,988 by the ratio of A's other 
foreign source passive category taxable income to A's other total 
taxable income, as follows:

                     Table 5 to Paragraph (c)(3)(ii)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Total other foreign source passive category taxable             $750,000
 income.................................................
Ratio of other foreign source passive category taxable               25%
 income to total other taxable income ($750,000/
 $3,000,000)............................................
Limitation amount (pre-credit U.S. tax of $1,074,988 x          $268,747
 ($750,000/$3,000,000)).................................
------------------------------------------------------------------------

    (iii) A may claim a foreign tax credit under section 901 for all 
$100,000 of the foreign withholding taxes on the other passive income. 
The U.S. tax on A's $3,000,000 of other taxable income is reduced from 
$1,074,988 to $974,988 ($1,074,88 minus $100,000).
    (d) Applicability dates. Except as otherwise provided in this 
paragraph (d), paragraph (b)(1)(i) of this section applies beginning the 
last taxable year of a foreign corporation that begins before January 1, 
2018, and with respect to a United States person, for the taxable year 
in which or with which such taxable year of the foreign corporation 
ends. Paragraphs (b)(1)(i)(A)(2) and (b)(1)(i)(B)(3) of this section 
apply to taxable years of a foreign corporation that end on or after 
March 4, 2019, and with respect to a United States person, for the 
taxable year in which or with which such taxable year of the foreign 
corporation ends. Paragraphs (a)(2), (b)(1)(ii), (b)(2)(i) through 
(iii), and (c) of this section apply to taxable years of a foreign 
corporation that end on or after July 15, 2020, and with respect to a 
United States person, for the taxable year in which or with which such 
taxable year of the foreign corporation ends. For taxable years that 
precede the applicability dates described in the preceding two 
sentences, taxpayers may choose to apply the provisions of paragraphs 
(a)(2), (b)(1)(i)(A)(2), (b)(1)(i)(B)(3), (b)(1)(ii), (b)(2)(i) through 
(iii), and (c) of this section for taxable years of a foreign 
corporation beginning on or after January 1, 2018, and with respect to a 
United States person, for the taxable year in which or with which such 
taxable year of the foreign corporation ends.

[T.D. 6858, 30 FR 13695, Oct. 28, 1965, as amended by T.D. 7413, 41 FR 
12640, Mar. 26, 1976; T.D. 9846, 84 FR 1874, Feb. 5, 2019; T.D. 9849, 84 
FR 9236, Mar. 14, 2019; T.D. 9901, 85 FR 43109, July 15, 2020]

[[Page 461]]



Sec. 1.962-2  Election of limitation of tax for individuals.

    (a) Who may elect. The election under section 962 may be made only 
by an individual (including a trust or estate) who is a United States 
shareholder (including an individual who is a United States shareholder 
because, by reason of section 958(b), he is considered to own stock of a 
foreign corporation owned (within the meaning of section 958(a)) by a 
domestic pass-through entity (as defined in Sec. 1.965-1(f)(19))).
    (b) Time and manner of making election. A United States shareholder 
shall make an election under this section by filing a statement to such 
effect with his return for the taxable year with respect to which the 
election is made. The statement shall include the following information:
    (1) The name, address, and taxable year of each controlled foreign 
corporation with respect to which the electing shareholder is a United 
States shareholder and of all other corporations, partnerships, trusts, 
or estates in any applicable chain of ownership described in section 
958(a);
    (2) The amounts, on a corporation-by-corporation basis, which are 
included in such shareholder's gross income for his taxable year under 
section 951(a);
    (3) Such shareholder's pro rata share of the earnings and profits 
(determined under Sec. 1.964-1) of each such controlled foreign 
corporation with respect to which such shareholder includes any amount 
in gross income for his taxable year under section 951(a) and the 
foreign income, war profits, excess profits, and similar taxes paid on 
or with respect to such earnings and profits;
    (4) The amount of distributions received by such shareholder during 
his taxable year from each controlled foreign corporation referred to in 
subparagraph (1) of this paragraph from excludable section 962 earnings 
and profits (as defined in paragraph (b)(1)(i) of Sec. 1.962-3), from 
taxable section 962 earnings and profits (as defined in paragraph 
(b)(1)(ii) of Sec. 1.962-3), and from earnings and profits other than 
section 962 earnings and profits, showing the source of such amounts by 
taxable year; and
    (5) Such further information as the Commissioner may prescribe by 
forms and accompanying instructions relating to such election.
    (c) Effect of election--(1) In general. Except as provided in 
subparagraph (2) of this paragraph, an election under this section by a 
United States shareholder for a taxable year shall be applicable to all 
controlled foreign corporations with respect to which such shareholder 
includes any amount in gross income for his taxable year under section 
951(a) and shall be binding for the taxable year for which such election 
is made.
    (2) Revocation. Upon application by the United States shareholder, 
an election made under this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless a material 
and substantial change in circumstances occurs which could not have been 
anticipated when the election was made. The application for consent to 
revocation shall be made by the United States shareholder's mailing a 
letter for such purpose to Commissioner of Internal Revenue, Attention: 
T:R, Washington, DC 20224, containing a statement of the facts upon 
which such shareholder relies in requesting such consent.
    (d) Applicability dates. Paragraph (a) of this section applies 
beginning the last taxable year of a foreign corporation that begins 
before January 1, 2018, and with respect to a United States person, for 
the taxable year in which or with which such taxable year of the foreign 
corporation ends.

[T.D. 6858, 30 FR 13696, Oct. 28, 1965, as amended by T.D. 9846, 84 FR 
1875, Feb. 5, 2019; T.D. 9849, 84 FR 9236, Mar. 14, 2019]



Sec. 1.962-3  Treatment of actual distributions.

    (a) In general. Section 962(d) provides that the earnings and 
profits of a foreign corporation attributable to amounts which are, or 
have been, included in the gross income of an individual United States 
shareholder under section 951(a) by reason of such shareholder's 
ownership (within the meaning of section 958(a)) of stock in such 
corporation and with respect to which

[[Page 462]]

amounts an election under Sec. 1.962-2 applies or applied shall, when 
such earnings and profits are distributed to such shareholder with 
respect to such stock, notwithstanding the provisions of section 
959(a)(1), be included in his gross income to the extent that such 
earnings and profits exceed the amount of income tax paid by such 
shareholder under this chapter on the amounts to which such election 
applies or applied. Thus, when such shareholder receives an actual 
distribution of section 962 earnings and profits (as defined in 
paragraph (b)(1) of this section) from a foreign corporation, only the 
excludable section 962 earnings and profits (as defined in paragraph 
(b)(1)(i) of this section) may be excluded from his gross income.
    (b) Rules of application. For purposes of this section--
    (1) Section 962 earnings and profits defined. With respect to an 
individual United States shareholder, the term ``section 962 earnings 
and profits'' means the earnings and profits of a foreign corporation 
referred to in paragraph (a) of this section. Such earnings and profits 
include--
    (i) Excludable section 962 earnings and profits. Excludable section 
962 earnings and profits which are the amount of the section 962 
earnings and profits equal to the amount of income tax paid under this 
chapter by such shareholder on the amounts included in his gross income 
under section 951(a); and
    (ii) Taxable section 962 earnings and profits. Taxable section 962 
earnings and profits which are the excess of section 962 earnings and 
profits over the amount described in subdivision (i) of this 
subparagraph.
    (2) Determinations made separately for each taxable year. If section 
962 earnings and profits attributable to more than one taxable year are 
distributed by a foreign corporation the determinations under this 
section shall be made separately with respect to each such taxable year.
    (3) Source of distributions--(i) In general. Except as otherwise 
provided in this subparagraph, the provisions of paragraphs (a) through 
(d) of Sec. 1.959-3 shall apply in determining the source of 
distributions of earnings and profits by a foreign corporation.
    (ii) Treatment of section 962 earnings and profits under Sec. 
1.959-3. For purposes of a section 959(c) amount and year classification 
under paragraph (b) of Sec. 1.959-3, a distribution of earnings and 
profits by a foreign corporation shall be first allocated to earnings 
and profits other than section 962 earnings and profits (as defined in 
subparagraph (1) of this paragraph) and then to section 962 earnings and 
profits. Thus distributions shall be considered first attributable to 
amounts described in paragraph (b)(1) of Sec. 1.959-3 which are not 
section 962 earnings and profits and then to amounts described in such 
paragraph (b)(1) which are section 962 earnings and profits (first for 
the current taxable year and then for prior taxable years beginning with 
the most recent prior taxable year), secondly to amounts described in 
paragraph (b)(2) of Sec. 1.959-3 which are not section 962 earnings and 
profits and then to amounts described in such paragraph (b)(2) which are 
section 962 earnings and profits (first for the current taxable year and 
then for prior taxable years beginning with the most recent prior 
taxable year), and finally to the amounts described in paragraph (b)(3) 
of Sec. 1.959-3 (first for the current taxable year and then for prior 
taxable years beginning with the most recent prior taxable year).
    (iii) Allocation to excludable section 962 earnings and profits. A 
distribution of section 962 earnings and profits by a foreign 
corporation for any taxable year shall be considered first attributable 
to the excludable section 962 earnings and profits (as defined in 
subparagraph (1)(i) of this paragraph) and then to taxable section 962 
earnings and profits.
    (iv) Allocation of deficits in earnings and profits. A United States 
shareholder's pro rata share (determined in accordance with the 
principles of paragraph (e) of Sec. 1.951-1) of a foreign corporation's 
deficit in earnings and profits (determined under Sec. 1.964-1) for any 
taxable year shall be applied in accordance with the provisions of 
paragraph (c) of Sec. 1.959-3 except that such deficit shall also be 
applied to taxable section 962 earnings and profits (as defined in 
subparagraph (1)(ii) of this paragraph).

[[Page 463]]

    (4) Distribution in exchange for stock. The provisions of this 
section shall not apply to a distribution of section 962 earnings and 
profits which is treated as in part or full payment in exchange for 
stock under subchapter C of chapter 1 of the Internal Revenue Code. The 
application of this subparagraph may be illustrated by the following 
example:

    Example. Individual United States shareholder A owns 60 percent of 
the only class of stock in foreign corporation M, the basis of which is 
$10,000. Both A and M Corporation use the calendar year as a taxable 
year. In each of the taxable years 1964, 1965, and 1966, M Corporation 
has $1,000 of earnings and profits and $1,000 of subpart F income. With 
respect to each such amount, A includes $600 in gross income under 
section 951(a), makes the election under section 962, and pays a United 
States tax of $132 (22 percent of $600). Accordingly, A increases the 
basis of his stock in M corporation under section 961(a) by $132 in each 
of the years 1964, 1965, and 1966, and thus on December 31, 1966, the 
adjusted basis for A's stock in M Corporation is $10,396. In 1967, M 
Corporation is completely liquidated (in a transaction described in 
section 331) and A receives $13,800, consisting of $1,800 of earnings 
and profits attributable to the amounts which A included in gross income 
under section 951(a) in 1964, 1965, and 1966, and $12,000 attributable 
to the other assets of M Corporation. No amount of the $3,404 gain 
realized by A on such distribution ($13,800 minus $10,396) may be 
excluded from gross income under section 959(a)(1). However, section 
962(d) will not prevent any part of such $3,404 from being treated as a 
capital gain under section 331.

    (5) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) M, a controlled foreign corporation is organized on 
January 1, 1963; A and B, individual United States shareholders, own 50 
percent and 25 percent, respectively, of the only class of stock in M 
Corporation. Corporation M, A, and B use the calendar year as a taxable 
year, and M Corporation is a controlled foreign corporation throughout 
the period here involved. For the taxable years 1963, 1964, 1965, and 
1966, A and B must include amounts in gross income under section 951(a) 
with respect to M Corporation. For the years 1963, 1965, and 1966, A 
makes the election under section 962. On January 1, 1967, B sells his 
25-percent interest in M Corporation to A; A satisfies the requirements 
of paragraph (d) of Sec. 1.959-1 so as to qualify as B's successor in 
interest. As of December 31, 1967, M Corporation's accumulated earnings 
and profits of $675 (before taking into account distributions made in 
1967) applicable to A's interest (including his interest as B's 
successor in interest) in such corporation are classified under Sec. 
1.959-3 and this section for purposes of section 962(d) as follows:

                      Classification of Earnings and Profits for Purposes of Sec. 1.962-3
----------------------------------------------------------------------------------------------------------------
                                           Section 959(c)(1)                 Section 959(c)(2)
                                  --------------------------------------------------------------------
                                      Non-    Excludable   Taxable      Non-    Excludable   Taxable
                                    section     section    section    section     section    section    Section
               Year                   962         962        962,       962         962        962        959
                                    earnings   earnings    earnings   earnings   earnings    earnings    (c)(3)
                                      and         and        and        and         and        and
                                    profits     profits    profits    profits     profits    profits
----------------------------------------------------------------------------------------------------------------
1963.............................        $25         $11        $39
1964.............................         75  ..........  .........        $60  ..........  .........        $15
1965.............................  .........  ..........  .........         75         $33       $117
1966.............................  .........  ..........  .........         50          22         78
1967.............................  .........  ..........  .........  .........  ..........  .........         75
----------------------------------------------------------------------------------------------------------------

    (b) During 1967, M Corporation makes three separate distributions to 
A of $200, $208, and $267. The source of such distributions under Sec. 
1.959-3 and this section is as follows:

------------------------------------------------------------------------
                                                      Classification of
                                                     distributions under
           Distribution             Amount    Year     sections 959 and
                                                            962(d)
------------------------------------------------------------------------
No. 1............................       $75    1964  (c)(1) non-section
                                         25    1963   962.
                                         11    1963   Do.
                                         39    1963  (c)(1) excludable
                                         50    1966   section 962.
                                                     (c)(1) taxable
                                                      section 962.
                                                     (c)(2) non-section
                                                      962.
                                  ----------
  Total..........................       200
------------------------------------------------------------------------

[[Page 464]]

 
No. 2............................        22    1966  (c)(2) excludable
                                         78    1966   section 962
                                         75    1965  (c)(2) taxable
                                         33    1965   section 962.
                                                     (c)(2) non-section
                                                      962.
                                                     (c)(2) excludable
                                                      section 962.
 
  Total..........................       208
------------------------------------------------------------------------
No. 3............................       117    1965  (c)(2) taxable
                                         60    1964   section 962.
                                         75    1967  (c)(2) non-section
                                         15    1964   962.
                                                     (c)(3).
                                                      Do.
                                  ----------
  Total..........................       267
------------------------------------------------------------------------

    (c) A must include $324 in his gross income for 1967. The source of 
these amounts is as follows:

------------------------------------------------------------------------
           Distribution             Amount    Year      Classification
------------------------------------------------------------------------
No. 1............................       $39    1963  (c)(1) taxable
                                                      section 962.
No. 2............................        78    1966  (c)(2) taxable
                                                      section 962.
No. 3............................       117    1965   Do.
                                         75    1967  (c)(3).
                                         15    1964   Do.
                                  ----------
  Total..........................       324
------------------------------------------------------------------------

    (c) Treatment of shareholder's successor in interest--(1) In 
general. If a United States person (as defined in Sec. 1.957-4) 
acquires from any person any portion of the interest in the foreign 
corporation of a United States shareholder referred to in this section, 
the rules of paragraphs (a) and (b) of this section shall apply to such 
acquiring person. However, no exclusion of section 962 earnings and 
profits under paragraph (a) of this section shall be allowed unless such 
acquiring person establishes to the satisfaction of the district 
director his right to such exclusion. The information to be furnished by 
the acquiring person to the district director with his return for the 
taxable year to support such exclusion shall include:
    (i) The name, address, and taxable year of the foreign corporation 
from which a distribution of section 962 earnings and profits is 
received and of all other corporations, partnerships, trusts, or estates 
in any applicable chain of ownership described in section 958(a);
    (ii) The name and address of the person from whom the stock interest 
was acquired;
    (iii) A description of the stock interest acquired and its relation, 
if any, to a chain of ownership described in section 958(a);
    (iv) The amount for which an exclusion under paragraph (a) of this 
section is claimed; and
    (v) Evidence showing that the section 962 earnings and profits for 
which an exclusion is claimed are attributable to amounts which were 
included in the gross income of a United States shareholder under 
section 951(a) subject to an election under Sec. 1.962-2, that such 
amounts were not previously excluded from the gross income of a United 
States person, and the identity of the United States shareholder 
including such amount.


The acquiring person shall also furnish to the district director such 
other information as may be required by the district director in support 
of the exclusion.
    (2) Taxes previously deemed paid by an individual United States 
shareholder. If a corporate successor in interest of an individual 
United States shareholder receives a distribution of section 962 
earnings and profits, the income, war profits, and excess profits taxes 
paid to any foreign country or to any possession of the United States in 
connection with such earnings and profits shall not be taken into 
account for purposes of section 902, to the extent such taxes were 
deemed paid by such individual United States shareholder under paragraph 
(b)(2) of Sec. 1.962-1 and section 960(a)(1) for any prior taxable 
year.

[T.D. 6858, 30 FR 13696, Oct. 28, 1965]



Sec. 1.963-0  Repeal of section 963; effective dates.

    (a) Repeal of section 963. Except as provided in paragraphs (b) and 
(c) of this section, the provisions of section 963 and Sec. Sec. 1.963-
1 through 1.963-7 are repealed for taxable years of foreign corporations 
beginning after December 31, 1975, and for taxable years of United 
States shareholders (within the meaning of section 951(b), within which 
or with which such taxable years of such foreign corporations end.
    (b) Transitional rules for chain or group election--(1) In general. 
If a United States shareholder (within the meaning of section 951(b) 
makes either a chain election pursuant to Sec. 1.963-1(e)

[[Page 465]]

or a group election pursuant to Sec. 1.963-1(f) for a taxable year of 
such shareholder beginning after December 31, 1975, then a foreign 
corporation shall be includible in such election only if--
    (i) It has a taxable year beginning before January 1, 1976, which 
ends within such taxable year of the United States shareholder, and
    (ii) It is either--
    (A) A controlled foreign corporation or
    (B) A foreign corporation by reason of ownership of stock in which 
such shareholder indirectly owns (within the meaning of section 
958(a)(2)) stock in a controlled foreign corporation to which this 
subparagraph applies.
    (2) Series rule. If any foreign corporation in a series of foreign 
corporations is excluded by subparagraph (i) of this paragraph from a 
chain or group election of a United States shareholder for its taxable 
year, then any foreign corporation in which the United States 
shareholder owns stock indirectly by reason of ownership of stock in 
such excluded corporation shall also be excluded from such election to 
the extent of such indirect ownership regardless of when its taxable 
year begins.
    (3) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) M is a domestic corporation, A, B, D, and E are 
controlled foreign corporations, and C is a foreign corporation other 
than a controlled foreign corporation. All five foreign corporations, 
each have only one class of stock outstanding. M owns directly all of 
the stock of A, which in turn owns directly all of the stock of B, which 
in turn owns directly 60 percent of the stock of D, which in turn owns 
directly all of the stock of E. M also owns directly 40 percent of the 
stock of C, which in turn owns directly the remaining 40 percent of the 
stock of D. M is a United States shareholder with respect to no other 
foreign corporation. M and B each use the calendar year as the taxable 
year. A, C, D, and E each use a fiscal year ending on November 30 as the 
taxable year. For calendar year 1976, M may make either a first-tier 
election with respect to A, a chain election with respect to C and D (to 
the extent of M's indirect 16-percent stock interest in D by reason of 
its direct ownership of 40 percent of the stock of C) or a group 
election with respect to A, C, D (to the extent of such 16-percent stock 
interest) and E (to the extent of M's indirect 16-percent stock interest 
in E).
    (b) M's indirect 100 percent stock interest in B will be excluded 
from any chain or group election made by M for calendar year 1976 since 
B is a controlled foreign corporation which does not have a taxable year 
beginning before January 1, 1976, which ends within the taxable year of 
M beginning after December 31, 1975, for which M has made either a chain 
or group election.
    (c) M's indirect 60 percent stock interest through A and B in D and 
E will be excluded from any chain or group election made by M for 
calendar year 1976 since such 60 percent interests are indirectly owned 
by M by reason of its indirect ownership of stock in B, which is a 
foreign corporation which does not have a taxable year beginning before 
January 1, 1976, which ends within the taxable year of M beginning after 
December 31, 1975, for which M has made either a chain or group 
election.
    (d) If C used the calendar year as its taxable year and was 
therefore excluded from a chain election made with respect to it and D, 
then D would also be excluded from such an election, since D would then 
be a foreign corporation in which M owns stock indirectly by reason of 
ownership of stock in C, which is excluded from such election.

    (c) Deficiency distributions. The rules relating to deficiency 
distributions under section 963(e)(2) and Sec. 1.963-6 shall continue 
to apply to a taxable year beginning after the effective date of the 
repeal of section 963 in which it is determined that a deficiency 
distribution must be made for an earlier taxable year for which a United 
States shareholder made an election to secure the exclusion under 
section 963 but failed to receive a minimum distribution.
    (d) Special adjustments pursuant to section 963 to be taken into 
account for taxable years subsequent to the repeal of section 963. If a 
United States shareholder of a controlled foreign corporation elects to 
receive a minimum distribution under section 963 for a taxable year, 
section 963 and the regulations thereunder may require certain elections 
and adjustments to be made in subsequent taxable years. These elections 
and adjustments shall be taken into account for subsequent taxable years 
as if section 963 were still in effect and no election to receive a 
minimum distribution were made after the effective date of the repeal of 
section 963. Examples of these elections and special adjustments 
include, but are not limited to, the election which may

[[Page 466]]

be made pursuant to Sec. 1.963-3(g)(2), relating to the special 
extended distribution period, and the special adjustments to be made 
pursuant to Sec. 1.963-4, relating to the minimum overall tax burden 
test.

[T.D. 7545, 43 FR 19652, May 8, 1978]



Sec. 1.963-1  [Reserved]



Sec. 1.963-2  Determination of the amount of the minimum distribution.

    (a) Application of statutory percentage to earnings and profits. The 
amount of the minimum distribution required to be received by a United 
States shareholder with respect to stock to which the election under 
paragraph (c) of Sec. 1.963-1 applies for the taxable year in order to 
qualify for a section 963 exclusion for such year shall be the amount, 
if any, determined by the multiplication of the statutory percentage 
applicable for the taxable year by--
    (1) In the case of a first-tier election, such shareholder's 
proportionate share (as determined under paragraph (d)(2) of this 
section) of the earnings and profits for the taxable year of the single 
first-tier corporation to which the election relates,
    (2) In the case of a chain election, the consolidated earnings and 
profits (as determined under paragraph (d)(3) of this section) with 
respect to such shareholder for the taxable year of the chain to which 
the election relates, or
    (3) In the case of a group election, the consolidated earnings and 
profits (as determined under paragraph (d)(3) of this section) with 
respect to such shareholder for the taxable year of the group to which 
the election relates.


For the requirement that the overall United States and foreign income 
tax incurred in respect of a minimum distribution from a chain or group 
must equal or exceed either 90 percent of the United States corporate 
tax rate applied against pretax and predistribution consolidated 
earnings and profits or, with the application of the special rules set 
forth therein, must equal or exceed the overall United States and 
foreign income tax which would have resulted from a pro rata minimum 
distribution, see paragraph (a)(1) of Sec. 1.963-4.
    (b) Statutory percentage. The statutory percentage (referred to in 
paragraph (a) of this section) for the taxable year shall be determined 
by applying the effective foreign tax rate (as defined in paragraph (c) 
of this section) for such year with respect to the single first-tier 
corporation, chain, or group, as the case may be, against--
    (1) The table set forth in section 963(b)(1) in the case of an 
election to secure an exclusion under section 963 for a taxable year of 
the United States shareholder beginning in 1963 and a taxable year 
entirely within the surcharge period ending before January 1, 1970.
    (2) The table set forth in section 963(b)(2) in the case of an 
election to secure an exclusion under section 963 for a taxable year of 
the U.S. shareholder beginning in 1964 or for a taxable year of such 
shareholder beginning in 1969 and ending in 1970 to the extent 
subparagraph (B) of section 963(b)(3) applies,
    (3) The table set forth in section 963(b)(3) in the case of an 
election to secure an exclusion under section 963 for a taxable year of 
the U.S. shareholder beginning after December 31, 1964 except a taxable 
year which includes any part of the surcharge period, or
    (4) The table set forth in paragraph (b) of Sec. 1.963-8 in the 
case of an election to secure an exclusion under section 963 for the 
calendar year 1970.

    Example. Domestic corporation M owns all the one class of stock in 
controlled foreign corporation A. Corporation M uses the calendar year 
as its taxable year, and A Corporation uses a fiscal year ending August 
31. For 1964, M Corporation makes a first-tier election in order to 
exclude from gross income for such year the subpart F income of A 
Corporation for its taxable year ending on August 31, 1964. Although, 
such election applies to the taxable year of A Corporation beginning on 
September 1, 1963, the applicable table, for purposes of determining the 
statutory percentages to be used under paragraph (a) of this section for 
the taxable year, is that set forth in section 963(b)(2), which relates 
to taxable years of United States shareholders beginning in 1964. Thus, 
if for the taxable year of A Corporation ending August 31, 1964, the 
effective foreign tax rate is 30 percent, A Corporation would have to 
distribute 72 percent of its earnings and profits for such year in order 
for M Corporation to

[[Page 467]]

be entitled to an exclusion under section 963 for 1964.

    (c) Effective foreign tax rate--(1) Single first-tier corporation. 
For purposes of section 963 the term ``effective foreign tax rate'' for 
a taxable year means, with respect to a single first-tier corporation, 
the percentage which--
    (i) The United States shareholder's proportionate share (as 
determined under paragraph (e)(1) of this section) of the foreign income 
tax of such corporation for such taxable year is of--
    (ii) The sum of--
    (a) The United States shareholder's proportionate share (as 
determined under paragraph (d)(2) of this section) of the earnings and 
profits of such corporation for such taxable year, and
    (b) The amount referred to in subdivision (i) of this subparagraph.
    (2) Chain or group of corporations. For purposes of section 963, the 
term ``effective foreign tax rate'' for a taxable year means, with 
respect to a chain or group, the percentage which--
    (i) The consolidated foreign income taxes (as determined under 
paragraph (e)(2) of this section) of such chain or group with respect to 
the United States shareholder for such taxable year is of--
    (ii) The sum of--
    (a) The consolidated earnings and profits (as determined under 
paragraph (d)(3) of this section) of such chain or group with respect to 
such United States shareholder for such taxable year, and
    (b) The amount referred to in subdivision (i) of this subparagraph.
    (3) Treatment of United States tax as foreign tax. For the purpose 
solely of determining the effective foreign tax rate under this 
paragraph, if a foreign corporation has pretax earnings and profits 
attributable to income from sources within the United States for the 
taxable year upon which it pays United States income tax and if 
distributions from the earnings and profits of such corporation for such 
year to the electing United States shareholder with respect to stock to 
which the election to secure an exclusion under section 963 relates do 
not entitled such shareholder to the dividends-received deduction under 
section 245, the amount of the United States income tax shall be taken 
into account as though such tax were foreign income tax. The amount so 
treated as foreign income tax shall not exceed 90 percent of an amount 
determined by multiplying such pretax earnings and profits attributable 
to income from sources within the United States by a percentage which is 
the sum of the normal tax rate and the surtax rate (determined without 
regard to the surtax exemption) prescribed by section 11 for the taxable 
year of the United States shareholder.
    (d) Determination of proportionate share of earnings and profits and 
consolidated earnings and profits--(1) Earnings and profits of foreign 
corporations. For purposes of Sec. Sec. 1.963-1 through 1.963-8, the 
earnings and profits, or deficit in earnings and profits, for the 
taxable year, of a single first-tier corporation or of a foreign 
corporation in a chain or group shall be the amount of its earnings and 
profits for such year, determined under section 964(a) and Sec. 1.964-1 
but without reduction for foreign income tax or for distributions made 
by such corporation, less--
    (i) In the case of a foreign corporation included in a chain or 
group, the amount of any distributions received (computed without 
reduction for any income tax paid or accrued by such corporation with 
respect to such distributions) by such corporation during its taxable 
year from the earnings and profits (whether or not from earnings and 
profits of the taxable year to which the election under section 963 
applies) of another foreign corporation in the chain or group.
    (ii) In the case of every foreign corporation, the amount of foreign 
income tax paid or accrued by such corporation during its taxable year 
other than foreign income tax referred to in subdivision (i) and (iii) 
of this subparagraph, and
    (iii) In the case of a foreign corporation included in a chain or 
group, the foreign income tax paid or accrued by such corporation with 
respect to distributions from the earnings and profits of any other 
foreign corporation in the chain or group for the taxable year of such 
other corporation to which the election under section 963 applies, but 
only if the U.S. shareholder chooses

[[Page 468]]

under this subdivision to take such tax into account in determining the 
effective foreign tax rate rather than count it toward the amount of the 
minimum distribution as provided in paragraph (b)(2) of Sec. 1.963-3.


In the event that the foreign income tax of a corporation included in a 
chain or group depends upon the extent to which distributions are made 
by such corporation, the amount of foreign income tax referred to in 
subdivision (ii) of this subparagraph shall, only for purposes of 
determining the effective foreign tax rate, be the amount which would 
have been paid or accrued if no distributions had been made. For the 
rules in other cases involving corporations whose foreign income tax 
varies with distributions, see Sec. 1.963-5. For the manner of 
computing the earnings and profits of a foreign branch treated as a 
wholly owned foreign subsidiary corporation see paragraph (f)(4)(ii) of 
Sec. 1.963-1.
    (2) Shareholder's proportionate share of earnings and profits--(i) 
Corporation with earnings and profits--(a) In general. A United States 
shareholder's proportionate share, with respect to stock to which the 
election to secure an exclusion under section 963 relates, of the 
earnings and profits of a foreign corporation (not including a foreign 
branch described in (b) of this subdivision) for its taxable year shall 
be the share which such shareholder would receive if the total amount of 
such corporation's earnings and profits, as determined under 
subparagraph (1) of this paragraph, for such year were distributed on 
the last day of such corporation's taxable year on which such 
corporation is a controlled foreign corporation or is a foreign 
corporation by reason of the ownership of stock in which the United 
States shareholder indirectly owns within the meaning of section 
958(a)(2) stock in a controlled foreign corporation.
    (b) Foreign branch treated as a foreign subsidiary corporation. A 
United States shareholder's proportionate share of the earnings and 
profits, for the taxable year, of a branch treated as a wholly owned 
foreign subsidiary corporation and included in a group under paragraph 
(f)(4) of Sec. 1.963-1 shall be the total earnings and profits of such 
branch for the taxable year, as determined under paragraph (f)(4)(ii) of 
such section.
    (c) Indirectly held foreign corporations. If the proportionate share 
to be determined is of earnings and profits of a foreign corporation the 
stock of which is owned by the United States shareholder by reason of 
its ownership of stock (with respect to which the election relates) in 
another corporation, such shareholder's proportionate share of such 
earnings and profits for the taxable year shall be determined on the 
basis of the amount such shareholder would receive from such foreign 
corporation with respect to stock in such foreign corporation if there 
were distributed for the taxable year all such earnings and profits, as 
determined under subparagraph (1) of this paragraph, and of all the 
earnings and profits of all other corporations through which such 
earnings and profits must pass in order to be received by such 
shareholder with respect to the stock to which the election relates. For 
purposes of the preceding sentence, the amount received by the 
shareholder from the earnings and profits of a foreign corporation shall 
be determined without taking into account deductions (whether or not 
allowable under chapter 1 of the Code) of other foreign corporations 
through which such earnings and profits are distributed.
    (d) More than one class of stock. If a foreign corporation for a 
taxable year has more than one class of stock outstanding, the earnings 
and profits of such corporation for such year which shall be taken into 
account with respect to any one class of such stock shall be the 
earnings and profits which would be distributed with respect to such 
class if all earnings and profits of such corporation for such year were 
distributed on the last day of such corporation's taxable year, on which 
such corporation is a controlled foreign corporation or is a foreign 
corporation by reason of the ownership of stock in which the United 
States shareholder indirectly owns within the meaning of section 
958(a)(2) stock in a controlled foreign corporation. If an arrearage in 
dividends for prior taxable years exists with respect to a class of 
preferred stock of such corporation, the earnings

[[Page 469]]

and profits for the taxable year shall be attributed to such arrearage 
only to the extent such arrearage exceeds the earnings and profits of 
such corporation remaining from prior taxable years beginning after 
December 31, 1962. For example, if a controlled foreign corporation, 
using the calendar year as its taxable year, has earnings and profits 
for 1963 of $100 accumulated at December 31, 1963, and an arrearage of 
$150 for such year in respect of preferred stock, the earnings and 
profits for 1964 attributable to such arrearage may not exceed $50 
($150-$100).
    (e) Discretionary power to allocate earnings to different classes of 
stock. If the allocation of a foreign corporation's earnings and profits 
for the taxable year between two or more classes of stock depends upon 
the exercise of discretion by that body of persons which exercises with 
respect to such corporation the power ordinarily exercised by the board 
of directors of a domestic corporation, the allocation of such earnings 
and profits to such classes shall be made for purposes of this 
subdivision as if such classes constituted one class of stock in which 
each share has the same rights to dividends as any other share, unless a 
different method of allocation of such earnings and profits is made by 
such body not later than 90 days after the close of such taxable year.
    (f) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

    Example 1. Domestic corporation M directly owns 80 percent of the 
one class of stock of controlled foreign corporation A, which directly 
owns 60 percent of the one class of stock of controlled foreign 
corporation B. Each such corporation has earnings and profits of $70 for 
the taxable year, as determined under subparagraph (1) of this 
paragraph. Corporation M's proportionate share of the earnings and 
profits is $56 (0.80 x $70) as to A Corporation and $33.60 (0.80 x 0.60 
x $70) as to B Corporation.
    Example 2. Throughout 1964 controlled foreign corporation A, which 
uses the calendar year as the taxable year, has outstanding 40 shares of 
common stock and 60 shares of 6-percent, nonparticipating, noncumulative 
preferred stock with a par value of $100 per share. Corporation A has 
earnings and profits of $1,000, for 1964, as determined under 
subparagraph (1) of this paragraph. In such case, $360 (0.06 x $100 x 
60) of earnings and profits would be taken into account with respect to 
the preferred stock and $640 ($1,000-$360), with respect to the common 
stock. Thus, if a United States shareholder owns 10 shares of common 
stock and 30 shares of preferred stock for 1964, its proportionate share 
of the earnings and profits for such year is $340 ([10/40 x $640] + [30/
60 x $360]).

    (ii) Deficit in earnings and profits of a corporation in a chain or 
group. A United States shareholder's proportionate share, with respect 
to stock to which the election to secure an exclusion under section 963 
relates, of a deficit in earnings and profits of a foreign corporation 
in a chain or group for a taxable year shall be the portion of such 
deficit which, if such corporation had earnings and profits for such 
year as determined under subparagraph (1) of this paragraph and all of 
such earnings and profits were distributed on the date described in 
subdivision (i)(a) of this subparagraph, the share of such earnings and 
profits such shareholder would receive bears to the total of the 
earnings and profits which would be so distributed on such date. For the 
determination of the deficit of a foreign branch treated as a wholly 
owned foreign subsidiary corporation and included in a group, see 
paragraph (f)(4)(ii) of Sec. 1.963-1. A United States shareholder's 
proportionate share of the deficit of such a branch shall be the total 
deficit of such branch for the taxable year.
    (iii) Controlled foreign corporation for part of year. If--
    (a) Stock in a foreign corporation is owned within the meaning of 
section 958(a) by a United States shareholder on the last day in the 
taxable year of such corporation for which such corporation is a 
controlled foreign corporation to which applies an election by such 
shareholder to secure an exclusion under section 963 with respect to 
such stock, or
    (b) Stock in a foreign corporation which is not a controlled foreign 
corporation is owned within the meaning of section 958(a) by a United 
States shareholder on the last day in the taxable year of such 
corporation on which another foreign corporation (which, by reason of 
the stock so owned, is owned by such shareholder within the meaning of 
section 958(a)) is a controlled foreign corporation to which applies an

[[Page 470]]

election by such shareholder to secure an exclusion under section 963 
with respect to such stock,


the earnings and profits of such foreign corporation for the taxable 
year which are taken into account in determining such shareholder's 
proportionate share thereof shall be an amount of such earnings and 
profits, determined as provided in subparagraph (1) of this paragraph, 
which bears to the total of such earnings and profits the same ratio 
which the part (computed on a daily basis) of such year during which 
such corporation is a controlled foreign corporation (or, in case such 
corporation is not a controlled foreign corporation, during which such 
other corporation is a controlled foreign corporation) bears to the 
total taxable year. If the United States shareholder by sufficient 
records and accounts establishes to the satisfaction of the district 
director the gross income received or accrued, and the deductions paid 
or accrued, for the part of such year during which such corporation is a 
controlled foreign corporation (or, in case such corporation is not a 
controlled foreign corporation, during which such other corporation is a 
controlled foreign corporation), the amount of earnings and profits 
based on such records and accounts may be used in lieu of the amount 
determined under the preceding sentence. The application of this 
subdivision may be illustrated by the following examples:

    Example 1. Domestic corporation M on June 30, 1963, purchases 60 
percent of the one class of stock of A Corporation which on July 1 
becomes a controlled foreign corporation and remains such throughout the 
remainder of 1963. Both corporations use the calendar year as the 
taxable year. Corporation M makes a first-tier election with respect to 
A Corporation. For 1963, A Corporation has $100 of earnings and profits, 
as determined under subparagraph (1) of this paragraph. Corporation M's 
proportionate share of such earnings and profits for 1963 is $30.25 
(0.60 x [184/365 x $100]).
    Example 2. (a) Throughout 1963 domestic corporation M directly owns 
20 percent of the one class of stock of foreign corporation A, not a 
controlled foreign corporation at any time, which directly owns 50 
percent of the one class of stock of foreign corporation B, which 
becomes a controlled foreign corporation on July 1, 1963, and remains 
such throughout the remainder of 1963. All such corporations use the 
calendar year as the taxable year. Each of corporations A and B has 
earnings and profits for 1963 of $100, as determined under subparagraph 
(1) of this paragraph. Corporation M makes a chain election for 1963 
with respect to corporations A and B. Corporation M's proportionate 
share of the earnings and profits of A Corporation for 1963 is $10.08 
(0.20 x [184/365 x $100]). Corporation M's proportionate share of the 
earnings and profits of B Corporation for 1963 is $5.04 (0.20 x 0.50 x 
[184/365 x $100]).
    (b) If B Corporation had been a controlled foreign corporation 
throughout 1963, M Corporation's proportionate share of the earnings and 
profits of corporations A and B for 1963 would have been $20 (0.20 x 
$100) and $10 (0.20 x 0.50 x $100), respectively.
    (c) If corporations A and B had each been a controlled foreign 
corporation only for the period of January 1, 1963, through June 30, 
1963, M Corporation's proportionate share of the earnings and profits of 
such corporations would have been $9.92 (0.20 x [181/365 x $100]) and 
$4.98 (0.20 x 0.50 x [181/365 x $100]), respectively.
    (d) If A Corporation had been a controlled foreign corporation 
throughout 1963 or during the period of July 1, 1963, through December 
31, 1963, but B Corporation had been a controlled foreign corporation 
only during the period of January 1, 1963, through June 30, 1963, M 
Corporation's proportionate share of the earnings and profits of such 
corporations would have been $20 (0.20 x $100) and $4.96 (0.20 x 0.50 x 
[181/365 x $100]), respectively.

    (3) Consolidated earnings and profits with respect to United States 
shareholder. The consolidated earnings and profits of a chain or group 
with respect to any United States shareholder for the taxable year shall 
be the sum of such shareholder's proportionate shares of the earnings 
and profits, and of the deficit in earnings and profits, determined 
under subparagraph (2) of this paragraph, for such year of all foreign 
corporations, whether or not controlled foreign corporations, in such 
chain or group.
    (e) Foreign income taxes used in determining effective foreign tax 
rate. For purposes of determining the effective foreign tax rate under 
paragraph (c) of this section--
    (1) Shareholder's proportionate share of taxes of a foreign 
corporation. The foreign income tax of a foreign corporation for a 
taxable year shall consist of the foreign income tax referred to in 
paragraph (d)(1)(ii) of this section with respect to such year and, if 
the United

[[Page 471]]

States shareholder chooses to take the foreign income tax described in 
paragraph (d)(1)(iii) of this section into account in determining the 
effective foreign tax rate of a chain or group which includes such 
foreign corporation, the foreign income tax referred to in such 
paragraph with respect to such year. A United States shareholder's 
proportionate share, with respect to stock to which the election to 
secure an exclusion under section 963 applies, of the foreign income tax 
of such foreign corporation for a taxable year shall be the same 
proportion of such foreign income tax that such shareholder's 
proportionate share (as determined under paragraph (d)(2)(i) of this 
section) of the earnings and profits of such corporation for such year 
bears to the total earnings and profits of such corporation for such 
year. A United States shareholder's proportionate share of the foreign 
income tax, for the taxable year, of a branch treated as a wholly owned 
foreign subsidiary corporation and included in a group under paragraph 
(f)(4) of Sec. 1.963-1 shall be the total foreign income tax of such 
branch for the taxable year.
    (2) Consolidated foreign income taxes with respect to United States 
shareholder. The consolidated foreign income taxes of a chain or group 
with respect to a United States shareholder for the taxable year of such 
chain or group shall be the sum of such shareholder's proportionate 
shares (as determined under subparagraph (1) of this paragraph) of the 
foreign income tax of all foreign corporations, whether or not 
controlled foreign corporations, in such chain or group.
    (3) Taxes paid by foreign corporation on distributions received 
during its distribution period. If a distribution received by a foreign 
corporation in a chain or group from another foreign corporation in such 
chain or group after the close of the recipient's taxable year but 
during its distribution period for such year is allocated to the 
earnings and profits of such recipient corporation for such year under 
paragraph (c)(2) of Sec. 1.963-3, then any foreign income tax paid or 
accrued by such recipient corporation on such distribution shall be 
treated as paid or accrued for such taxable year.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. For 1966, domestic corporation M makes a first-tier 
election with respect to controlled foreign corporation A, 80 percent of 
the one class of stock of which M Corporation owns directly. Both 
corporations use the calendar year as the taxable year. For 1966, A 
Corporation has earnings and profits (before reduction for foreign 
income tax) of $100 with respect to which it pays foreign income tax of 
$30. Its earnings and profits are $70 ($100-$30). Corporation M's 
proportionate share of such earnings and profits is $56 (0.80 x $70), 
and its proportionate share of the foreign income tax is $24 ($56/$70 x 
$30). The effective foreign tax rate is 30 percent ($24/[$56 + $24]). 
Based on such effective foreign tax rate, the statutory percentage under 
section 963(b)(3) for 1966 is 69 percent. Thus, the amount of the 
minimum distribution which M Corporation must receive from A 
Corporation's 1966 earnings and profits is a dividend of $38.64 (0.69 x 
$56).
    Example 2. For 1966, domestic corporation M makes a first-tier 
election with respect to controlled foreign corporation A, all of whose 
one class of stock M Corporation owns directly. Both corporations use 
the calendar year as the taxable year. For 1966, A Corporation has 
earnings and profits (before reduction for income tax) of $100, of which 
$40 is attributable to income from sources within the United States on 
which $12 United States income tax is paid. The foreign country in which 
A Corporation is incorporated imposes an income tax at 30 percent on the 
$100 but allows a credit against its tax for the $12 of United States 
income tax, so that it imposes a net foreign income tax of $18 for 1966. 
In determining the effective foreign tax rate of A Corporation for 1966, 
such $12 of United States income tax may be treated as foreign income 
tax to the extent it does not exceed $17.28 ($40 x 0.90 x 0.48). 
Corporation A has earnings and profits of $70 for 1966. Although A 
Corporation's effective foreign tax rate for 1966 is 30 percent, 
determined by dividing $30 by the sum of $70 plus $30, none of the 
United States tax which is taken into account in determining such rate 
shall be treated as foreign income tax for purposes of determining the 
foreign tax credit of M Corporation under section 902. Based on such 
effective foreign tax rate, the statutory percentage under section 
963(b)(3) for 1966 is 69 percent. Thus, the amount of the minimum 
distribution which M Corporation must receive from A Corporation's 1966 
earnings and profits is a dividend of $48.30 (0.69 x $70).
    Example 3. Domestic corporation M directly owns throughout 1966, 60 
percent of the one class of stock of controlled foreign corporation A, 
not a less developed country corporation under section 902(d), which has

[[Page 472]]

for 1966 earnings and profits of $70 (all of which is attributable to 
subpart F income) after having paid foreign income tax of $30. Both 
corporations use the calendar year as the taxable year. Corporation A is 
created under the laws of a foreign country which imposes a 6-percent 
dividend withholding tax. Corporation M would be required, but for 
section 963, to include $42 (0.60 x $70) of A Corporation's subpart F 
income in gross income under section 951(a)(1)(A)(i). For 1966, however, 
M Corporation makes a first-tier election with respect to A Corporation. 
Since the tax withheld on distributions made by A Corporation is 
considered to have been paid by M Corporation, the effective foreign tax 
rate applicable to A Corporation for 1966 is only 30 percent, the 
percentage which such $30 of foreign income tax is of $100 (the sum of 
$30 plus $70). Thus, the statutory percentage under section 963(b) for 
1966 is 69 percent. The amount of the minimum distribution which M 
Corporation must receive from A Corporation's 1966 earnings and profits 
is the distribution M Corporation will receive if A Corporation 
distributes 69 percent of its earnings and profits for 1966. Thus, if M 
Corporation receives a distribution of 69 percent of its proportionate 
share of such earnings and profits or $28.98 (0.69 x 0.60 x $70), it may 
exclude from gross income for 1966 $42 otherwise required to be included 
in gross income under section 951(a)(1)(A)(i) and will determine its 
income tax, assuming no other income and no surtax exemption under 
section 11(c), as follows:

Dividend.......................................................   $28.98
Gross-up under section 78 ($28.98/ $70 x $30)..................    12.42
Taxable income.................................................    41.40
U.S. tax before foreign tax credit ($41.40 x 0.48).............    19.87
Foreign tax credit ($12.42 + [0.06 x $28.98])..................    14.16
U.S. tax payable...............................................     5.71
 

    Example 4. (a) For 1966 domestic corporation M makes a chain 
election with respect to controlled foreign corporation A, all of whose 
one class of stock it directly owns, and controlled foreign corporation 
B, all of whose one class of stock is directly owned by A Corporation. 
Both foreign corporations are subject to a foreign income tax at a flat 
rate of 30 percent, and all corporations use the calendar year as a 
taxable year. For 1966, B Corporation has pretax earnings and profits of 
$100 and distributes $51.50. For 1966, A Corporation has pretax earnings 
and profits of $151.50, consisting of $100 from selling activities and 
$51.50 received as a distribution from B Corporation, upon which it pays 
a foreign income tax of $45.45 (i.e., 30 percent of $151.50).
    (b) Corporation M chooses under paragraph (d)(1)(iii) of this 
section to take the foreign tax paid by A Corporation on the dividend 
received from B Corporation into account in determining the effective 
foreign tax rate of the chain rather than count it toward the amount of 
the minimum distribution. Thus, to determine consolidated earnings and 
profits of the chain for 1966, A Corporation's pretax earnings and 
profits of $151.50 are first reduced by the intercorporate dividend of 
$51.50 received from B Corporation so that A Corporation has pretax and 
predistribution earnings and profits of $100 ($151.50 less $51.50). 
Corporation A's pretax and predistribution earnings and profits of $100 
are then reduced by the foreign income tax of $30 (30 percent of $100) 
paid on such earnings and profits, resulting in predistribution earnings 
and profits of $70 ($100 less $30). Since M Corporation chooses to count 
toward the effective foreign tax rate, rather than toward the minimum 
distribution, A Corporation's foreign income tax of $15.45 (0.30 x 
51.50) imposed on the dividend received from B Corporation, such 
predistribution earnings and profits of $70 of A Corporation are further 
reduced by such $15.45 of tax to $54.55 ($70-$15.45). Corporation B, 
having received no dividends from any other corporation in the chain, 
has predistribution earnings and profits of $70 ($100 less foreign 
income tax of $30).
    (c) The consolidated earnings and profits of the chain for 1966 are 
$124.55 ($54.55 + $70). The consolidated foreign income taxes for such 
year are $75.45 ($30 + $15.45 + $30). The effective foreign tax rate of 
the chain for 1966 is 37.73 percent ($75.45/[$124.55 + $75.45]). The 
statutory percentage for 1966 under section 963(b)(3) is 51 percent. 
Thus, the amount of the minimum distribution which M Corporation must 
receive from the 1966 consolidated earnings and profits of the chain is 
$63.52 (0.51 x $124.55).
    Example 5. The facts are the same as in example 4 except that M 
Corporation does not choose under paragraph (d)(1)(iii) of this section 
to take into account, in determining the effective foreign tax rate, the 
foreign income tax of $15.45 paid by A Corporation on the distribution 
of $51.50 received from B Corporation. In such case, the consolidated 
earnings and profits of the chain are $140 ($70 + $70) and the 
consolidated foreign income taxes are $60 ($30 + $30), the latter amount 
being determined without taking into account A Corporation's foreign 
income tax of $15.45 on the distribution of $51.50 received from B 
Corporation. The effective foreign tax rate for 1966 is 30 percent ($60/
[$140 + $60]), and the statutory percentage under section 963(b) is 69 
percent. Thus, the amount of the minimum distribution which must be made 
from the 1966 consolidated earnings and profits of the chain is $96.60 
(0.69 x $140). For the counting of such $15.45 of A Corporation's tax 
toward the $96.60 amount of the minimum distribution, see paragraph 
(b)(2) of Sec. 1.963-3.
    Example 6. For 1966 domestic corporation M directly owns the 
following percentages of the one class of stock of the following 
controlled foreign corporations in respect of

[[Page 473]]

which it makes a group election: 80 percent of A Corporation, 60 percent 
of B Corporation, and 70 percent of C Corporation. All corporations use 
the calendar year as the taxable year; none of the foreign corporations 
is a less developed country corporation under section 902(d). Each 
foreign corporation makes distributions during 1966. The consolidated 
earnings and profits, and the consolidated foreign income taxes, of the 
group for 1966 with respect to M Corporation, and the amount of the 
minimum distribution which M Corporation must receive, are determined as 
follows, based on the earnings and profits and foreign income tax shown 
in the following table:

------------------------------------------------------------------------
                                                    Controlled foreign
                                                       corporations
                                                 -----------------------
                                                    A      B        C
------------------------------------------------------------------------
Predistribution and pretax earnings and profits.   $100   $100   $100.00
Foreign income tax..............................     15     25     35.00
Predistribution earnings and profits............     85     75     65.00
M Corporation's proportionate share of earnings
 and profits:
  (0.80 x $85)..................................     68
  (0.60 x $75)..................................  .....     45
  (0.70 x $65)..................................  .....  .....     45.50
Consolidated earnings and profits with respect    .....  .....    158.50
 to M Corporation ($68 + $45 + $45.50)..........
M Corporation's proportionate share of foreign
 income tax:
  ($15 x [$68/$85]).............................     12
  ($25 x [$45/$75]).............................  .....     15
  ($35 x [$45.50/$65])..........................  .....  .....     24.50
Consolidated foreign income taxes with respect    .....  .....     51.50
 to M Corporation ($12 + $15 + $24.50)..........
------------------------------------------------------------------------


The effective foreign tax rate for 1966 is 24.5 percent ($51.50/[$158.50 
+ $51.50]) and the statutory percentage under section 963(b)(3) for such 
year is 76 percent. Thus, the amount of the minimum distribution which M 
Corporation must receive from the 1966 consolidated earnings and profits 
of the group is $120.46 (0.76 x $158.50).
    Example 7. (a) For 1966 domestic corporation M makes a chain 
election with respect to the following controlled foreign corporations: 
A Corporation, 80 percent of whose one class of stock M Corporation owns 
directly; B Corporation, 60 percent of whose one class of stock is 
directly owned by A Corporation; and C Corporation, 70 percent of whose 
one class of stock is directly owned by B Corporation. All corporations 
use the calendar year as the taxable year; none of the foreign 
corporations is a less developed country corporation under section 
902(d). The predistribution and pretax earnings and profits of each 
foreign corporation are $100. Each foreign corporation pays a flat rate 
of foreign income tax on all income computed without reduction for 
dividends paid and determined by including dividends received. Such rate 
is 15 percent for A Corporation, 25 percent for B Corporation, and 35 
percent for C Corporation. Corporation C distributes $65, and B 
Corporation distributes $100, for 1966. Corporation M chooses under 
paragraph (d)(1)(iii) of this section to count toward the effective 
foreign tax rate, rather than toward the amount of the minimum 
distribution, the foreign income tax paid by corporations A and B, 
respectively, on distributions received from corporations B and C, 
respectively.
    (b) The consolidated earnings and profits, and the consolidated 
foreign income taxes, of the chain, and the amount of the minimum 
distribution for 1966, with respect to M Corporation are determined as 
follows:

------------------------------------------------------------------------
                                      Controlled foreign corporations
                                 ---------------------------------------
                                      A         B         C       Total
------------------------------------------------------------------------
Pretax earnings and profits.....   $160.00   $145.50   $100.00
Reduction for intercorporate
 dividends:
  (0.60 x $100).................     60.00
  (0.70 x $65)..................  ........     45.50
                                 ------------------------------
Pretax and predistribution          100.00    100.00    100.00
 earnings and profits...........
Reduction for foreign income tax
 on such pretax and
 predistribution earnings and
 profits:
  (0.15 x $100).................     15.00
  (0.25 x $100).................  ........     25.00
  (0.35 x $100).................  ........  ........     35.00
                                 ------------------------------
Predistribution earnings and         85.00     75.00     65.00
 profits........................
Reduction for foreign income tax
 on intercorporate distributions
 of 1966 earnings and profits:
  (0.15 x $60)..................      9.00
  (0.25 x $45.50)...............  ........     11.38
                                 ------------------------------
                                     76.00     63.62     65.00
                                 ==============================
Consolidated earnings and
 profits with respect to M
 Corporation:
  (0.80 x $76)..................     60.80
  (0.80 x 0.60 x $63.62)........  ........     30.54

[[Page 474]]

 
  (0.80 x 0.60 x 0.70 x $65)....  ........  ........     21.84   $113.18
Consolidated foreign income
 taxes with respect to M
 Corporation:
  ($60.80/$76 x [$15 + $9]).....     19.20
  ($30.54/$63.62 x [$25 +         ........     17.46
   $11.38]).....................
  ($21.84/$65 x $35)............  ........  ........     11.76    $48.42
Effective foreign tax rate        ........  ........  ........    29.96%
 ($48.42/[$113.18 + $48.42])....
Statutory percentage under        ........  ........  ........       69%
 section 963(b).................
Amount of minimum distribution    ........  ........  ........     $78.0
 which M Corporation must
 receive from 1966 consolidated
 earnings and profits (0.69 x
 $113.18), no amount of the tax
 on intercorporate distributions
 being counted toward the
 minimum distribution...........
------------------------------------------------------------------------

    Example 8. The facts are the same as in example 7 except that M 
Corporation does not choose under paragraph (d)(1)(iii) of this section 
to take into account, in determining the effective foreign tax rate, the 
foreign income tax paid by the recipient corporations on the 
intercorporate distributions. The consolidated earnings and profits, the 
consolidated foreign income taxes, of the chain, and the amount of the 
minimum distribution which M Corporation must receive, for 1966 are 
determined as follows:

------------------------------------------------------------------------
                                      Controlled foreign corporations
                                 ---------------------------------------
                                      A         B         C       Total
------------------------------------------------------------------------
Pretax earnings and profits.....   $160.00   $145.50   $100.00
Reduction for intercorporate
 dividends:
  (0.60 x $100).................     60.00
  (0.70 x $65)..................  ........     45.50
                                 ------------------------------
Pretax and predistribution          100.00    100.00    100.00
 earnings and profits...........
Reduction for foreign income tax
 on such pretax and
 predistribution earnings and
 profits:
  (0.15 x $100).................     15.00
  (0.25 x $100).................  ........     25.00
  (0.35 x $100).................  ........  ........     35.00
------------------------------------------------------------------------
Predistribution earnings and         85.00     75.00     65.00
 profits........................
Consolidated earnings and
 profits with respect to M
 Corporation:
  (0.80 x $85)..................     68.00
  (0.80 x 0.60 x $75)...........  ........     36.00
  (0.80 x 0.60 x 0.70 x $65)....  ........  ........     21.84   $125.84
Consolidated foreign income
 taxes with respect to M
 Corporation:
  ($68/$85 x $15)...............     12.00
  ($36/$75 x $25)...............  ........     12.00
  ($21.84/$65 x $35)............  ........  ........     11.76    $35.76
Effective foreign tax rate        ........  ........  ........    22.13%
 ($35.76/[$125.84 + $35.76])....
Statutory percentage under        ........  ........  ........       76%
 section 963(b).................
Amount of minimum distribution    ........  ........  ........    $95.64
 to be made from 1966
 consolidated earnings and
 profits with respect to M
 Corporation: (0.76 x $125.84)..
Foreign income tax on
 intercorporate distributions of
 1966 earnings and profits which
 is counted toward the minimum
 distribution (see Sec. 1.963-
 3(b)(2)):
  ($68/$85 x [0.15 x $60])......      7.20
  ($36/$75 x [0.25 x $45.50])...  ........      5.46  ........    $12.66
Amount of minimum distribution    ........  ........  ........    $82.98
 which M Corporation must
 actually receive from the chain
 ($95.64-$12.66)................
------------------------------------------------------------------------


[T.D. 6759, 29 FR 13329, Sept. 25, 1964, as amended by T.D. 6767, 29 FR 
14877, Nov. 3, 1964; T.D. 7100, 36 FR 5335, Mar. 20, 1971]



Sec. 1.963-3  Distributions counting toward a minimum distribution.

    (a) Conditions under which earnings and profits are counted toward a 
minimum distribution--(1) In general. A distribution to the United 
States shareholder by a single first-tier corporation or by a foreign 
corporation included in a chain or group shall count toward a minimum 
distribution for the taxable year of such shareholder to which the 
election under section 963 relates only to the extent that--

[[Page 475]]

    (i) It is received by such shareholder during such year or within 
180 days thereafter,
    (ii) It is a distribution of the type described in paragraph (b) of 
this section,
    (iii) Under paragraph (c) of this section, it is deemed to be 
distributed from the earnings and profits of the foreign corporations 
for the taxable year of such corporation to which the election relates, 
and
    (iv) Such shareholder chooses to include it in gross income for the 
taxable year of such shareholder to which the election relates 
notwithstanding that such distribution, by reason of its receipt after 
the close of such year, would ordinarily be includible in the gross 
income of a subsequent year.


Amounts taken into account under this subparagraph as gross income of 
the United States shareholder for the taxable year to which the election 
relates shall not be considered to be includible in the gross income of 
such shareholder for a subsequent taxable year. For purposes of 
determining the foreign tax credit under sections 901 through 905, 
foreign income tax paid or accrued by such shareholder on or with 
respect to such amounts shall be treated as paid or accrued during the 
taxable year of such election.
    (2) Distributions made prior to acquisition of stock. A United 
States shareholder which owns within the meaning of section 958(a) stock 
in a foreign corporation with respect to which such shareholder elects 
to secure an exclusion under section 963 for the taxable year may count 
toward the minimum distribution any distribution made with respect to 
such stock, and before its acquisition by the United States shareholder, 
to any other domestic corporation not exempt from income tax under 
chapter 1 of the Code, to the extent that such distribution is made out 
of the United States shareholder's proportionate share, as determined 
under paragraph (d)(2) of Sec. 1.963-2, of such corporation's earnings 
and profits for the taxable year and would have counted toward a minimum 
distribution if it had been distributed to such United States 
shareholder. The application of this subparagraph may be illustrated by 
the following examples:

    Example 1. Controlled foreign corporation A, which uses the calendar 
year as the taxable year, has for 1963 $100 of earnings and profits and 
100 shares of only one class of stock outstanding. Domestic corporation 
M, not exempt from income tax under chapter 1 of the Code, directly owns 
all of such shares during the period from January 1, 1963, through June 
30, 1963. On June 30, 1963, M Corporation transfers all of such shares 
to domestic corporation N, which owns them throughout the remainder of 
1963 and elects to secure an exclusion under section 963 for such year 
with respect to the subpart F income of A Corporation. During June 1963, 
M Corporation receives a dividend of $75 from A Corporation, which would 
count toward a minimum distribution if it had been distributed to N 
Corporation for such year. Corporation N's proportionate share of the 
earnings and profits of A Corporation for 1963 is $100; N Corporation 
may count toward a minimum distribution for 1963 the entire dividend of 
$75 paid to M Corporation.
    Example 2. The facts are the same as in example 1 except that M is a 
nonresident alien individual. Since A Corporation is not a controlled 
foreign corporation from January 1, 1963, through June 30, 1963, N 
Corporation's proportionate share of the earnings and profits of A 
Corporation for 1963 is $50.41 ($100 x 184/365), as determined under 
paragraph (d)(2)(iii) of Sec. 1.963-2. Although $25.41 ($75-$49.59) of 
the $75 distribution to M is paid from N Corporation's proportionate 
share of A Corporation's 1963 earnings and profits, N Corporation may 
not count toward a minimum distribution any part of the $75 dividend 
distributed to M, since M is not a domestic corporation.

    (b) Qualifying distributions--(1) Amounts not counted toward a 
minimum distribution. No distribution received by a United States 
shareholder shall count toward a minimum distribution for the taxable 
year with respect to such shareholder to the extent the distribution is 
excludable from gross income to the extent gain on the distribution is 
not recognized, or to the extent the distribution is treated as a 
distribution in part or full payment in exchange for stock. 
Undistributed amounts required to be included in gross income under 
section 551 as undistributed foreign personal holding company income or 
under section 951 as undistributed amounts of a controlled foreign 
corporation shall not count toward a minimum distribution under section 
963. An amount received by a United States shareholder as a distribution 
which under section 302 or

[[Page 476]]

section 331 is treated as a distribution in part or full payment in 
exchange for stock shall not count toward a minimum distribution even 
though such amount is includible in gross income under section 1248 as a 
dividend. For purposes of this subparagraph, any portion of a 
distribution of earnings and profits which is attributable to an 
increase in current earnings, invested in United States property which, 
but for paragraph (e) of this section, would be included in the gross 
income of the United States shareholder under section 951(a)(1)(B) shall 
not be treated as an amount excludable from gross income.
    (2) Inclusion of tax on intercorporate distributions. In the case of 
a chain or group election, the United States shareholder's proportionate 
share of the amount of the foreign income tax paid or accrued for the 
taxable year by a foreign corporation in the chain or group with respect 
to distributions received by such corporation from the earnings and 
profits, of another foreign corporation in such chain or group, for the 
taxable year of such other corporation to which the election relates 
shall count toward a minimum distribution from such chain or group for 
the taxable year, but only if the United States shareholder does not 
choose under paragraph (d)(1)(iii) of Sec. 1.963-2 to take such tax 
into account in determining the effective foreign tax rate of such chain 
or group for the taxable year. To the extent that foreign income tax 
counts toward a minimum distribution under this subparagraph, it shall 
be applied against and reduce the amount of the minimum distribution 
required to be received by the United States shareholder, determined 
without regard to this paragraph.
    (c) Rules for allocation of distributions to earnings and profits 
for a taxable year. To determine whether a distribution to the United 
States shareholder by a single first-tier corporation or by a foreign 
corporation in a chain or group is made from the earnings and profits of 
such corporation for the taxable year to which the election under 
section 963 relates, the following subparagraphs shall apply:
    (1) Exception to section 316. Section 316 shall apply except that a 
distribution of earnings and profits made by a foreign corporation 
either to another foreign corporation or to the United States 
shareholder shall be treated as having been paid from the earnings and 
profits of the distributing corporation for the taxable year of such 
corporation to which the election relates only if it is made during its 
distribution period (described in paragraph (g) of this section) for 
such year.
    (2) Distributions from other corporations. The earnings and profits 
of a foreign corporation shall be determined in accordance with 
paragraph (d)(1) of Sec. 1.963-2 (applied as though the United States 
shareholder had chosen under subparagraph (1)(iii) of such paragraph to 
take the tax described therein into account in determining the effective 
foreign tax rate) except that, in the case of a chain or group election, 
a distribution received by a foreign corporation in the chain or group 
from another foreign corporation in such chain or group shall be taken 
into account as earnings and profits of the recipient corporation for 
the taxable year of such recipient corporation to which the election 
relates but only to the extent that--
    (i) The distribution is received by the recipient corporation during 
the distribution period for the taxable year of such recipient 
corporation to which the election relates,
    (ii) If the distribution had been received by the United States 
shareholder, it would have constituted a distribution of the type 
described in paragraph (b) of this section, and
    (iii) The distribution is made from the earnings and profits of the 
distributing corporation for the taxable year of such distributing 
corporation to which the election relates.
    (d) Year of inclusion in income of foreign corporation and effect 
upon subpart F income. To the extent that a distribution to the United 
States shareholder counting toward a minimum distribution from a chain 
or group consists of earnings and profits distributed to a foreign 
corporation in the chain or group after the close of the recipient 
corporation's taxable year but during its distribution period for such 
year by another foreign corporation in such chain or group, such amount 
shall be

[[Page 477]]

treated as received by the recipient corporation on the last day of such 
taxable year and shall not be regarded as foreign personal holding 
company income (within the meaning of section 553(a) or 954(c)) of such 
corporation for the taxable year in which such amount is actually 
received. The extent to which a distribution counting toward a minimum 
distribution consists of earnings and profits distributed to a foreign 
corporation in a chain or group shall be determined under the ordering 
rules of paragraph (b)(3) of Sec. 1.963-4 (applied in each instance as 
though the United States shareholder had not chosen under paragraph 
(d)(1)(iii) of Sec. 1.963-2 to take the tax described therein into 
account in determining the effective foreign tax rate). However, for 
such purpose, the amount of foreign income tax, if any, which counts 
toward the minimum distribution shall be determined without regard to 
paragraph (b)(2) of this section but in accordance with paragraph 
(b)(3)(iii) of Sec. 1.963-4.
    (e) Distribution of current earnings invested in United States 
property. A distribution made by a foreign corporation during its 
distribution period for a taxable year shall, notwithstanding section 
959(c), first be attributed to earnings and profits for such year 
described in section 959(c)(3) and then to other earnings and profits. 
For such purposes, earnings and profits of such foreign corporation for 
such year attributable to amounts which would otherwise be included in 
gross income of the United States shareholder under section 951(a)(1)(B) 
for such year shall be treated as earnings and profits to which section 
959(c)(3) applies, shall not be excluded from gross income under section 
959 (a) or (b), and shall count toward a minimum distribution for such 
year. See paragraph (c)(1)(v) of Sec. 1.960-1 and paragraph (a) of 
Sec. 1.960-2.
    (f) Cumulative dividends in arrears. A distribution in satisfaction 
of arrearages shall be treated as being made out of earnings and profits 
of the foreign corporation for the taxable year to which the election 
under section 963 applies only to the extent the dividend is not 
attributed, under paragraph (d)(2)(i)(d) of Sec. 1.963-2, to the 
earnings and profits of such corporation remaining from prior taxable 
years beginning after December 31, 1962. The application of this 
paragraph may be illustrated by the following example:

    Example. For 1963, single first-tier corporation A, which uses the 
calendar year as the taxable year, has earnings and profits of $50; for 
1964, a deficit in earnings and profits of $20; for 1965, earnings and 
profits of $100; and for 1966, earnings and profits of $240. For each of 
such years preferred dividends accumulate at the rate of $60; but no 
dividend is paid until 1966 during which year the current dividend is 
paid and $180 is distributed toward the arrearages. Of this $180, only 
$50 ($180-$130) shall be treated as paid from 1966 earnings and profits.

    (g) Distribution period of a foreign corporation--(1) General 
distribution period. Except as provided by subparagraph (2) of this 
paragraph, the distribution period with respect to a foreign corporation 
for its taxable year shall begin immediately after the close of the 
distribution period for the preceding taxable year and shall end with 
the close of the 60th day of the next succeeding taxable year. If no 
election to secure an exclusion under section 963 applied to the 
preceding taxable year, the distribution period for the taxable year 
shall begin with the 61st day of the taxable year.
    (2) Special extended distribution period. If the United States 
shareholder of the foreign corporation so elects in statement filed with 
its return for the taxable year for which the election to secure the 
exclusion under section 963 is made, the distribution period with 
respect to such foreign corporation for its taxable year to which the 
election to secure the exclusion applies shall end with any day which 
occurs no earlier than the last day of such taxable year of such foreign 
corporation and no later than the 180th day after the close of such 
taxable year. The statement shall designate the day so elected as the 
end of the distribution period.
    (h) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. For 1963 domestic corporation M makes a chain election 
with respect to controlled foreign corporation A, all of whose one class 
of stock M Corporation directly owns, and controlled foreign corporation 
B, all of whose one class of stock is directly owned by A Corporation. 
All such corporations use the calendar year as the taxable

[[Page 478]]

year, and the distribution periods of corporations A and B for 1963 
coincide. Corporations A and B each have earnings and profits (before 
distributions) of $100 for 1963. On June 1, 1963, B Corporation 
distributes earnings and profits of $120, of which $100 is from its 
earnings and profits for 1963 and $20 is from prior earnings. For 1963, 
A Corporation pays no income tax and distributes earnings and profits of 
$150 to M Corporation. Under paragraph (c) of this section, such $150 is 
allocated to A Corporation's earnings and profits of $200 for 1963, 
consisting of its total earnings and profits for that year of $220 less 
the $20 received as a distribution from B Corporation's prior earnings.
    Example 2. Domestic corporation M directly owns all of the one class 
of stock of controlled foreign corporation A. Both corporations use the 
calendar year as the taxable year, and A Corporation's taxable year and 
its distribution period for 1963 coincide. For 1963, $50 is included in 
the gross income of M Corporation under section 951(a)(1)(B) as A 
Corporation's increase in earnings invested for such year in United 
States property. For 1964, M Corporation makes a first-tier election 
with respect to A Corporation. For 1964, A Corporation has earnings and 
profits of $100, including $10 attributable to an increase in earnings 
invested for such year in United States property. During 1964, A 
Corporation distributes earnings and profits of $80 to M Corporation. 
Without regard to paragraph (e) of this section, $10 of this 
distribution is attributable under section 959(c)(1) to A Corporation's 
1964 earnings and profits required to be included in M Corporation's 
gross income under section 951(a)(1)(D). Pursuant to paragraph (e) of 
this section, however, the entire distribution of $80 counts toward a 
minimum distribution for 1964 and is considered to be from earnings and 
profits of A Corporation for 1964 described in section 959(c)(3). Thus 
the entire distribution of $80 is included in M Corporation's gross 
income as a dividend and the foreign tax credit in respect of such 
amount is determined in accordance with section 902 as modified by the 
regulations under section 963. On the other hand, if A Corporation made 
no distributions for 1964, no part of the $10 of A Corporation's 
increase in earnings invested in United States property for such year 
would count toward a minimum distribution for any other year but would 
be included in the gross income for M Corporation for 1964 under section 
951(a)(1)(B), and the foreign tax credit in respect of such amount would 
be determined in accordance with Sec. 1.960-1.
    Example 3. For 1964 domestic corporation M makes a chain election 
with respect to controlled foreign corporation A, all the one class of 
stock of which is owned directly by M Corporation, and controlled 
foreign corporation B, all the one class of stock of which is owned 
directly by A Corporation. Corporation M makes no election under section 
963 for 1963 or 1965. Corporations M and B use the calendar year as the 
taxable year, and A Corporation uses for its taxable year a fiscal year 
ending on September 30. Corporation M elects to have the distribution 
period for each controlled foreign corporation end on March 29, 1965, 
such date being the 180th day after the close of A Corporation's taxable 
year ending on September 30, 1964. Corporation A's distribution period 
for its taxable year ending on September 30, 1964, begins on November 
30, 1963, the 61st day of such taxable year. The distribution period of 
B Corporation for 1964 begins on March 1, 1964, the 61st day of such 
taxable year. A distribution counting toward a minimum distribution for 
1964 may be made from the earnings and profits of B Corporation only if 
the amount thereof is distributed by B Corporation to A Corporation, and 
in turn by A Corporation to M Corporation, during the period of March 1, 
1964, through March 29, 1965.
    Example 4. The facts are the same as in example 3, except that for 
their taxable years ending in 1964, corporations A and B each have 
earnings and profits (before distributions) of $100. On March 10, 1965, 
B Corporation distributes to A Corporation a dividend of $80 upon which 
A Corporation incurs foreign income tax at the rate of 10 percent. On 
March 15, 1965, A Corporation distributes to M Corporation a dividend of 
$50. Corporation M chooses to take into account as gross income for 1964 
from such distribution only $40. For purposes of applying this section, 
the distribution counting toward a minimum distribution is $44.44, 
consisting of the $40 of earnings and profits actually received by M 
Corporation plus the $4.44 ($40/$72 x $8) of foreign income tax incurred 
by A Corporation attributable thereto; A Corporation is deemed to have 
received $44.44 ($40 / 0.90) of the distribution from B Corporation on 
September 30, 1964, the last day of the taxable year of A Corporation to 
which the election relates; and the foreign personal holding company 
income derived by A Corporation for its taxable year ending in 1965 from 
the distribution from B is only $35.56 ($80-$44.44). Assuming that no 
exceptions, exclusions, or exemptions were applicable, subpart F income 
would be realized by A Corporation for its taxable year ending on 
September 30, 1965, upon the distribution by B Corporation to A 
Corporation, but only in the amount of $32 ($35.56 less a deduction 
under section 954(b)(5) for taxes of $3.56).

[T.D. 7100, 36 FR 10860, June 4, 1971; 36 FR 11924, June 23, 1971, as 
amended by T.D. 7334, 39 FR 44214, Dec. 23, 1974]

[[Page 479]]



Sec. 1.963-4--1.963-5  [Reserved]



Sec. 1.963-6  Deficiency distribution.

    (a) In general. Section 963(e)(2) and this section provide a method 
under which, by virtue of a deficiency distribution, a United States 
shareholder may be relieved from the payment of a deficiency in tax for 
any taxable year arising by reason of failure to include subpart F 
income in gross income under section 951(a)(1)(A)(i), when it has been 
determined that such shareholder has failed to receive a minimum 
distribution for such year in respect of which it elected to secure the 
exclusion under section 963. In addition, this section provides rules 
with respect to a credit or refund of part or all of any such deficiency 
which has been paid. Under the method provided, the benefit of the 
exclusion of subpart F income from gross income of the United States 
shareholder is allowed retroactively for the taxable year in respect of 
which the election under section 963 applied, but only if the subsequent 
deficiency distribution meets the requirements of this section. The 
benefits of the retroactive exclusion will not, however, prevent the 
assessment of interest, additional amounts, and assessable penalties.
    (b) Requirements for deficiency distribution--(1) Distribution made 
on or after date of determination. If--
    (i) A United States shareholder, in making its return of the tax 
imposed by chapter 1 of the Code for any taxable year, elects to secure 
an exclusion under section 963 for such year,
    (ii) It is subsequently determined (within the meaning of paragraph 
(c) of this section) that an exclusion under section 963 of subpart F 
income with respect to stock to which such election relates does not 
apply for such taxable year because of the failure of such shareholder 
to receive a minimum distribution for such year with respect to such 
stock, and
    (iii) Such failure is due to reasonable cause, a deficiency 
distribution which is received by such shareholder with respect to such 
stock from a foreign corporation which was the single first-tier 
corporation, or a corporation in the chain or group, as the case may be, 
with respect to which the election was made, shall count toward a 
minimum distribution under section 963 for such year of election if such 
deficiency distribution is received (except as provided by subparagraph 
(2) of this paragraph) on, or within 90 days after, the date of such 
determination and prior to the filing of a claim under paragraph (d)(1) 
of this section. Such claim must be filed within 120 days after the date 
of such determination, and the deficiency distribution must be a 
dividend of such a nature (except as otherwise provided in this section) 
as would have permitted it to count toward a minimum distribution for 
the taxable year of the election if it had been received by the United 
States shareholder during such year. No distribution shall count as a 
deficiency distribution under this subparagraph unless a claim therefor 
is filed under paragraph (d)(1) of this section.
    (2) Distribution made before date of determination. A deficiency 
distribution may also be received by a United States shareholder at any 
time prior to the date on which the determination required by 
subparagraph (1) of this paragraph is made. A distribution will count as 
a deficiency distribution under this subparagraph--
    (i) To the extent that such distribution otherwise satisfies the 
requirements of this section;
    (ii) If the United States shareholder files within 90 days after 
such distribution but before the determination date an advance claim 
described in paragraph (d)(2) of this section for treatment of such 
distribution as a deficiency distribution;
    (iii) If such shareholder consents in such claim to include such 
deficiency distribution in gross income for the taxable year of the 
election to the extent necessary to complete a minimum distribution for 
such year and under section 6501 to extend the period for the making of 
assessments, and the bringing of distraint or a proceeding in court for 
collection, in respect of a deficiency and all interest, additional 
amounts, and assessable penalties for such taxable year;
    (iv) If, when requested by the district director, such shareholder 
consents

[[Page 480]]

under section 6501 in such claim to extend the period for the making of 
assessments, and the bringing of distraint or a proceeding in court for 
collection, in respect of a deficiency and all interest, additional 
amounts and assessable penalties for the year of receipt of such 
distribution; and
    (v) To the extent that such shareholder makes advance payment of tax 
which would result from the inclusion of such distribution in gross 
income as a minimum distribution for the year of such deficiency.


To the extent that such distribution is not necesasry under the 
determination (when made under paragraph (c) of this section) for a 
deficiency distribution, it shall be included in the United States 
shareholder's gross income for the taxable year of receipt of such 
distribution and paragraph (g) of this section shall not apply.
    (3) Earnings and profits of year of election to be first 
distributed. If--
    (i) In the case of a first-tier election, the United States 
shareholder's proportionate share of the earnings and profits of the 
foreign corporation which was the single first-tier corporation, or
    (ii) In the case of a chain or group election, any portion of the 
share of any corporation or corporations (which were in the chain or 
group) of the consolidated earnings and profits with respect to the 
United States shareholder,


for the taxable year of the election has not been distributed on the 
stock with respect to which the election was made, then a distribution, 
in order to be counted toward a deficiency distribution, must be made by 
such corporation or corporations and from such earnings and profits to 
the extent thereof. Once all such earnings and profits of such 
corporation or corporations have been completely distributed, a 
deficiency distribution may be made from other earnings and profits of 
such foreign corporation which was a single first-tier corporation, or 
of such corporation or corporations which were in such chain or group, 
as the case may be.
    (4) Proof of reasonable cause. Reasonable cause for failure to 
receive a minimum distribution shall be deemed to exist, in the absence 
of circumstances demonstrating bad faith, if the electing United States 
shareholder receives, within the period prescribed by paragraph 
(a)(1)(i) of Sec. 1.963-3 with respect to the year of election, at 
least 80 percent of the amount of a minimum distribution (from the 
earnings and profits to which the election for such year relates) which 
if received during such period would have satisfied the conditions for 
the section 963 exclusion to apply to such year. If less than 80 percent 
of the amount of a minimum distribution is received during such period, 
the existence of a reasonable cause for failure to receive a minimum 
distribution must be established by clear and convincing evidence; 
however, the preceding sentence shall not be taken as a limitation on 
the establishment of reasonable cause by any other proof of reasonable 
cause. For example, reasonable cause will exist if a single first-tier 
corporation for its taxable year makes a distribution which would be a 
minimum distribution but for a refund of foreign income tax which it has 
paid in good faith under foreign law but which is found not to be due 
after the United States income tax return of the United States 
shareholder has been filed.
    (c) Nature and details of determination. (1) A determination that 
the section 963 exclusion does not apply to a United States shareholder 
for a taxable year due to its failure to receive a minimum distribution 
for such year shall, for the purposes of this section, be established 
by--
    (i) A decision by the Tax Court or a judgment, decree, or other 
order by any court of competent jurisdiction, which has become final;
    (ii) A closing agreement made under section 7121; or,
    (iii) An agreement which is signed by the district director, or such 
other official to whom authority to sign the agreement is delegated, and 
by, or on behalf of, such shareholder and which relates to the liability 
of such shareholder for the tax under chapter 1 of the Code for such 
year.
    (2) The date of determination by a decision of the Tax Court shall 
be the date upon which such decision becomes final, as prescribed in 
section 7481.

[[Page 481]]

    (3) The date upon which a judgment of a court becomes final shall be 
determined upon the basis of the facts in the particular case. 
Ordinarily, a judgment of a United States district court shall become 
final upon the expiration of the time allowed for taking an appeal, if 
no such appeal is duly taken within such time; and a judgment of the 
United States Court of Claims shall become final upon the expiration of 
the time allowed for filing a petition for certiorari, if no such 
petition is duly filed within such time.
    (4) The date of determination by a closing agreement made under 
section 7121 shall be the date such agreement is approved by the 
Commissioner.
    (5) The date of a determination made by an agreement which is signed 
by the district director, or such other official to whom authority to 
sign the agreement is delegated, shall be the date prescribed by this 
subparagraph. The agreement shall be sent to the United States 
shareholder at his last known address by either registered or certified 
mail. For further guidance regarding the definition of last known 
address, see Sec. 301.6212-2 of this chapter. If registered mail is 
used for such purpose, the date of registration shall be treated as the 
date of determination; if certified mail is used for such purpose, the 
date of the postmark on the sender's receipt for such mail shall be 
treated as the date of determination. However, if the deficiency 
distribution is received by such shareholder before such registration or 
postmark date but on or after the date the agreement is signed by the 
district director or such other official to whom authority to sign the 
agreement is delegated, the date of determination shall be the date on 
which the agreement is so signed.
    (6) The determination under this paragraph shall find that, due to 
the United States shareholder's failure to receive a minimum 
distribution, the section 963 exclusion does not apply for the taxable 
year with respect to stock to which the election under such section 
relates. A determination described in subdivision (ii) or (iii) of 
subparagraph (1) of this paragraph shall set forth the amount of the 
deficiency distribution and the amount of additional income tax for 
which the United States shareholder is liable under Chapter 1 of the 
Code by reason of not including in gross income for such year the amount 
of the deficiency distribution. If a determination described in 
subdivision (i) of subparagraph (1) of this paragraph does not establish 
the amount of the deficiency distribution and such amount of additional 
tax, such amounts may be established by an agreement which is signed by 
the district director, or such other official to whom authority to sign 
the agreement is delegated.
    (d) Claim for treatment of distribution as a deficiency 
distribution--(1) Claim filed after date of determination. A claim 
(including any amendments thereof) for treatment of a deficiency 
distribution as counting toward a minimum distribution for the taxable 
year of election shall be filed in duplicate, within 120 days after the 
date of the determination described in paragraph (c) of this section, 
with the requisite declaration prescribed by the Commissioner on the 
appropriate claim form and shall be accompanied by--
    (i) A copy of such determination and a description of how it became 
final;
    (ii) If requested by the district director, or by such other 
official to whom authority to sign the agreement referred to in 
paragraph (c)(1) or (6) of this section is delegated, a consent by the 
United States shareholder under section 6501 to extend the period for 
the making of assessments, and the bringing of distraint or a proceeding 
in court for collection, in respect of a deficiency and all interest, 
additional amounts, and assessable penalties for the taxable year of 
election; and
    (iii) Such other information as may be required by the claim form or 
the district director, or other official, in support of the claim.
    (2) Advance claim. An advance claim for treatment of a deficiency 
distribution as counting toward a minimum distribution for the taxable 
year of election shall be filed in duplicate, within 90 days after such 
distribution but before the date of determination described in paragraph 
(c) of this section, and shall satisfy all requirements of subparagraph 
(1) of this paragraph other than subdivision (i) of such subparagraph. 
However, within 120 days

[[Page 482]]

after the date of the determination described in paragraph (c) of this 
section, the advance claim shall be completed so that it satisfies all 
requirements of subparagraph (1) of this paragraph.
    (e) Computation of interest on deficiencies in tax. If a United 
States shareholder, for the taxable year of the election under section 
963, completes a minimum distribution for such year by receiving a 
deficiency distribution to which this section applies, the interest on 
the deficiency in tax due by reason of the failure to include the amount 
of such deficiency distribution in such shareholder's gross income for 
such year shall be computed for the period from the last date prescribed 
for payment of the tax for such year to the date such deficiency in tax 
is paid. No interest shall be due by reason of the failure to include 
Subpart F income in gross income for a taxable year in respect of which 
a minimum distribution under section 963 is completed by a deficiency 
distribution to which this section applies.
    (f) Claim for credit or refund. If a deficiency in tax is asserted 
for any taxable year by reason of failure to include Subpart F income in 
gross income under section 951(a)(1)(A)(i) and the United States 
shareholder has paid any portion of such asserted deficiency, such 
shareholder is entitled to a credit or refund of such payment to the 
extent that such payment constitutes an overpayment of tax as the result 
of the receipt of a deficiency distribution to which this section 
applies. To secure credit or refund of such overpayment of tax, the 
United States shareholder must file a claim for refund in accordance 
with Sec. 301.6402-3, in addition to the claim form required under 
paragraph (d) of this section. No interest shall be allowed on such 
credit or refund. For other rules applicable to the filing of claims for 
credit or refund of an overpayment of tax, see section 6402 and the 
regulations thereunder. For the limitations applicable to the credit or 
refund for an overpayment of tax, see section 6511 and the regulations 
thereunder.
    (g) Effect of deficiency distribution--(1) Allocation of 
distributions. The deficiency distribution shall be allocated, by 
applying the rules of Sec. 1.963-3 (and paragraph (b) of Sec. 1.963-4, 
if applicable for the year of election), as a distribution first from 
the earnings and profits (to the extent thereof) of the foreign 
corporation which was the single first-tier corporation, or of the 
distributing corporation or corporations which were in the chain or 
group, as the case may be, for the taxable year in respect of which the 
election was made, and then from earnings and profits (to the extent 
thereof) described in section 959(c)(3) and determined as provided in 
section 959 for the most recent taxable year and the first, second, 
etc., taxable years preceding such recent taxable years, in that order, 
of the distributing corporation or corporations. In applying the 
preceding sentence to taxable years other than the taxable year in 
respect of which the election was made, the deficiency distribution 
shall first be allocated, in the order of allocation prescribed by such 
sentence, first to taxable years in respect of which no election under 
section 963 was made with respect to the stock on which such 
distribution is received and then to taxable years in respect of which 
an election under such section was made.
    (2) Year of receipt. Any deficiency distribution made with respect 
to a taxable year of the United States shareholder shall be treated, 
except as provided in paragraph (b)(2) of this section, as having been 
received by the shareholder in that year for which such shareholder 
elected to secure an exclusion under section 963; and, for purposes of 
the foreign tax credit under section 901, the foreign income taxes paid 
or accrued, or deemed paid, by the United States shareholder by reason 
of a distribution of any amount treated as a deficiency distribution for 
such year shall be treated as paid or accrued, or deemed paid, for such 
year.
    (3) Year of payment. A distribution counting toward a deficiency 
distribution for a taxable year of election shall, except as provided in 
paragraph (b)(2) of this section, be treated for purposes of applying 
paragraph (a) of Sec. 1.963-3, relating to conditions under which 
earnings and profits are counted toward a minimum distribution, and 
paragraph (b)(3) of Sec. 1.963-4, relating to rules for distributing 
through a chain

[[Page 483]]

or group, as if it were distributed during the distribution period (as 
defined in paragraph (g) of Sec. 1.963-3) with respect to the 
distributing corporation and each foreign corporation through which such 
distribution is made to the United States shareholder, for the taxable 
year to which the election under section 963 applies; and the foreign 
income taxes paid by any foreign corporation by reason of such 
distribution shall, in the application of section 902 and of the special 
rules of paragraph (c) of Sec. 1.963-4, be treated as paid or accrued 
by such foreign corporation for its taxable year to which such election 
applies. The distribution shall not count toward a minimum distribution 
for any other taxable year.
    (4) Allocation of reduction in tax credit. If any portion of a 
deficiency distribution from a corporation which was in a chain or group 
is paid from earnings and profits of a taxable year other than that in 
respect of which the election was made, then the minimum distribution 
toward which such deficiency distribution counts may not be treated as a 
pro rata minimum distribution for purposes of Sec. 1.963-4. Moreover, 
the amount of the overall United States and foreign income tax with 
respect to such minimum distribution must satisfy the minimum tax 
requirements of paragraph (a)(1)(i), or paragraph (ii), of Sec. 1.963-
4, but, if the latter applies, without any reduction and deferral under 
paragraph (c)(3) of such section of the foreign tax credit allowable 
under section 901 with respect to the deficiency distribution.

[T.D. 6759, 29 FR 13346, Sept. 25, 1964, as amended by T.D. 6767, 29 FR 
14879, Nov. 3, 1964; T.D. 7410, 41 FR 11020, Mar. 16, 1976; T.D. 8939, 
66 FR 2819, Jan. 12, 2001]



Sec. 1.964-1  Determination of the earnings and profits of a foreign
corporation.

    (a)(1) In general. For rules for determining the earnings and 
profits (or deficit in earnings and profits) of a foreign corporation 
for taxable years beginning before January 1, 1987, for purposes of 
sections 951 through 964, see 26 CFR 1.964-1(a) (revised as of April 1, 
2006). For taxable years beginning after December 31, 1986, except as 
otherwise provided in the Code and regulations, the earnings and profits 
(or deficit in earnings and profits) of a foreign corporation for its 
taxable year shall be computed for all Federal income tax purposes 
substantially as if such corporation were a domestic corporation by--
    (i) Preparing a profit and loss statement with respect to such year 
from the books of account regularly maintained by the corporation for 
the purpose of accounting to its shareholders.
    (ii) Making the adjustments necessary to conform such statement to 
the accounting principles described in paragraph (b) of this section; 
and
    (iii) Making the further adjustments necessary to conform such 
statement to the tax accounting standards described in paragraph (c) of 
this section.
    (2) Required adjustments. The computation described in paragraph 
(a)(1) of this section shall be made in the foreign corporation's 
functional currency (determined under section 985 and the regulations 
under that section) and may be made by following the procedures 
described in paragraphs (a)(1)(i) through (a)(1)(iii) of this section in 
an order other than the one listed, as long as the result so obtained 
would be the same. In determining earnings and profits, or the deficit 
in earnings and profits, of a foreign corporation under section 964, the 
amount of an illegal bribe, kickback, or other payment (within the 
meaning of section 162(c), as amended by section 288 of the Tax Equity 
and Fiscal Responsibility Act of 1982 in the case of payments made after 
September 3, 1982, and the regulations issued pursuant to section 964) 
paid after November 3, 1976, by or on behalf of the corporation during 
the taxable year of the corporation directly or indirectly to an 
official, employee, or agent in fact of a government shall not be taken 
into account to decrease such earnings and profits or to increase such 
deficit. No adjustment shall be required under paragraph (a)(1)(ii) or 
(iii) of this section unless it is material. Whether an adjustment is 
material depends on the facts and circumstances of the particular case, 
including the amount of the adjustment, its size relative to the general 
level of the corporation's total assets and annual profit or loss, the 
consistency with which

[[Page 484]]

the practice has been applied, and whether the item to which the 
adjustment relates is of a recurring or merely a nonrecurring nature. 
For the treatment of earnings and profits whose distribution is 
prevented by restrictions and limitations imposed by a foreign 
government, see section 964(b) and the regulations issued pursuant to 
section 964.
    (3) Translation into dollars. In the case of a foreign corporation 
with a functional currency other than the United States dollar (dollar), 
see sections 986(b) and 989(b) for rules regarding the time and manner 
of translating distributions or inclusions of the foreign corporation's 
earnings and profits into dollars.
    (b) Accounting adjustments--(1) In general. The accounting 
principles to be applied in making the adjustments required by paragraph 
(a)(1)(ii) of this section shall be those accounting principles 
generally accepted in the United States for purposes of reflecting in 
the financial statements of a domestic corporation the operations of its 
foreign affiliates, including the following:
    (i) Clear reflection of income. Any accounting practice designed for 
purposes other than the clear reflection on a current basis of income 
and expense for the taxable year shall not be given effect. For example, 
an adjustment will be required where an allocation is made to an 
arbitrary reserve out of current income.
    (ii) Physical assets, depreciation, etc. All physical assets (as 
defined in paragraph (e)(5)(ii) of this section), including inventory 
when reflected at cost, shall be taken into account at historical cost 
computed either for individual assets or groups of similar assets. The 
historical cost of such an asset shall not reflect any appreciation or 
depreciation in its value or in the relative value of the currency in 
which its cost was incurred. Depreciation, depletion, and amortization 
allowances shall be based on the historical cost of the underlying asset 
and no effect shall be given to any such allowance determined on the 
basis of a factor other than historical cost. For special rules for 
determining historical cost where assets are acquired during a taxable 
year beginning before January 1, 1950, or a majority interest in the 
foreign corporation is acquired after December 31, 1949, but before 
October 27, 1964, see subparagraph (2) of this paragraph.
    (iii) Valuation of assets and liabilities. Any accounting practice 
which results in the systematic undervaluation of assets or 
overvaluation of liabilities shall not be given effect, even though 
expressly permitted or required under foreign law, except to the extent 
allowable under paragraph (c) of this section. For example, an 
adjustment will be required where inventory is written down below market 
value. For the definition of market value, see paragraph (a) of Sec. 
1.471-4.
    (iv) Income equalization. Income and expense shall be taken into 
account without regard to equalization over more than one accounting 
period; and any equalization reserve or similar provision affecting 
income or expense shall not be given effect, even though expressly 
permitted or required under foreign law, except to the extent allowable 
under paragraph (c) of this section.
    (v) Foreign currency. If transactions effected in a foreign currency 
other than that in which the books of the corporation are kept are 
translated into the foreign currency reflected in the books, such 
translation shall be made in a manner substantially similar to that as 
prescribed in section 988 and the regulations under that section for the 
translation of foreign currency amounts into United States dollars.
    (2) Historical cost. For purposes of this section, the historical 
cost of an asset acquired by the foreign corporation during a taxable 
year beginning before January 1, 1963, shall be determined, if it is so 
elected by or on behalf of such corporation--
    (i) In the event that the foreign corporation became a majority 
owned subsidiary of a United States person (within the meaning of 
section 7701(a)(30)) after December 31, 1949, but before October 27, 
1964, and the asset was held by such foreign corporation at that time, 
as though the asset was purchased on the date during such period the 
foreign corporation first became a majority owned subsidiary at a price 
equal to its then fair market value, or

[[Page 485]]

    (ii) In the event that subdivision (i) of this subparagraph is 
inapplicable but the asset was acquired by the foreign corporation 
during a taxable year beginning before January 1, 1950, as though the 
asset were purchased on the first day of the first taxable year of the 
foreign corporation beginning after December 31, 1949, at a price equal 
to the undepreciated cost (cost or other basis minus book depreciation) 
of that asset as of that date as shown on the books of account of such 
corporation regularly maintained for the purpose of accounting to its 
shareholders.


For purposes of this subparagraph, a foreign corporation shall be 
considered a majority owned subsidiary of a United States person if, 
taking into account only stock acquired by purchase (as defined in 
section 334(b)(3)), the United States person owns (within the meaning of 
section 958(a)) more than 50 percent of the total combined voting power 
of all classes of stock of the foreign corporation entitled to vote. The 
election under this subparagraph shall be made for the first taxable 
year beginning after December 31, 1962, in which the foreign corporation 
is a controlled foreign corporation (within the meaning of section 957), 
or for which it is included in a chain or group under section 
963(c)(2)(B) or (3)(B) (applied as if section 963 had not been repealed 
by the Tax Reduction Act of 1975), or has a deficit in earnings and 
profits sought to be taken into account under section 952(d) or pays a 
dividend that is included in the foreign base company shipping income of 
a controlled foreign corporation under Sec. 1.954-6(f). Once made, such 
an election shall be irrevocable. For the time and manner in which an 
election may be made on behalf of a foreign corporation, see paragraph 
(c)(3) of this section.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Corporation M is a controlled foreign corporation which 
regularly maintains books of account for the purpose of accounting to 
its shareholders in accordance with the accounting practices prevalent 
in country X, the country in which it operates. As a consequence of 
those practices, the profit and loss statement prepared from these books 
of account reflects an allocation to an arbitrary reserve out of current 
income and depreciation allowances based on replacement values which are 
greater than historical cost. Adjustments are necessary to conform such 
statement to accounting principles generally accepted in the United 
States. Assuming these adjustments to be material, the unacceptable 
practices, will have to be eliminated from the statement, an increase in 
the amount of profit (or a decrease in the amount of loss) thereby 
resulting.
    Example 2. In 1973, Corporation N is a foreign corporation which is 
not a controlled foreign corporation but which is included in a chain, 
for minimum distribution purposes, under section 963(c)(2)(B). 
Corporation N regularly maintains books of account for the purpose of 
accounting to its shareholders in accordance with the accounting 
practices of country Y, the country in which it operates. As a 
consequence of those practices, the profit and loss statement prepared 
from these books of account reflects the inclusion in income of stock 
dividends and of corporate distributions representing a return of 
capital. Adjustments are necessary to conform such statement to 
accounting principles generally accepted in the United States. Assuming 
these adjustments to be material, the unacceptable practices will have 
to be eliminated from the statement, a decrease in the amount of profit 
(or increase in the amount of loss) thereby resulting.

    (c) Tax adjustments--(1) In general. The tax accounting standards to 
be applied in making the adjustments required by paragraph (a)(1)(iii) 
of this section shall be the following:
    (i) Accounting methods. The method of accounting shall reflect the 
provisions of section 446 and the regulations thereunder.
    (ii) Inventories. Inventories shall be taken into account in 
accordance with the provisions of sections 471 and 472 and the 
regulations thereunder.
    (iii) Depreciation. Depreciation shall be computed as follows:
    (a) For any taxable year beginning before July 1, 1972; depreciation 
shall be computed in accordance with section 167 and the regulations 
thereunder.
    (b) If, for any taxable year beginning after June 30, 1972, 20 
percent or more of the gross income from all sources of the corporation 
is derived from sources within the United States, then depreciation 
shall be computed in accordance with the provisions of Sec. 1.312-15.
    (c) If, for any taxable year beginning after June 30, 1972, less 
than 20 percent

[[Page 486]]

of the gross income from all sources of the corporation is derived from 
sources within the United States, then depreciation shall be computed in 
accordance with section 167 and the regulations thereunder.
    (iv) Elections. Effect shall be given to any election made in 
accordance with an applicable provision of the Code and the regulations 
thereunder and these regulations.
    (v) Taxable years. The period for computation of taxable income and 
earnings and profits known as the taxable year shall reflect the 
provisions of section 441 and the regulations under that section.
    (vi) Applicable requirements. Except as provided in paragraphs 
(c)(2) and (c) (3) of this section, any requirements imposed by the Code 
or applicable regulations with respect to making an election or adopting 
or changing a method of accounting or taxable year must be satisfied by 
or on behalf of the foreign corporation just as though it were a 
domestic corporation if such election or such adoption or change of 
method or taxable year is to be taken into account in the computation of 
its earnings and profits.
    (2) Adoption or change of method or taxable year. For the first 
taxable year of a foreign corporation beginning after April 25, 2006, in 
which such foreign corporation first qualifies as a controlled foreign 
corporation (as defined in section 957 or 953) or a noncontrolled 
section 902 corporation (as defined in section 904(d)(2)(E)), any method 
of accounting or taxable year allowable under this section may be 
adopted, and any election allowable under this section may be made, by 
such foreign corporation or on its behalf notwithstanding that, in 
previous years, its books or financial statements were prepared on a 
different basis, and notwithstanding that such election is required by 
the Code or regulations to be made in a prior taxable year. Any 
allowable methods adopted or elections made shall be reflected in the 
computation of the foreign corporation's earnings and profits for such 
taxable year, prior taxable years, and (unless the Commissioner consents 
to a change) subsequent taxable years. However, see section 898 for the 
rules regarding the taxable year of a specified foreign corporation as 
defined in section 898(b). Any allowable method of accounting or 
election that relates to events that first arise in a subsequent taxable 
year may be adopted or made by or on behalf of the foreign corporation 
for such year. Adjustments to the appropriate separate category (as 
defined in Sec. 1.904-5(a)(1)) of earnings and profits and income of 
the foreign corporation shall be required under section 481 to prevent 
any duplication or omission of amounts attributable to previous years 
that would otherwise result from any change in a method of accounting. 
See paragraph (c)(3) of this section for the manner in which a method of 
accounting or a taxable year may be adopted or changed on behalf of the 
foreign corporation. See paragraph (c)(4) of this section for applicable 
rules if the amount of the foreign corporation's earnings and profits 
became significant for United States tax purposes before a method of 
accounting or taxable year was adopted by the foreign corporation or on 
its behalf in accordance with the rules of paragraph (c)(3) of this 
section. See paragraph (c)(6) of this section for special rules 
postponing the time for taking action by or on behalf of a foreign 
corporation until the amount of its earnings and profits becomes 
significant for U.S. tax purposes. See also Sec. Sec. 1.985-5, 1.985-6, 
and 1.985-7 relating to adjustments to earnings and profits of a QBU 
required when the QBU changes its functional currency or begins to use 
the dollar approximate separate transactions method of accounting.
    (3) Action on behalf of corporation--(i) In general. An election 
shall be deemed made, or an adoption or change in method of accounting 
or taxable year deemed effectuated, on behalf of the foreign corporation 
only if its controlling domestic shareholders (as defined in paragraph 
(c)(5) of this section)--
    (A) Satisfy for such corporation any requirements imposed by the 
Internal Revenue Code or applicable regulations with respect to such 
election or such adoption or change in method or taxable year (including 
the provisions of sections 442 and 446 and the regulations under those 
sections, as well as any operative provisions), such as the filing of

[[Page 487]]

forms, the execution of consents, securing the permission of the 
Commissioner, or maintaining books and records in a particular manner. 
For purposes of this paragraph (c)(3)(i)(A), the books of the foreign 
corporation shall be considered to be maintained in a particular manner 
if the controlling domestic shareholders or the foreign corporation 
regularly keep the records and accounts required by section 964(c) and 
the regulations under that section in that manner;
    (B) File the statement described in paragraph (c)(3)(ii) of this 
section, at the time and in the manner prescribed therein; and
    (C) Provide the written notice required by paragraph (c)(3)(iii) of 
this section at the time and in the manner prescribed therein.
    (ii) Statement required to be filed with a tax return. The statement 
required by this paragraph (c)(3)(ii) shall set forth the name, country 
of organization, and U.S. employer identification number (if applicable) 
of the foreign corporation, the name, address, stock interests, and U.S. 
employer identification number of each controlling domestic shareholder 
(or, if applicable, the shareholder's common parent) approving the 
action, and the names, addresses, U.S. employer identification numbers, 
and stock interests of all other domestic shareholders notified of the 
action taken. Such statement shall describe the nature of the action 
taken on behalf of the foreign corporation and the taxable year for 
which made, and identify a designated shareholder who retains a jointly 
executed consent confirming that such action has been approved by all of 
the controlling domestic shareholders and containing the signature of a 
principal officer of each such shareholder (or its common parent). Each 
controlling domestic shareholder (or its common parent) shall file the 
statement with, and on or before the due date (including extensions) of, 
its own tax return (or information return, if applicable) for its 
taxable year with or within which ends the taxable year of the foreign 
corporation for which the election is made or for which the method of 
accounting or taxable year is adopted or changed. In the case of a 
controlling domestic shareholder that is the sole shareholder of a 
controlled foreign corporation, no separate statement need be filed if 
the information described in this paragraph (c)(3)(ii) is included on 
Form 5471 and Form 3115 or 1128, as applicable, filed with respect to 
the controlled foreign corporation with the shareholder's return for 
such taxable year.
    (iii) Notice. On or before the filing date described in paragraph 
(c)(3)(ii) of this section, the controlling domestic shareholders shall 
provide written notice of the election made or the adoption or change of 
method or taxable year effected to all other persons known by them to be 
domestic shareholders who own (within the meaning of section 958(a)) 
stock of the foreign corporation. Such notice shall set forth the name, 
country of organization and U.S. employer identification number (if 
applicable) of the foreign corporation, and the names, addresses, and 
stock interests of the controlling domestic shareholders. Such notice 
shall describe the nature of the action taken on behalf of the foreign 
corporation and the taxable year for which made, and identify a 
designated shareholder who retains a jointly executed consent confirming 
that such action has been approved by all of the controlling domestic 
shareholders and containing the signature of a principal officer of each 
such shareholder (or its common parent). However, the failure of the 
controlling domestic shareholders to provide such notice to a person 
required to be notified shall not invalidate the election made or the 
adoption or change of method or taxable year effected.
    (4) Effect of action or inaction by controlling domestic 
shareholders--(i) In general. Any election, or adoption or change of 
method of accounting or taxable year made by the controlling domestic 
shareholders on behalf of the foreign corporation pursuant to paragraph 
(c)(3) of this section or any other provision of the regulations (for 
example, Sec. 1.985-2(c)(2) or (3)) shall be reflected in the 
computation of the earnings and profits of such corporation under this 
section to the extent that it bears upon the federal income tax 
liability of the domestic shareholders of

[[Page 488]]

the foreign corporation. Any such action shall bind both the foreign 
corporation and its domestic shareholders as to the computation of the 
foreign corporation's earnings and profits for the taxable year of the 
foreign corporation for which the election is made or for which the 
method of accounting or taxable year is adopted or changed and in 
subsequent taxable years unless the Commissioner consents to a change. 
The preceding sentence shall apply regardless of--
    (A) When the action was taken;
    (B) Whether the foreign corporation was a controlled foreign 
corporation or a noncontrolled section 902 corporation at the time the 
action was taken;
    (C) When ownership was acquired; or
    (D) Whether the domestic shareholder received the written notice 
required by paragraph (c)(3)(iii) of this section.
    (ii) Inaction or untimely action. In the event that action by or on 
behalf of the foreign corporation is not undertaken by the time 
specified in paragraph (c)(6) of this section and such failure is shown 
to the satisfaction of the Commissioner to be due to reasonable cause, 
such action may be undertaken during any period of at least 30 days 
occurring after such showing is made which the Commissioner may specify 
as appropriate for this purpose. In the event that action by or on 
behalf of the foreign corporation is not undertaken by the time 
specified in paragraph (c)(6) of this section and such failure is not 
shown to the satisfaction of the Commissioner to be due to reasonable 
cause, earnings and profits shall be computed as if no elections had 
been made and any permissible accounting methods not requiring an 
election and reflected in the books of account regularly maintained by 
the foreign corporation for the purpose of accounting to its 
shareholders had been adopted. Accordingly, if the earnings and profits 
of a noncontrolled section 902 corporation became significant for United 
States income tax purposes in a taxable year beginning on or before 
April 25, 2006, the corporation's earnings and profits shall be computed 
as if no elections had been made and any permissible accounting methods 
not requiring an election and reflected in the books of account 
regularly maintained by the foreign corporation for purposes of 
accounting to its shareholders had been adopted. Thereafter, any change 
in a particular accounting method or methods or taxable year may be made 
by, or on behalf of, the foreign corporation only with the 
Commissioner's consent.
    (iii) Computation of earnings and profits by a minority shareholder 
prior to majority election or significant event. A shareholder of a 
foreign corporation may be required to compute the foreign corporation's 
earnings and profits before the foreign corporation or its controlling 
domestic shareholders make, or are required under this section to make, 
an election or adopt a method of accounting for federal income tax 
purposes. In such a case, the shareholder must compute earnings and 
profits in accordance with this section. Such computation shall be made 
as if no elections had been made and any permissible accounting methods 
not requiring an election and reflected in the books of account 
regularly maintained by the foreign corporation for the purpose of 
accounting to its shareholders had been adopted. However, a later, 
properly filed, and timely election or adoption of method by, or on 
behalf of, the foreign corporation shall not be treated as a change in 
accounting method.
    (5) Controlling domestic shareholders--(i) Controlled foreign 
corporations. For purposes of this paragraph (c), the controlling 
domestic shareholders of a controlled foreign corporation shall be its 
controlling United States shareholders. The controlling United States 
shareholders of a controlled foreign corporation shall be those United 
States shareholders (as defined in section 951(b) or 953(c)) who, in the 
aggregate, own (within the meaning of section 958(a)) more than 50 
percent of the total combined voting power of all classes of the stock 
of such foreign corporation entitled to vote and who undertake to act on 
its behalf. In the event that the United States shareholders of the 
controlled foreign corporation do not, in the aggregate, own (within the 
meaning of section 958(a)) more than 50 percent of the total combined 
voting power of all classes of the

[[Page 489]]

stock of such foreign corporation entitled to vote, the controlling 
United States shareholders of the controlled foreign corporation shall 
be all those United States shareholders who own (within the meaning of 
section 958(a)) stock of such corporation.
    (ii) Noncontrolled section 902 corporations. For purposes of this 
paragraph (c), the controlling domestic shareholders of a noncontrolled 
section 902 corporation that is not a controlled foreign corporation 
shall be its majority domestic corporate shareholders. The majority 
domestic corporate shareholders of a noncontrolled section 902 
corporation shall be those domestic corporations that meet the ownership 
requirements of section 902(a) with respect to the noncontrolled section 
902 corporation (or to a first-tier foreign corporation that is a member 
of the same qualified group (as defined in section 902(b)(2)) as the 
noncontrolled section 902 corporation) that, in the aggregate, own 
directly or indirectly more than 50 percent of the combined voting power 
of all of the voting stock of the noncontrolled section 902 corporation 
that is owned directly or indirectly by all domestic corporations that 
meet the ownership requirements of section 902(a) with respect to the 
noncontrolled section 902 corporation (or a relevant first-tier foreign 
corporation).
    (6) Action not required until significant. Notwithstanding any other 
provision of this paragraph, action by or on behalf of a foreign 
corporation (other than a foreign corporation subject to tax under 
section 882) to make an election or to adopt a taxable year or method of 
accounting shall not be required until the due date (including 
extensions) of the return for a controlling domestic shareholder's first 
taxable year with or within which ends the foreign corporation's first 
taxable year in which the computation of its earnings and profits is 
significant for United States tax purposes with respect to its 
controlling domestic shareholders (as defined in Sec. 1.964-1(c)(5)). 
The filing of the information return required by section 6038 shall not 
itself constitute a significant event. For taxable years beginning after 
April 25, 2006, events that cause a foreign corporation's earnings and 
profits to have United States tax significance include, without 
limitation:
    (A) A distribution from the foreign corporation to its shareholders 
with respect to their stock.
    (B) An amount is includible in gross income with respect to such 
corporation under section 951(a).
    (C) An amount is excluded from subpart F income of the foreign 
corporation or another foreign corporation by reason of section 952(c).
    (D) Any event making the foreign corporation subject to tax under 
section 882.
    (E) The use by the foreign corporation's controlling domestic 
shareholders of the tax book value (or alternative tax book value) 
method of allocating interest expense under section 864(e)(4).
    (F) A sale or exchange of the foreign corporation's stock of the 
controlling domestic shareholders that results in the recharacterization 
of gain under section 1248.
    (7) Revocation of election. Notwithstanding any other provision of 
this section, any election made by or on behalf of a foreign corporation 
(other than a foreign corporation subject to tax under section 882) may 
be modified or revoked by or on behalf of such corporation for the 
taxable year for which made whenever the consent of the Commissioner is 
secured for such modification or revocation, even though such election 
would be irrevocable but for this subparagraph.
    (8) [Reserved]
    (d) Effective/applicability dates. Paragraphs (c)(1)(v) through 
(c)(6) of this section apply to taxable years ending on or after April 
20, 2009. See 26 CFR Sec. Sec. 1.964-1T(c)(1)(v) through (c)(6) 
(revised as of April 1, 2009) for rules applicable to taxable years 
beginning after April 25, 2006, and ending before April 20, 2009. 
However, taxpayers may choose to apply paragraphs (c)(1)(v) through 
(c)(6) of this section in their entirety in lieu of 26 CFR Sec. Sec. 
1.964-1T(c)(1)(v) through (c)(6) for periods covered by the temporary 
regulations, provided that appropriate adjustments are made to eliminate 
duplicate benefits arising from the application of paragraphs (c)(1)(v) 
through (c)(6) of

[[Page 490]]

this section to taxable years that are not open for assessment.


[T.D. 6764, 29 FR 14628, Oct. 27, 1964]

    Editorial Note: For Federal Register citations affecting Sec. 
1.964-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec. 1.964-2  Treatment of blocked earnings and profits.

    (a) General rule. If, in accordance with paragraph (d) of this 
section, it is established to the satisfaction of the district director 
that any amount of the earnings and profits of a controlled foreign 
corporation for the taxable year (determined under Sec. 1.964-1) was 
subject to a currency or other restriction or limitation imposed under 
the laws of any foreign country (within the meaning of paragraph (b) of 
this section) on its distribution to United States shareholders who own 
(within the meaning of section 958(a)) stock of such corporation, such 
amount shall not be included in earnings and profits for purposes of 
sections 952, 955 (as in effect both before and after the enactment of 
the Tax Reduction Act of 1975), and 956 for such taxable year. For rules 
governing the treatment of amounts with respect to which such 
restriction or limitation is removed, see paragraph (c) of this section.
    (b) Rules of application. For purposes of paragraph (a) of this 
section--
    (1) Period of restriction or limitation. An amount of earnings and 
profits of a controlled foreign corporation for any taxable year shall 
not be included in earnings and profits for purposes of sections 952, 
955 (as in effect both before and after the enactment of the Tax 
Reduction Act of 1975), and 956 only if such amount of earnings and 
profits is subject to a currency or other restriction or limitation 
(within the meaning of subparagraph (2) of this paragraph) throughout 
the 150-day period beginning 90 days before the close of the taxable 
year and ending 60 days after the close of such taxable year.
    (2) Restriction or limitation defined. Whether earnings and profits 
of a controlled foreign corporation are subject to a currency or other 
restriction or limitation imposed under the laws of a foreign country 
must be determined on the basis of all the facts and circumstances in 
each case. Generally, such a restriction or limitation must prevent--
    (i) The ready conversion (directly or indirectly) of such currency 
into United States dollars, or into property of a type normally owned by 
such corporation in the operation of its business or other money which 
is readily convertible into United States dollars; or
    (ii) The distribution of dividends by such corporation to its United 
States shareholders.


For purposes of this subparagraph, if a United States shareholder owns 
(within the meaning of section 958(a)), or is considered as owning by 
applying the rules of ownership of section 958(b), 80 percent or more of 
the total combined voting power of all classes of stock of a foreign 
corporation in a chain of ownership described in section 958(a), the 
distribution of dividends by such corporation to such shareholder will 
not be considered prevented solely by reason of the existence of a 
currency or other restriction or limitation at an intermediate tier in 
such chain if dividends may be distributed directly to such 
shareholders.
    (3) Foreign laws. A currency or other restriction or limitation on 
the distribution of earnings and profits may be imposed in a foreign 
country by express statutory provisions, executive orders or decrees, 
rules or regulations of a governmental agency, court decisions, the 
actions of appropriate officials who are acting within the scope of 
their authority, or by any similar official action. A currency 
restriction will not be considered to exist unless export restrictions 
are also imposed which prevent the exportation of property of a type 
normally owned by the controlled foreign corporation in the operation of 
its business which could be readily converted into United States 
dollars.
    (4) Voluntary restriction or limitation. A currency or other 
restriction or limitation arising from the voluntary act of the 
controlled foreign corporation or its United States shareholders during 
a taxable year beginning after December 31, 1962, will not be taken into 
account.

[[Page 491]]

For example, if a controlled foreign corporation--
    (i) Issues a stock dividend which has the effect of capitalizing 
earnings and profits;
    (ii) Elects to restrict its earnings and profits or to make certain 
investments as a means of avoiding current tax or securing a reduced 
rate of tax; or
    (iii) Allocates earnings and profits to an optional or arbitrary 
reserve; such restriction is voluntary and will not be taken into 
account.
    (5) Treatment of earnings and profits in cases of certain mandatory 
reserves--(i) In general. If a controlled foreign corporation is 
required under the laws of a foreign country to establish a reserve out 
of earnings and profits for the taxable year, such earnings and profits 
shall be considered subject to a restriction or limitation by reason of 
such requirement only to the extent that the amount required to be 
included in such reserve at the close of the taxable year exceeds the 
accumulated earnings and profits (determined in accordance with 
subdivision (ii) of this subparagraph) of such corporation at the close 
of the preceding taxable year.
    (ii) Determination of earnings and profits. For purposes of 
determining the accumulated earnings and profits of a controlled foreign 
corporation under subdivision (i) of this subparagraph, such earnings 
and profits shall not include any amounts which are attributable to--
    (a) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder under section 951(a) and 
have not been distributed;
    (b) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such foreign 
corporation under section 551(b) and have not been distributed; or
    (c) Amounts which become subject to a voluntary restriction or 
limitation (within the meaning of subparagraph (4) of this paragraph) 
during a taxable year beginning before January 1, 1963.


The rules of this subdivision apply only in determining the accumulated 
earnings and profits of a controlled foreign corporation for purposes of 
this subparagraph. See section 959 and the regulations thereunder for 
limitations on the exclusion from gross income of previously taxed 
earnings and profits.
    (6) Exhaustion of procedures for distributing earnings and profits. 
Earnings and profits of a controlled foreign corporation for a taxable 
year will not be considered subject to a currency or other restriction 
or limitation on their distribution unless the United States 
shareholders of such corporation demonstrate either that the available 
procedures for distributing such earnings and profits have been 
exhausted or that the use of such procedures will be futile. As a 
general rule, such procedures will be considered to have been exhausted 
if the foreign corporation applies for dollars (or foreign currency 
readily convertible into dollars) at the appropriate rate of exchange 
and complies with the applicable laws and regulations governing the 
acquisition and transfer of such currency including submission of the 
necessary documentation to the exchange authority. The fact that 
available procedures for distributing earnings and profits were 
exhausted without success with respect to a prior year is not, of 
itself, sufficient evidence that such procedures would not be successful 
with respect to the current taxable year.
    (c) Removal of restriction or limitation--(1) In general. If, during 
any taxable year, a currency or other restriction or limitation (within 
the meaning of paragraph (b) of this section) imposed under the laws of 
a foreign country on the distribution of earnings and profits of a 
controlled foreign corporation to its United States shareholders is 
removed--
    (i) Treatment of deferred income. Each United States shareholder of 
such corporation on the last day in such year that such corporation is a 
controlled foreign corporation shall include in his gross income for 
such taxable year the amounts attributable to such earnings and profits 
which would have been includible in his gross income under section 
951(a) for prior taxable years but for the existence of the currency or 
other restriction or limitation except that the amounts included under 
this subdivision (i) shall not exceed his pro rata share of--

[[Page 492]]

    (a) The earnings and profits upon which the restriction was removed 
determined on the basis of his stock ownership on the last day of the 
immediately preceding taxable year, and
    (b) The applicable limitations under paragraph (c) of Sec. 1.952-1, 
paragraph (b)(2) of Sec. 1.955-1, paragraph (b)(2) of Sec. 1.955A-1, 
or paragraph (b) of Sec. 1.956-1, determined as of the last day of the 
immediately preceding taxable year, taking into account the provisions 
of subdivision (ii) of this subparagraph.
    (ii) Treatment of earnings and profits. For purposes of sections 
952, 955 (as in effect both before and after the enactment of the Tax 
Reduction Act of 1975), and 956, the earnings and profits which are no 
longer subject to a currency or other restriction or limitation shall be 
treated as included in the corporation's earnings and profits for the 
year in which such earnings and profits were derived.


Amounts with respect to which a currency or other restriction or 
limitation is removed shall be translated into United States dollars at 
the appropriate exchange rate for the translation period during which 
such currency or other restriction or limitation is removed. See 
paragraph (d) of Sec. 1.964-1. Amounts with respect to which a currency 
or other restriction or limitation is removed shall not be taken into 
account in determining whether a deficiency distribution (within the 
meaning of Sec. 1.963-6 (applied as if section 963 had not been 
repealed by the Tax Reduction Act of 1975)) is required to be made for 
the year in which such earnings and profits were derived.
    (2) Removal of restriction or limitation defined. An amount of 
earnings and profits shall be considered no longer subject to a 
limitation or restriction if and to the extent that--
    (i) Money or property in such foreign country is readily convertible 
into United States dollars, or into other money or property of a type 
normally owned by such corporation in the operation of its business 
which is readily convertible into United States dollars;
    (ii) Notwithstanding the existence of any laws or regulations 
forbidding the exchange of money or property into United States dollars, 
conversion is actually made into United States dollars, or other money 
or property of a type normally owned by such corporation in the 
operation of its business which is readily convertible into United 
States dollars; or
    (iii) A mandatory reserve requirement (described in paragraph (b)(5) 
of this section) is removed either by a change in law of the foreign 
country imposing such requirement or by an accumulation of earnings and 
profits not subject to such requirement.
    (3) Distribution in foreign country. If, during any taxable year, 
earnings and profits previously subject to a currency or other 
restriction or limitation are distributed in a foreign country to one or 
more United States shareholders of a controlled foreign corporation 
directly, or indirectly through a chain of ownership described in 
section 958(a), such earnings and profits shall be considered no longer 
subject to a restriction or limitation. However, distributed amounts may 
be excluded from such shareholder's gross income for the taxable year of 
receipt if such shareholder elects a method of accounting under which 
the reporting of blocked foreign income is deferred until the income 
ceases to be blocked.
    (4) Source of distribution. If, during any taxable year, earnings 
and profits previously subject to a currency or other restriction or 
limitation is distributed to one or more United States shareholders of a 
controlled foreign corporation directly, or indirectly through a chain 
of ownership described in section 958(a), the source of such 
distribution shall be determined in accordance with the rules of Sec. 
1.959-3.
    (5) Illustration. The provisions of this paragraph may be 
illustrated by the following example:

    Example. (a) M, a United States person, owns all of the only class 
of stock of A Corporation, a foreign corporation incorporated under the 
laws of foreign country X on January 1, 1963. Both M and A Corporations 
use the calendar year as a taxable year and A Corporation is a 
controlled foreign corporation throughout the period here involved.
    (b) During 1963, A Corporation derives income of $100,000 all of 
which is subpart F income and has earnings and profits of $100,000. 
Under the laws of X Country, currency cannot be exported without a 
license. During the last 90 days of 1963 and the first 60 days of 1964, 
A Corporation can obtain a license to

[[Page 493]]

distribute only an amount equivalent to $10,000. M must include $10,000 
in his gross income for 1963 under section 951(a)(1)(A)(i) and $90,000 
of A Corporation's earnings and profits for 1963 are not taken into 
account for purposes of sections 952, 955, and 956.
    (c) During 1964, A Corporation has no income and no earnings and 
profits. On June 1, 1964, A Corporation converts an amount equivalent to 
$20,000 into property of a type normally owned by such corporation in 
the operation of its business which is readily convertible into United 
States dollars but does not distribute such amount. Corporation A must 
include $20,000 in its earnings and profits for 1963 for purposes of 
sections 952, 955, and 956. M must include $20,000 in his gross income 
for 1964.
    (d) During 1965, A Corporation has no income and no earnings and 
profits. On December 15, 1965, A Corporation distributes an amount 
equivalent to $15,000 to M in X Country. Neither M nor A Corporation can 
obtain a license to export currency from X Country. In his return for 
the taxable year 1965, M elects a method of accounting under which the 
reporting of blocked foreign income is deferred until the income ceases 
to be blocked. Accordingly, M does not include the $15,000 in his gross 
income for 1965.
    (e) During 1966, A Corporation has no income and no earnings and 
profits. On February 1, 1966, notwithstanding the laws and regulations 
of X Country which forbid the exchange of X Country's currency into 
United States dollars, M converts an amount equivalent to $15,000 into a 
currency which is readily convertible into United States dollars. Since 
the income has ceased to be blocked, M must include $15,000 in his gross 
income for 1966.

    (d) Manner of claiming existence of restriction or limitation on 
distribution of earnings and profits. A United States shareholder 
claiming that an amount of the earnings and profits of a controlled 
foreign corporation for the taxable year was subject to a currency or 
other restriction or limitation imposed under the laws of a foreign 
country on its distribution shall file a statement with his return for 
the taxable year with or within which the taxable year of the foreign 
corporation ends which shall include--
    (1) The name and address of the foreign corporation,
    (2) A description of the classes of stock of the foreign corporation 
and a statement of the number of shares of each class owned (within the 
meaning of section 958(a)) or considered as owned (by applying the rules 
of ownership of section 958(b)) by the United States shareholder,
    (3) A description of the currency or other restriction or limitation 
on the distribution of earnings and profits,
    (4) The total earnings and profits of the foreign corporation for 
the taxable year (before any amount is excluded from earnings and 
profits under this section) and the United States shareholder's pro rata 
share of such total earnings and profits,
    (5) The United States shareholder's pro rata share of the amount of 
earnings and profits subject to a restriction or limitation on 
distribution,
    (6) The amounts which would be includible in the United States 
shareholder's gross income under section 951(a) but for the existence of 
the currency or other restriction or limitation,
    (7) A description of the available procedures for distributing 
earnings and profits and a statement setting forth the steps taken to 
exhaust such procedures or a statement setting forth the reasons that 
the use of such procedures would be futile, and
    (8) The amount of distributions made in a foreign country and a 
statement as to whether a method of accounting has been elected under 
which the reporting of blocked income is deferred until such income 
ceases to be blocked, including an identification of the taxable year 
and place of filing of such election.


In addition, such United States shareholder shall furnish to the 
district director such other information as he may require to verify the 
status of a currency or other restriction or limitation.

[T.D. 6892, 31 FR 11142, Aug. 23, 1966, as amended by T.D. 7545, 43 FR 
19652, May 8, 1978; T.D. 7893, 48 FR 22510, May 19, 1983]



Sec. 1.964-3  Records to be provided by United States shareholders.

    (a) Shareholder's responsibility for providing records. For purposes 
of verifying his income tax liability in respect of amounts includible 
in income under section 951 for the taxable year of a controlled foreign 
corporation each United State shareholder (as defined in section 951(b)) 
who owns (within the meaning of section 958(a)) stock of such

[[Page 494]]

corporation shall, within a reasonable time after demand by the district 
director, provide the district director--
    (1) Such permanent books of account or records as are sufficient to 
satisfy the requirements of section 6001 and section 964(c), or true 
copies thereof, as are reasonably demanded, and
    (2) If such books or records are not maintained in the English 
language, either (i) an accurate English translation of such books or 
records or (ii) the services of a qualified interpreter satisfactory to 
the district director.


If such books or records are being used by another district director, 
the United States shareholder upon whom the district director has made a 
demand to provide such books or records shall file a statement of such 
fact with his district director, indicating the location of such books 
or records. For the length of time the United States shareholder of a 
controlled foreign corporation must cause such books or records as are 
under his control to be retained, see paragraph (e) of Sec. 1.6001-1.
    (b) Records to be provided. Except as otherwise provided in 
paragraph (c) of this section, the requirements of section 6001 and 
section 964(c) for record keeping shall be considered satisfied if the 
books or records produced are sufficient to verify for the taxable 
year--
    (1) The subpart F income of the controlled foreign corporation and, 
if any part of such income is excluded from the income of the United 
States shareholder under section 963 or section 970(a), the application 
of such exclusion,
    (2) The previously excluded subpart F income of such corporation 
withdrawn from investment in less developed countries,
    (3) The previously excluded subpart F income of such corporation 
withdrawn from investment in foreign base company shipping operations,
    (4) The previously excluded export trade income of such corporation 
withdrawn from investment, and
    (5) The increase in earnings invested by such corporation in United 
States property.
    (c) Special rules. Verification of the subpart F income of the 
controlled foreign corporation for the taxable year shall not be 
required if--
    (1) It can be demonstrated to the satisfaction of the district 
director that--
    (i) The locus and nature of such corporation's activities were such 
as to make it unlikely that the foreign base company income of such 
corporation (determined in accordance with paragraph (c)(3) of Sec. 
1.952-3) exceeded 5 percent of its gross income (determined in 
accordance with paragraph (b)(1) of Sec. 1.952-3) for the taxable year. 
(For taxable years to which Sec. 1.952-3 does not apply, such amounts 
shall be determined under 26 CFR Sec. 1.954-1(d)(3)(i) and (ii) 
(Revised as of April 1, 1975))), and
    (ii) If such corporation reinsures or issues insurance or annuity 
contracts in connection with United States risks, the 5-percent minimum 
premium requirement prescribed in paragraph (b) of Sec. 1.953-1 has not 
been exceeded for the taxable year, or
    (2) The United States shareholder's pro rata share of such subpart F 
income is excluded in full from his income under section 963 and the 
books or records verify the application of such exclusion.

[T.D. 6824, 30 FR 6480, May 11, 1965, as amended by T.D. 7893, 48 FR 
22510, May 19, 1983]



Sec. 1.964-4  Verification of certain classes of income.

    (a) In general. The provisions of this section shall apply for 
purposes of determining when books or records are sufficient for 
purposes of Sec. 1.964-3 to verify the classes of income described in 
such section.
    (b) Subpart F income. Books or records sufficient to verify the 
subpart F income of a controlled foreign corporation must establish for 
the taxable year--
    (1) Its gross income and deductions,
    (2) The income derived from the insurance of United States risks (as 
provided in paragraph (c) of this section),
    (3) The foreign base company income (as provided in paragraph (d) of 
this section), and
    (4) In the case of a United States shareholder claiming the benefit 
of the exclusion provided in section 952(b) or the limitation provided 
in section 952(c)--
    (i) The items of income excluded from subpart F income by paragraph 
(b) of Sec. 1.952-1 as income derived from

[[Page 495]]

sources within the United States, the United States income tax incurred 
with respect thereto, and the deductions properly allocable thereto and 
connected therewith, and
    (ii) The earnings and profits, or deficit in earnings and profits, 
of any foreign corporation necessary for the determinations provided in 
paragraphs (c) and (d) of Sec. 1.952-1.
    (c) Income from insurance of United States risks. Books or records 
sufficient to verify the income of a controlled foreign corporation from 
the insurance of United States risks must establish for the taxable 
year--
    (1) That the 5-percent minimum premium requirement prescribed in 
paragraph (b) of Sec. 1.953-1 has not been exceeded, or
    (2) The taxable income, as determined under Sec. 1.953-4 or Sec. 
1.953-5, which is attributable to the reinsuring or the issuing of any 
insurance or annuity contracts in connection with United States risks, 
as defined in Sec. 1.953-2 or Sec. 1.953-3.
    (d) Foreign base company income and exclusions therefrom. Books or 
records sufficient to verify the income of a controlled foreign 
corporation which is foreign base company income must establish for the 
taxable year the following items:
    (1) Foreign personal holding company income. The foreign personal 
holding company income to which section 954(c) and Sec. 1.954-2 apply, 
for which purpose there must be established the gross income from--
    (i) All rents and royalties,
    (ii) Rents and royalties received in the active conduct of a trade 
or business from an unrelated person, as determined under section 
954(c)(3)(A) and paragraph (d)(1) of Sec. 1.954-2,
    (iii) Rents and royalties received from a related person for the use 
of property in the country of incorporation of the controlled foreign 
corporation, as determined under section 954(c)(4)(C) and paragraph 
(e)(3) of Sec. 1.954-2,
    (iv) All dividends, interest, and except where the controlled 
foreign corporation is a regular dealer in stock or securities, all 
gains and losses from the sale or exchange of stock or securities,
    (v) Dividends, interest, and gains from the sale or exchange of 
stock or securities, received in the conduct of a banking, financing, or 
insurance business from an unrelated person, as determined under section 
954(c)(3)(B) and paragraph (d)(2) and (3) of Sec. 1.954-2,
    (vi) Dividends and interest received from a related corporation 
organized in the country of incorporation of the controlled foreign 
corporation, as determined under section 954(c)(4)(A) and paragraph 
(e)(1) of Sec. 1.954-2,
    (vii) Interest received in the conduct of a banking or other 
financing business from a related person, as determined under section 
954(c)(4)(B) and paragraph (e)(2) of Sec. 1.954-2,
    (viii) All annuities,
    (ix) All gains from commodities transactions described in section 
553(a)(3),
    (x) All income from estates and trusts described in section 
553(a)(4),
    (xi) All income from personal service contracts described in section 
553(a)(5), and
    (xii) All compensation for the use of corporate property by 
shareholders described in section 553(a)(6).
    (2) Foreign base company sales income. The foreign base company 
sales income to which section 954(d) and Sec. 1.954-3 apply, for which 
purpose there must be established the gross income from--
    (i) All sales by the controlled foreign corporation of its personal 
property and all purchases or sales of personal property by such 
corporation on behalf of another person,
    (ii) Purchases and/or sales of personal property in connection with 
transactions not involving related persons (as defined in paragraph 
(e)(2) of Sec. 1.954-1),
    (iii) Purchases and/or sales of personal property manufactured, 
produced, etc., in the country of incorporation of the controlled 
foreign corporation, as determined under paragraph (a)(2) of Sec. 
1.954-3,
    (iv) Purchases and/or sales of personal property for use, etc., in 
the country of incorporation of the controlled foreign corporation, as 
determined under paragraph (a)(3) of Sec. 1.954-3, and
    (v) Sales of personal property manufactured or produced by the 
controlled

[[Page 496]]

foreign corporation, as determined under paragraph (a)(4) of Sec. 
1.954-3.


Where an item of income falls within more than one of subdivisions (ii) 
through (v) of this subparagraph, it shall be sufficient to establish 
that it falls within any one of them. If a branch or similar 
establishment is treated as a wholly owned subsidiary corporation 
through the application of section 954(d)(2) and paragraph (b) of Sec. 
1.954-3, the requirements of this subparagraph shall be satisfied 
separately for each branch or similar establishment so treated and for 
the remainder of the controlled foreign corporation.
    (3) Foreign base company services income. The foreign base company 
services income to which section 954(e) and Sec. 1.954-4 apply, for 
which purpose there must be established the gross income from--
    (i) All services performed by the controlled foreign corporation,
    (ii) Services other than those (as determined under paragraph (b) of 
Sec. 1.954-4) performed for, or on behalf of, a related person,
    (iii) Services performed in the country of incorporation of the 
controlled foreign corporation, as determined under paragraph (c) of 
Sec. 1.954-4, and
    (iv) Services performed in connection with the sale or exchange of, 
or with an offer or effort to sell or exchange, personal property 
manufactured, produced, etc., by the controlled foreign corporation, as 
determined under paragraph (d) of Sec. 1.954-4.


Where an item of income falls within more than one of subdivisions (ii) 
through (iv) of this subparagraph, it shall be sufficient to establish 
that it falls within any one of them.
    (4) Foreign base company oil related income. (i) The foreign base 
company oil related income described in section 954(g) and Sec. 1.954-
8, for which purpose there must be established, with respect to each 
foreign country, the gross income derived from--
    (A) The processing of minerals extracted (by the taxpayer or by any 
other person) from oil or gas wells into their primary products, as 
determined under section 907(c)(2)(A),
    (B) The transportation of such minerals or primary products, as 
determined under section 907(c)(2)(B),
    (C) The distribution or sale of such minerals or primary products, 
as determined under section 907(c)(2)(C),
    (D) The disposition of assets used by the taxpayer in a trade or 
business described in subdivision (A), (B) or (C), as determined under 
section 907(c)(2)(D),
    (E) Dividends, interests, partnership distributions, and other 
amounts, as determined under section 907(c)(3).


Where an item of income falls within more than one of the listings in 
paragraphs (d)(4)(i)(A) through (E) of this section, it shall be 
sufficient to establish that it falls within any one of them.
    (ii) If any of the items of income listed in paragraph (d)(4)(i) of 
this section arising from sources within a foreign country relates to 
oil, gas, or a primary product thereof and is described in section 
954(g)(1)(A) or (B) and Sec. 1.954-8(a)(1)(i) or (ii) (and, hence, is 
not foreign base company oil related income), then there must be 
established facts sufficient to verify the amount of such item of income 
which is not foreign base company oil related income. In this regard, 
the total quantities of oil, gas and primary products thereof which gave 
rise to such item of income and the portions of such quantities which 
were extracted or sold within the foreign country must be established.
    (5) Qualified investments in less developed countries. For rules in 
effect for taxable years of foreign corporations beginning before 
January 1, 1976, see 26 CFR 1.964-4(d)(4) (Revised as of April 1, 1975).
    (6) Income derived from aircraft or ships. For rules in effect for 
taxable years of foreign corporations beginning before January 1, 1976, 
see CFR Sec. 1.964-4(d)(5) (Revised as of April 1, 1975).
    (7) Foreign base company shipping income. The foreign base company 
shipping income to which section 954(f) and Sec. 1.954-6 apply, for 
which purpose there must be established--
    (i) Gross income derived from, or in connection with, the use (or 
hiring or leasing for use) of any aircraft or vessel in foreign 
commerce, as determined under Sec. 1.954-6(c),

[[Page 497]]

    (ii) Gross income derived from, or in connection with, the 
performance of services directly related to the use of any aircraft or 
vessel in foreign commerce, as determined under Sec. 1.954-6(d),
    (iii) Gross income incidental to income described in subdivisions 
(i) and (ii) of this subparagraph, as determined under Sec. 1.954-6(e),
    (iv) Gross income derived from the sale, exchange, or other 
disposition of any aircraft or vessel used (by the seller or by a person 
related to the seller) in foreign commerce,
    (v) Dividends, interest, and gains described in Sec. Sec. 1.954-
6(f) and 1.954(b) (1)(viii),
    (vi) Income described in Sec. 1.954-6(g) (relating to partnerships, 
trusts, etc.), and
    (vii) Exchange gain, to the extent allocable to foreign base company 
shipping income, as determined under Sec. 1.952-2(c)(2)(v)(b).


If the controlled foreign corporation has income derived from or in 
connection with, the use (or hiring or leasing for use) of any aircraft 
or vessel in foreign commerce, or derived from, or in connection with, 
the performance of services directly related to the use of any aircraft 
or vessel in foreign commerce, it shall be necessary to establish, from 
the books and records of the controlled foreign corporation, that such 
aircraft or vessel was used in foreign commerce within the meaning of 
subparagraphs (3) and (4) of Sec. 1.954-6(b).
    (8) Income on which taxes are not substantially reduced. The gross 
income excluded from foreign base company income under section 954(b)(4) 
and paragraph (b)(3) or (4) of Sec. 1.954-1 in the case of a controlled 
foreign corporation not availed of to substantially reduce income taxes, 
the income or similar taxes incurred with respect thereto, and all other 
factors necessary to verify the application of such exclusion.
    (9) Qualified investments in foreign base company shipping 
operations. The foreign base company shipping income that is excluded 
from foreign base company income under section 954(b)(2) and Sec. 
1.954-1(b)(1).
    (10) Special rule for shipping income. The distributions received 
through a chain of ownership described in section 958(a) which are 
excluded from foreign base company income under section 954(b)(6)(B) and 
Sec. 1.954-1(b)(2).
    (11) Deductions. The deductions allocable, under paragraph (c) of 
Sec. 1.954-1, to each of the classes and subclasses of gross income 
described in subparagraphs (1) through (9) of this paragraph.
    (e) [Reserved]
    (f) Exclusion under section 970(a). Books or records sufficient to 
verify the application for the taxable year of the exclusion provided by 
section 970(a) in respect of export trade income which is foreign base 
company income must establish for such year--
    (1) That the controlled foreign corporation is an export trade 
corporation, as defined in section 971(a) and paragraph (a) of Sec. 
1.971-1,
    (2) The export trade income, as determined under section 971(b) and 
paragraph (b) of Sec. 1.971-1, which constitutes foreign base company 
income,
    (3) The export promotion expenses, as determined under section 
971(d) and paragraph (d) of Sec. 1.971-1, which are allocable to the 
excludable export trade income,
    (4) The gross receipts, and the gross amount on which is computed 
compensation included in gross receipts, from property in respect of 
which the excludable export trade income is derived, as described in 
section 970(a)(1)(B) and paragraph (b)(2)(ii) of Sec. 1.970-1, and
    (5) The increase in investments in export trade assets, as 
determined under section 970(c)(2) and paragraph (d)(2) of Sec. 1.970-
1.
    (g-1) Withdrawal of previously excluded subpart F income from 
qualified investment in less developed countries. Books or records 
sufficient to verify the previously excluded subpart F income of the 
controlled foreign corporation withdrawn from investment in less 
developed countries for the taxable year must establish--
    (1) The sum of the amounts of income excluded from foreign base 
company income under section 954(b)(1) and paragraph (b)(1) of Sec. 
1.954-1 (as in effect for taxable years beginning before January 1, 
1976; see 26 CFR 1.954-1(b)(1) (Revised as of April 1, 1975)) for all 
prior taxable years,

[[Page 498]]

    (2) The sum of the amounts of previously excluded subpart F income 
withdrawn from investment in less developed countries for all prior 
taxable years, as determined under section 955(a) (as in effect before 
the enactment of the Tax Reduction Act of 1975) and paragraph (b) of 
Sec. 1.955-1, and
    (3) The amount withdrawn from investment in less developed countries 
for the taxable year as determined under section 955(a) (as in effect 
before the enactment of the Tax Reduction Act of 1975) and paragraph (b) 
of Sec. 1.955-1.
    (g-2) Withdrawal of previously excluded subpart F income from 
investment in foreign base company shipping operations. Books or records 
sufficient to verify the previously excluded subpart F income of the 
controlled foreign corporation withdrawn from investment in foreign base 
company shipping operations for the taxable year must establish--
    (1) The sum of the amounts of income excluded from foreign base 
company income under section 954(b)(2) and paragraph (b)(1) of Sec. 
1.954-1 for all prior taxable years,
    (2) The sum of the amounts of previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations 
for all prior taxable years, as determined under section 955(a) and 
paragraph (b) of Sec. 1.955A-1,
    (3) The amount withdrawn from investment in foreign base company 
shipping operations for the taxable year as determined under section 
955(a) and paragraph (b) of Sec. 1.955A-1, and
    (4) If the carryover (as described in Sec. 1.955A-1(b)(3)) of 
amounts relating to investments in less developed country shipping 
companies (as described in Sec. 1.995-5(b)) is applicable, (i) the 
amount of the corporation's qualified investments (determined under 
Sec. 1.955-2 other than paragraph (b)(5) thereof) in less developed 
country shipping companies at the close of the last taxable year of the 
corporation beginning before January 1, 1976, and (ii) the amount of the 
limitation with respect to previously excluded subpart F income 
(determined under Sec. 1.955-1(b)(1)(i)(b)) for the first taxable year 
of the corporation beginning after December 31, 1975.
    (h) Withdrawal of previously excluded export trade income from 
investment. Books or records sufficient to verify the previously 
excluded export trade income of the controlled foreign corporation 
withdrawn from investment for the taxable year must establish the United 
States shareholder's proportionate share of--
    (1) The sum of the amounts by which the subpart F income of such 
corporation was reduced for all prior taxable years under section 970(a) 
and paragraph (b) of Sec. 1.970-1,
    (2) The sum of the amounts described in section 970(b)(1)(B),
    (3) The sum of the amounts of previously excluded export trade 
income of such corporation withdrawn from investment under section 
970(b) and paragraph (c) of Sec. 1.970-1 for all prior taxable years, 
and
    (4) The amount withdrawn from investment under section 970(b) and 
paragraph (c) of Sec. 1.970-1 for the taxable year.
    (i) Increase in earnings invested in United States property. Books 
or records sufficient to verify the increase for the taxable year in 
earnings invested by the controlled foreign corporations in United 
States property must establish--
    (1) The amount of such corporation's earnings invested in United 
States property (as defined in section 956(b)(1) and paragraph (a) of 
Sec. 1.956-2) at the close of the current and preceding taxable years, 
as determined under paragraph (b) of Sec. 1.956-1,
    (2) The amount of excluded property described in section 956(b)(2) 
and paragraph (b) of Sec. 1.956-2 held by such corporation at the close 
of such years,
    (3) The earnings and profits, to which section 959(c)(1) and 
paragraph (b)(1) of Sec. 1.959-3 apply, distributed by such corporation 
during the preceding taxable year, and
    (4) The amount of increase in earnings invested by such corporation 
in United States property which is excluded from the United States 
shareholder's gross income for the taxable

[[Page 499]]

year under section 959(a)(2) and paragraph (c) of Sec. 1.959-1.

[T.D. 6824, 30 FR 6481, May 11, 1965, as amended by T.D. 7211, 37 FR 
21436, Oct. 11, 1972; T.D. 7893, 48 FR 22511, May 19, 1983; T.D. 8331, 
56 FR 2849, Jan. 25, 1991; T.D. 9849, 84 FR 9237, Mar. 14, 2019]



Sec. 1.964-5  Effective date of subpart F.

    Sections 951 through 964 and Sec. Sec. 1.951 through 1.964-4 shall 
apply with respect to taxable years of foreign corporations beginning 
after December 31, 1962, and to taxable years of United States 
shareholders within which or with which such taxable years of such 
corporations end.

[T.D. 7120, 36 FR 10862, June 4, 1971]



Sec. 1.965-0  Outline of section 965 regulations.

    This section lists the headings for Sec. Sec. 1.965-1 through 
1.965-9.

         Sec. 1.965-1 Overview, general rules, and definitions.

    (a) Overview.
    (1) In general.
    (2) Scope.
    (b) Section 965(a) inclusion amounts.
    (1) Inclusion of the pro rata share of the section 965(a) earnings 
amount.
    (2) Reduction by the allocable share of the aggregate foreign E&P 
deficit.
    (c) Section 965(c) deduction amounts.
    (d) Treatment of specified foreign corporation as a controlled 
foreign corporation.
    (e) Special rule for certain controlled domestic partnerships.
    (1) In general.
    (2) Definition of a controlled domestic partnership.
    (f) Definitions.
    (1) 8 percent rate amount.
    (2) 8 percent rate equivalent percentage.
    (3) 15.5 percent rate amount.
    (4) 15.5 percent rate equivalent percentage.
    (5) Accounts payable.
    (6) Accounts receivable.
    (7) Accumulated post-1986 deferred foreign income.
    (8) Aggregate foreign cash position.
    (9) Aggregate foreign E&P deficit.
    (10) Aggregate section 965(a) inclusion amount.
    (11) Allocable share.
    (12) Bona fide hedging transaction.
    (13) Cash-equivalent asset.
    (i) In general.
    (ii) Specified commodity.
    (14) Cash-equivalent asset hedging transaction.
    (i) In general.
    (ii) Aggregate hedging transactions.
    (15) Cash measurement dates.
    (16) Cash position.
    (i) General rule.
    (ii) Fair market value of cash-equivalent assets.
    (iii) Measurement of derivative financial instruments.
    (iv) Translation of cash position amounts.
    (17) Deferred foreign income corporation.
    (i) In general.
    (ii) Priority rule.
    (18) Derivative financial instrument.
    (19) Domestic pass-through entity.
    (20) Domestic pass-through owner.
    (21) Domestic pass-through owner share.
    (22) E&P deficit foreign corporation.
    (i) In general.
    (ii) Determination of deficit in post-1986 earnings and profits.
    (23) E&P measurement dates.
    (24) Final cash measurement date.
    (25) First cash measurement date.
    (26) Inclusion year.
    (27) Net accounts receivable.
    (28) Pass-through entity.
    (29) Post-1986 earnings and profits.
    (i) General rule.
    (ii) Foreign income taxes.
    (iii) Deficits in earnings and profits.
    (30) Pro rata share.
    (31) Second cash measurement date.
    (32) Section 958(a) stock.
    (33) Section 958(a) U.S. shareholder.
    (34) Section 958(a) U.S. shareholder inclusion year.
    (35) Section 965 regulations.
    (36) Section 965(a) earnings amount.
    (37) Section 965(a) inclusion.
    (38) Section 965(a) inclusion amount.
    (39) Section 965(a) previously taxed earnings and profits.
    (40) Section 965(b) previously taxed earnings and profits.
    (41) Section 965(c) deduction.
    (42) Section 965(c) deduction amount.
    (43) Short-term obligation.
    (44) Specified E&P deficit.
    (45) Specified foreign corporation.
    (i) General rule.
    (ii) Special attribution rule.
    (A) In general.
    (B) Attribution for purposes of the ten percent standard.
    (iii) Passive foreign investment companies.
    (46) Spot rate.
    (47) United States shareholder.
    (g) Examples.
    (1) Example 1.
    (i) Facts.
    (ii) Analysis.
    (2) Example 2.
    (i) Facts.
    (ii) Analysis.
    (3) Example 3.
    (i) Facts.
    (ii) Analysis.

[[Page 500]]

    (4) Example 4.
    (i) Facts.
    (ii) Analysis.
    (5) Example 5.
    (i) Facts.
    (ii) Analysis.
    (A) Determination of status as a deferred foreign income 
corporation.
    (B) Determination of status as an E&P deficit foreign corporation.
    (6) Example 6.
    (i) Facts.
    (ii) Analysis.
    (7) Example 7.
    (i) Facts.
    (ii) Analysis.
    (8) Example 8.
    (i) Facts.
    (ii) Analysis.

      Sec. 1.965-2 Adjustments to earnings and profits and basis.

    (a) Scope.
    (b) Determination of and adjustments to earnings and profits of a 
specified foreign corporation for purposes of applying sections 902, 
959, 960, and 965.
    (c) Adjustments to earnings and profits by reason of section 965(a).
    (d) Adjustments to earnings and profits by reason of section 965(b).
    (1) Adjustments to earnings and profits described in section 
959(c)(2) and (c)(3) of deferred foreign income corporations.
    (2) Adjustments to earnings and profits described in section 
959(c)(3) of E&P deficit foreign corporations.
    (i) Increase in earnings and profits by an amount equal to the 
portion of the section 958(a) U.S. shareholder's pro rata share of the 
specified E&P deficit.
    (A) In general.
    (B) Reduction of a qualified deficit.
    (ii) Determination of portion of a section 958(a) U.S. shareholder's 
pro rata share of a specified E&P deficit taken into account.
    (A) In general.
    (B) Designation of portion of a section 958(a) U.S. shareholder's 
pro rata share of a specified E&P deficit taken into account.
    (e) Adjustments to basis by reason of section 965(a).
    (1) General rule.
    (2) Section 962 election.
    (f) Adjustments to basis by reason of section 965(b).
    (1) In general.
    (2) Election to make adjustments to basis to account for the 
application of section 965(b).
    (i) In general.
    (ii) Basis adjustments.
    (A) Increase in basis with respect to a deferred foreign income 
corporation.
    (1) In general.
    (2) Limited basis adjustment.
    (B) Reduction in basis with respect to an E&P deficit foreign 
corporation.
    (1) In general.
    (2) Limited basis adjustment.
    (C) Section 962 election.
    (iii) Rules regarding the election.
    (A) Consistency requirement.
    (B) Manner of making election.
    (1) Timing.
    (i) In general.
    (ii) Transition rule.
    (2) Election statement.
    (g) Gain reduction rule.
    (1) Reduction in gain recognized under section 961(b)(2) by reason 
of distributions attributable to section 965 previously taxed earnings 
and profits in the inclusion year.
    (i) In general.
    (ii) Definition of section 965 previously taxed earnings and 
profits.
    (2) Reduction in basis by an amount equal to the gain reduction 
amount.
    (h) Rules of application for specified basis adjustments.
    (1) Timing of basis adjustments.
    (2) Netting of basis adjustments.
    (3) Gain recognition for reduction in excess of basis.
    (4) Adjustments with respect to each share.
    (i) Section 958(a) stock.
    (ii) Applicable property.
    (5) Stock or property for which adjustments are made.
    (i) In general.
    (ii) Special rule for an interest in a foreign pass-through entity.
    (i) Definitions.
    (1) Applicable property.
    (2) Foreign pass-through entity.
    (3) Property.
    (j) Examples.
    (1) Example 1.
    (i) Facts.
    (ii) Analysis.
    (A) Adjustments to section 959(c) classification of earnings and 
profits for inclusion under section 951(a)(1)(A) without regard to 
section 965.
    (B) Distributions between specified foreign corporations before 
January 1, 2018.
    (C) Section 965(a) inclusion amount.
    (1) CFC1 section 965(a) earnings amount.
    (2) CFC2 section 965(a) earnings amount.
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3).
    (D) Distribution to United States shareholder.
    (E) Section 902 and section 960 consequences.
    (1) Distribution by and inclusions with respect to CFC2.
    (2) Inclusions with respect to CFC1.
    (2) Example 2.
    (i) Facts.
    (ii) Analysis.
    (A) Adjustments to section 959(c) classification of earnings and 
profits for inclusion

[[Page 501]]

under section 951(a)(1)(A) without regard to section 965.
    (B) Distributions between specified foreign corporations before 
January 1, 2018.
    (C) Section 965(a) inclusion amount.
    (1) CFC1 section 965(a) earnings amount.
    (2) CFC2 section 965(a) earnings amount.
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3).
    (D) Distribution to United States shareholder.
    (3) Example 3.
    (i) Facts.
    (ii) Analysis.
    (A) Adjustments to section 959(c) classification of earnings and 
profits for inclusion under section 951(a)(1)(A) without regard to 
section 965.
    (B) Distributions between specified foreign corporations before 
January 1, 2018.
    (C) Section 965(a) inclusion amount.
    (1) CFC1 section 965(a) earnings amount.
    (2) CFC2 section 965(a) earnings amount.
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3).
    (D) Distribution to United States shareholder.
    (4) Example 4.
    (i) Facts.
    (ii) Analysis.
    (A) Adjustments to section 959(c) classification of earnings and 
profits for inclusion under section 951(a)(1)(A) without regard to 
section 965.
    (B) Distributions between specified foreign corporations before 
January 1, 2018.
    (C) Section 965(a) inclusion amount.
    (1) CFC1 section 965(a) earnings amount.
    (2) CFC2 section 965(a) earnings amount.
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3).
    (D) Distribution to United States shareholder.
    (1) Distribution that is a specified payment.
    (2) Distribution to United States shareholder.
    (E) Section 902 and section 960 consequences.
    (5) Example 5.
    (i) Facts.
    (ii) Analysis.
    (A) Section 965(a) inclusion amount.
    (1) CFC section 965(a) earnings amount.
    (2) Effect on earnings and profits described in section 959(c)(2) 
and (3).
    (6) Example 6.
    (i) Facts.
    (ii) Analysis.
    (A) Adjustments to section 959(c) classification of earnings and 
profits for section 1248 inclusion.
    (B) Section 965(a) inclusion amount.
    (C) Distributions to United States shareholders.
    (7) Example 7.
    (i) Facts.
    (ii) Analysis.
    (8) Example 8.
    (i) Facts.
    (ii) Analysis.
    (A) Application of the gain reduction rule.
    (B) Adjustments to the basis of CFC1.
    (9) Example 9.
    (i) Facts.
    (ii) Analysis.
    (A) Application of the gain reduction rule.
    (B) Adjustments to the basis of CFC1 and CFC2.

                Sec. 1.965-3 Section 965(c) deductions.

    (a) Scope.
    (b) Rules for disregarding certain assets for determining aggregate 
foreign cash position.
    (1) Disregard of certain obligations between related specified 
foreign corporations.
    (2) Disregard of other assets upon demonstration of double-counting.
    (3) Disregard of portion of cash position of noncorporate entities 
treated as specified foreign corporations.
    (4) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Analysis.
    (1) Loan from CFC1 to CFC2.
    (2) Account receivable of CFC1 held by CFC2.
    (3) Loan from CFC1 to CFC3.
    (ii) Example 2.
    (A) Facts.
    (B) Analysis.
    (iii) Example 3.
    (A) Facts.
    (B) Analysis.
    (iv) Example 4.
    (A) Facts.
    (B) Analysis.
    (v) Example 5.
    (A) Facts.
    (B) Analysis.
    (1) Treatment of PS1.
    (2) Treatment of PS2.
    (c) Determination of aggregate foreign cash position for a section 
958(a) U.S. shareholder inclusion year.
    (1) Single section 958(a) U.S. shareholder inclusion year.
    (2) Multiple section 958(a) U.S. shareholder inclusion years.
    (i) Allocation to first section 958(a) U.S. shareholder inclusion 
year.
    (ii) Allocation to succeeding section 958(a) U.S. shareholder 
inclusion years.
    (3) Estimation of aggregate foreign cash position.
    (4) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Analysis.
    (ii) Example 2.
    (A) Facts.
    (B) Analysis.

[[Page 502]]

    (d) Increase of income by section 965(c) deduction of an expatriated 
entity.
    (1) In general.
    (2) Definition of expatriated entity.
    (3) Definition of surrogate foreign corporation.
    (e) Section 962 election.
    (1) In general.
    (2) Example.
    (i) Facts.
    (ii) Analysis.
    (f) Treatment of section 965(c) deduction under certain provisions 
of the Internal Revenue Code.
    (1) Section 63(d).
    (2) Sections 705, 1367, and 1368.
    (i) Adjustments to basis.
    (ii) S corporation accumulated adjustments account.
    (iii) Example.
    (A) Facts.
    (B) Analysis.
    (3) Section 1411.
    (4) Section 4940.
    (g) Domestic pass-through entities.

            Sec. 1.965-4 Disregard of certain transactions.

    (a) Scope.
    (b) Transactions undertaken with a principal purpose of changing the 
amount of a section 965 element.
    (1) General rule.
    (2) Presumptions and exceptions for the application of the general 
rule.
    (i) Overview.
    (ii) Definitions.
    (A) Relatedness.
    (B) Transfer.
    (1) In general.
    (2) Indirect transfer.
    (iii) Cash reduction transactions.
    (A) General rule.
    (B) Per se rules for certain distributions.
    (iv) E&P reduction transactions.
    (A) General rule.
    (1) Definition of pro rata share reduction transaction.
    (2) Definition of E&P deficit transaction.
    (B) Per se rule for internal group transactions.
    (C) Example.
    (1) Facts.
    (2) Analysis.
    (c) Disregard of certain changes in method of accounting and entity 
classification elections.
    (1) Changes in method of accounting.
    (2) Entity classification elections.
    (d) Definition of a section 965 element.
    (e) Rules for applying paragraphs (b) and (c) of this section.
    (1) Determination of whether there is a change in the amount of a 
section 965 element.
    (2) Treatment of domestic pass-through owners as United States 
shareholders.
    (3) Exception for certain incorporation transactions.
    (i) In general.
    (ii) Aggregate foreign cash position.
    (4) Consequences of liquidation.
    (i) In general.
    (ii) Specified liquidation date.
    (f) Disregard of certain transactions occurring between E&P 
measurement dates.
    (1) Disregard of specified payments.
    (2) Definition of specified payment.
    (3) Non-application of disregard rule.
    (4) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Analysis.
    (ii) Example 2.
    (A) Facts.
    (B) Analysis.
    (iii) Example 3.
    (A) Facts.
    (B) Analysis.
    (iv) Example 4.
    (A) Facts.
    (B) Analysis.
    (v) Example 5.
    (A) Facts.
    (B) Analysis.
    (vi) Example 6.
    (A) Facts.
    (B) Analysis.

Sec. 1.965-5 Allowance of credit or deduction for foreign income taxes.

    (a) Scope.
    (b) Rules for foreign income taxes paid or accrued.
    (c) Rules for foreign income taxes treated as paid or accrued.
    (1) Disallowed credit.
    (i) In general.
    (ii) Foreign income taxes deemed paid under section 960(a)(3) (as in 
effect on December 21, 2017).
    (iii) [Reserved]
    (2) Disallowed deduction.
    (3) Coordination with section 78.
    (i) In general.
    (ii) Domestic corporation that is a domestic pass-through owner.
    (d) Applicable percentage.
    (1) In general.
    (2) No section 965(a) inclusion amount.
    (3) Applicable percentage for domestic pass-through owners.
    (4) Applicable percentage with respect to certain distributions of 
previously taxed earnings and profits.

   Sec. 1.965-6 Computation of foreign income taxes deemed paid and 
               allocation and apportionment of deductions.

    (a) Scope.
    (b) Computation of foreign income taxes deemed paid.
    (1) In general.

[[Page 503]]

    (2) Dividend or inclusion in excess of post-1986 undistributed 
earnings.
    (3) Treatment of adjustment under section 965(b)(4)(B).
    (4) Section 902 fraction.
    (c) Allocation and apportionment of deductions.
    (d) Hovering deficits.

       Sec. 1.965-7 Elections, payment, and other special rules.

    (a) Scope.
    (b) Section 965(h) election.
    (1) In general.
    (i) Amount of installments.
    (ii) Increased installments due to a deficiency or a timely filed or 
amended return.
    (A) In general.
    (B) Timing.
    (C) Exception for negligence, intentional disregard, or fraud.
    (iii) Due date of installments.
    (A) In general.
    (B) Extension for specified individuals.
    (2) Manner of making election.
    (i) Eligibility.
    (ii) Timing.
    (iii) Election statement.
    (3) Acceleration of payment.
    (i) Acceleration.
    (ii) Acceleration events.
    (iii) Eligible section 965(h) transferee exception.
    (A) In general.
    (1) Requirement to have a covered acceleration event.
    (2) Requirement to enter into a transfer agreement.
    (B) Transfer agreement.
    (1) Eligibility.
    (2) Filing requirements.
    (i) In general.
    (ii) Transition rule.
    (3) Signature requirement.
    (4) Terms of agreement.
    (5) Consolidated groups.
    (6) Leverage ratio.
    (C) Consent of Commissioner.
    (1) In general.
    (2) Material misrepresentations and omissions.
    (D) Effect of assumption.
    (1) In general.
    (2) Eligible section 965(h) transferor liability.
    (E) Qualifying consolidated group member transaction.
    (1) Definition of qualifying consolidated group member transaction.
    (2) Definition of qualified successor.
    (3) Departure of multiple members of a consolidated group.
    (c) Section 965(i) election.
    (1) In general.
    (2) Manner of making election.
    (i) Eligibility.
    (ii) Timing.
    (iii) Election statement.
    (3) Triggering events.
    (i) In general.
    (ii) Triggering events.
    (iii) Partial transfers.
    (iv) Eligible section 965(i) transferee exception.
    (A) In general.
    (1) Requirement to have a covered triggering event.
    (2) Requirement to enter into a transfer agreement.
    (B) Transfer agreement.
    (1) Eligibility.
    (2) Filing requirements.
    (i) In general.
    (ii) Transition rule.
    (iii) Death of eligible section 965(i) transferor.
    (3) Signature requirement.
    (4) Terms of agreement.
    (5) Special rule in the case of death of eligible section 965(i) 
transferor.
    (6) Leverage ratio.
    (C) Consent of Commissioner.
    (1) In general.
    (2) Material misrepresentations and omissions.
    (D) Effect of assumption.
    (1) In general.
    (2) Eligible section 965(i) transferor liability.
    (v) Coordination with section 965(h) election.
    (A) In general.
    (B) Timing for election.
    (C) Due date for installment.
    (D) Limitation.
    (1) In general.
    (2) Manner of obtaining consent.
    (i) In general.
    (ii) Transition rule.
    (3) Signature requirement.
    (4) Terms of agreement.
    (5) Consent of Commissioner.
    (i) In general.
    (ii) Material misrepresentations and omissions.
    (6) Leverage ratio.
    (4) Joint and several liability.
    (5) Extension of limitation on collection.
    (6) Annual reporting requirement.
    (i) In general.
    (ii) Failure to report.
    (d) Section 965(m) election and special rule for real estate 
investment trusts.
    (1) In general.
    (2) Inclusion schedule for section 965(m) election.
    (3) Manner of making election.
    (i) Eligibility.
    (ii) Timing.
    (iii) Election statement.
    (4) Coordination with section 965(h).
    (5) Acceleration of inclusion.
    (6) Treatment of section 965(a) inclusions of a real estate 
investment trust.

[[Page 504]]

    (e) Section 965(n) election.
    (1) In general.
    (i) General rule.
    (ii) Applicable amount for section 965(n) election.
    (iii) Scope of section 965(n) election.
    (iv) [Reserved]
    (2) Manner of making election.
    (i) Eligibility.
    (ii) Timing.
    (iii) Election statement.
    (f) Election to use alternative method for calculating post-1986 
earnings and profits.
    (1) Effect of election for specified foreign corporations that do 
not have a 52-53-week taxable year.
    (2) Effect of election for specified foreign corporations that have 
a 52-53-week taxable year.
    (3) Computation of post-1986 earnings and profits using alternative 
method.
    (4) Definitions.
    (i) 52-53-week taxable year.
    (ii) Annualized earnings and profits amount.
    (iii) Daily earnings amount.
    (iv) Notional measurement date.
    (5) Manner of making election.
    (i) Eligibility.
    (ii) Timing.
    (iii) Election statement.
    (6) Examples.
    (i) Example 1.
    (A) Facts.
    (B) Analysis.
    (ii) Example 2.
    (A) Facts.
    (B) Analysis.
    (g) Definitions.
    (1) Deferred net tax liability.
    (2) REIT section 965 amounts.
    (3) Section 965(h) election.
    (4) Section 965(h) net tax liability.
    (5) Section 965(i) election.
    (6) Section 965(i) net tax liability.
    (7) Section 965(m) election.
    (8) Section 965(n) election.
    (9) Specified individual.
    (10) Total net tax liability under section 965.
    (i) General rule.
    (ii) Net income tax.
    (iii) Foreign tax credits.

    Sec. 1.965-8 Affiliated groups (including consolidated groups).

    (a) Scope.
    (b) Reduction of E&P net surplus shareholder's pro rata share of the 
section 965(a) earnings amount of a deferred foreign income corporation 
by the allocable share of the applicable share of the aggregate unused 
E&P deficit.
    (1) In general.
    (2) Consolidated group as part of an affiliated group.
    (c) Designation of portion of excess aggregate foreign E&P deficit 
taken into account.
    (1) In general.
    (2) Consolidated group as part of an affiliated group.
    (d) [Reserved]
    (1) [Reserved]
    (2) Consolidated groups.
    (e) Treatment of a consolidated group as a single section 958(a) 
U.S. shareholder or a single person.
    (1) In general.
    (2) Limitation.
    (3) Determination of section 965(c) deduction amount.
    (f) Definitions.
    (1) Aggregate unused E&P deficit.
    (i) In general.
    (ii) Reduction with respect to E&P net deficit shareholders that are 
not wholly owned by the affiliated group.
    (2) Allocable share.
    (3) Applicable share.
    (4) Consolidated group aggregate foreign cash position.
    (5) E&P net deficit shareholder.
    (6) E&P net surplus shareholder.
    (7) Excess aggregate foreign E&P deficit.
    (8) Group cash ratio.
    (9) Group ownership percentage.
    (g) Examples.
    (1) Example 1.
    (i) Facts.
    (A) In general.
    (B) Facts relating to section 965.
    (ii) Analysis.
    (A) Section 965(a) inclusion amounts before application of section 
965(b)(5).
    (B) Application of section 965(b)(5).
    (1) Determination of E&P net surplus shareholders and E&P net 
deficit shareholders.
    (2) Determining section 965(a) inclusion amounts under section 
965(b)(5).
    (C) Aggregate foreign cash position.
    (D) Section 965(c) deduction amount.
    (2) Example 2.
    (i) Facts.
    (ii) Analysis.
    (A) Section 965(a) inclusion amount.
    (1) Single section 958(a) U.S. shareholder treatment.
    (2) Determination of inclusion amount.
    (B) Consolidated group aggregate foreign cash position.
    (C) Section 965(a) deduction amount.

                   Sec. 1.965-9 Applicability dates.

    (a) In general.
    (b) Applicability dates for rules disregarding certain transactions.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9846, 84 FR 
14260, Apr. 10, 2019]

[[Page 505]]



Sec. 1.965-1  Overview, general rules, and definitions.

    (a) Overview--(1) In general. This section provides general rules 
and definitions under section 965. Section 1.965-2 provides rules 
relating to adjustments to earnings and profits and basis to determine 
and account for the application of section 965 and a rule that limits 
the amount of gain recognized under section 961(b)(2) by reason of 
distributions attributable to section 965 previously taxed earnings and 
profits (as defined in Sec. 1.965-2(g)(1)(ii)) in the inclusion year. 
Section 1.965-3 provides rules regarding the determination of section 
965(c) deductions. Section 1.965-4 sets forth rules that disregard 
certain transactions for purposes of section 965. Sections 1.965-5 and 
1.965-6 provide rules with respect to foreign tax credits. Section 
1.965-7 provides rules regarding elections and payments. Section 1.965-8 
provides rules regarding affiliated groups, including consolidated 
groups. Section 1.965-9 provides dates of applicability. See also 
Sec. Sec. 1.962-1 and 1.962-2 (providing rules regarding the 
application of section 962) and 1.986(c)-1 (providing rules regarding 
the application of section 986(c)).
    (2) Scope. Paragraph (b) of this section provides the general rules 
concerning section 965(a) inclusion amounts. Paragraph (c) of this 
section provides the general rule concerning section 965(c) deduction 
amounts. Paragraph (d) of this section provides a rule for specified 
foreign corporations that are not controlled foreign corporations. 
Paragraph (e) of this section treats certain controlled domestic 
partnerships as foreign partnerships for purposes of section 965. 
Paragraph (f) of this section provides definitions applicable for the 
section 965 regulations and Sec. Sec. 1.962-1, 1.962-2, and 1.986(c)-1. 
Paragraph (g) of this section contains examples illustrating the general 
rules and definitions set forth in this section.
    (b) Section 965(a) inclusion amounts--(1) Inclusion of the pro rata 
share of the section 965(a) earnings amount. For an inclusion year of a 
deferred foreign income corporation, the subpart F income of the 
deferred foreign income corporation (as otherwise determined for the 
inclusion year under section 952 and Sec. 1.952-1) is increased by the 
section 965(a) earnings amount of the deferred foreign income 
corporation. See section 965(a). Accordingly, a section 958(a) U.S. 
shareholder with respect to a deferred foreign income corporation 
generally includes in gross income under section 951(a)(1) for the 
section 958(a) U.S. shareholder inclusion year its pro rata share of the 
section 965(a) earnings amount of the deferred foreign income 
corporation, translated (if necessary) into U.S. dollars using the spot 
rate on December 31, 2017, and subject to reduction under section 
965(b), paragraph (b)(2) of this section, and Sec. 1.965-8(b). The 
amount of the section 958(a) U.S. shareholder's inclusion with respect 
to a deferred foreign income corporation as a result of section 965(a) 
and this paragraph (b)(1), as reduced under section 965(b), paragraph 
(b)(2) of this section, and Sec. 1.965-8(b), as applicable, is referred 
to as the section 965(a) inclusion amount. Neither the section 965(a) 
earnings amount nor the section 965(a) inclusion amount is subject to 
the rules or limitations in section 952 or limited by the accumulated 
earnings and profits of the deferred foreign income corporation on the 
date of the inclusion.
    (2) Reduction by the allocable share of the aggregate foreign E&P 
deficit. For purposes of determining a section 958(a) U.S. shareholder's 
section 965(a) inclusion amount with respect to a deferred foreign 
income corporation, the U.S. dollar amount of the section 958(a) U.S. 
shareholder's pro rata share of the section 965(a) earnings amount of 
the deferred foreign income corporation, translated (if necessary) into 
U.S. dollars using the spot rate on December 31, 2017, is reduced by the 
deferred foreign income corporation's allocable share of the section 
958(a) U.S. shareholder's aggregate foreign E&P deficit. See section 
965(b). If the section 958(a) U.S. shareholder is a member of a 
consolidated group, under Sec. 1.965-8(e), all section 958(a) U.S. 
shareholders that are members of the consolidated group are treated as a 
single section 958(a) U.S. shareholder for purposes of this paragraph 
(b)(2).
    (c) Section 965(c) deduction amounts. For a section 958(a) U.S. 
shareholder inclusion year, a section 958(a) U.S.

[[Page 506]]

shareholder is generally allowed a deduction in an amount equal to the 
section 965(c) deduction amount.
    (d) Treatment of specified foreign corporation as a controlled 
foreign corporation. A specified foreign corporation described in 
section 965(e)(1)(B) and paragraph (f)(45)(i)(B) of this section that is 
not otherwise a controlled foreign corporation is treated as a 
controlled foreign corporation solely for purposes of paragraph (b) of 
this section and sections 951, 961, and Sec. 1.1411-10. See 965(e)(2).
    (e) Special rule for certain controlled domestic partnerships--(1) 
In general. For purposes of the section 965 regulations, a controlled 
domestic partnership is treated as a foreign partnership for purposes of 
determining the section 958(a) U.S. shareholder of a specified foreign 
corporation and the section 958(a) stock of the specified foreign 
corporation owned by the section 958(a) U.S. shareholder if the 
following conditions are satisfied--
    (i) Without regard to this paragraph (e), the controlled domestic 
partnership is a section 958(a) U.S. shareholder of the specified 
foreign corporation and thus owns section 958(a) stock of the specified 
foreign corporation (tested section 958(a) stock);
    (ii) If the controlled domestic partnership (and all other 
controlled domestic partnerships in the chain of ownership of the 
specified foreign corporation) were treated as foreign--
    (A) The specified foreign corporation would continue to be a 
specified foreign corporation; and
    (B) At least one United States shareholder of the specified foreign 
corporation--
    (1) Would be treated as a section 958(a) U.S. shareholder of the 
specified foreign corporation; and
    (2) Would be treated as owning (within the meaning of section 
958(a)) tested section 958(a) stock of the specified foreign corporation 
through another foreign corporation that is a direct or indirect partner 
in the controlled domestic partnership.
    (2) Definition of a controlled domestic partnership. For purposes of 
paragraph (e)(1) of this section, the term controlled domestic 
partnership means a domestic partnership that is controlled by a United 
States shareholder described in paragraph (e)(1)(ii)(B) of this section 
and persons related to the United States shareholder. For purposes of 
this paragraph (e)(2), control is determined based on all the facts and 
circumstances, except that a partnership will be deemed to be controlled 
by a United States shareholder and related persons if those persons, in 
the aggregate, own (directly or indirectly through one or more 
partnerships) more than 50 percent of the interests in the partnership 
capital or profits. For purposes of this paragraph (e)(2), a related 
person is, with respect to a United States shareholder, a person that is 
related (within the meaning of section 267(b) or 707(b)(1)) to the 
United States shareholder.
    (f) Definitions. This paragraph (f) provides definitions that apply 
for purposes of the section 965 regulations and Sec. Sec. 1.962-1, 
1.962-2, and 1.986(c)-1. Unless otherwise indicated, all amounts are 
expressed as positive numbers.
    (1) 8 percent rate amount. The term 8 percent rate amount means, 
with respect to a section 958(a) U.S. shareholder and a section 958(a) 
U.S. shareholder inclusion year, the excess, if any, of the section 
958(a) U.S. shareholder's aggregate section 965(a) inclusion amount for 
the section 958(a) U.S. shareholder inclusion year over the amount of 
the section 958(a) U.S. shareholder's aggregate foreign cash position 
for the section 958(a) U.S. shareholder inclusion year as determined 
under Sec. 1.965-3(c).
    (2) 8 percent rate equivalent percentage. The term 8 percent rate 
equivalent percentage means, with respect to a section 958(a) U.S. 
shareholder and a section 958(a) U.S. shareholder inclusion year, the 
percentage that would result in the 8 percent rate amount being subject 
to an 8 percent rate of tax determined by only taking into account a 
deduction equal to such percentage of such amount and the highest rate 
of tax specified in section 11 for the section 958(a) U.S. shareholder 
inclusion year. In the case of a section 958(a) U.S. shareholder 
inclusion year of a section 958(a) U.S. shareholder to which section 15 
applies, the highest rate of tax under section 11 before the effective 
date of the change in rates and the highest rate of tax under section 11

[[Page 507]]

after the effective date of such change will each be taken into account 
under the preceding sentence in the same proportions as the portion of 
the section 958(a) U.S. shareholder inclusion year that is before and 
after such effective date, respectively.
    (3) 15.5 percent rate amount. The term 15.5 percent rate amount 
means, with respect to a section 958(a) U.S. shareholder and a section 
958(a) U.S. shareholder inclusion year, the amount of the section 958(a) 
U.S. shareholder's aggregate foreign cash position for the section 
958(a) U.S. shareholder inclusion year as determined under Sec. 1.965-
3(c) to the extent it does not exceed the section 958(a) U.S. 
shareholder's aggregate section 965(a) inclusion amount for the section 
958(a) U.S. shareholder inclusion year.
    (4) 15.5 percent rate equivalent percentage. The term 15.5 percent 
rate equivalent percentage, with respect to a section 958(a) U.S. 
shareholder and a section 958(a) U.S. shareholder inclusion year, has 
the meaning provided for the term ``8 percent rate equivalent 
percentage'' applied by substituting ``15.5 percent rate amount'' for 
``8 percent rate amount'' and ``15.5 percent rate of tax'' for ``8 
percent rate of tax.''
    (5) Accounts payable. The term accounts payable means payables 
arising from the purchase of property described in section 1221(a)(1) or 
section 1221(a)(8) or the receipt of services from vendors or suppliers, 
provided the payables have a term upon issuance of less than one year.
    (6) Accounts receivable. The term accounts receivable means 
receivables described in section 1221(a)(4) that have a term upon 
issuance of less than one year.
    (7) Accumulated post-1986 deferred foreign income--(i) In general. 
The term accumulated post-1986 deferred foreign income means, with 
respect to a specified foreign corporation, the post-1986 earnings and 
profits of the specified foreign corporation except to the extent such 
earnings and profits--
    (A) Are attributable to income of the specified foreign corporation 
that is effectively connected with the conduct of a trade or business 
within the United States and subject to tax under chapter 1;
    (B) If distributed, would, in the case of a controlled foreign 
corporation, be excluded from the gross income of a United States 
shareholder under section 959; or
    (C) If distributed, would, in the case of a controlled foreign 
corporation that has shareholders that are not United States 
shareholders on an E&P measurement date, be excluded from the gross 
income of such shareholders under section 959 if such shareholders were 
United States shareholders, determined by applying the principles of 
Revenue Ruling 82-16, 1982-1 C.B. 106.
    (ii) Earnings and profits attributable to subpart F income in the 
same taxable year as an E&P measurement date. For purposes of 
determining the accumulated post-1986 deferred foreign income of a 
specified foreign corporation as of an E&P measurement date, earnings 
and profits of the specified foreign corporation that are or would be, 
applying the principles of Revenue Ruling 82-16, 1982-1 C.B. 106, 
described in section 959(c)(2) by reason of subpart F income (as defined 
in section 952 without regard to section 965(a)) are described in 
section 965(d)(2)(B) and paragraph (f)(7)(i)(B) or (f)(7)(i)(C) of this 
section only to the extent that such income has been accrued by the 
specified foreign corporation as of the E&P measurement date. For rules 
regarding the interaction of sections 951, 956, 959, and 965 generally, 
see Sec. 1.965-2(b).
    (8) Aggregate foreign cash position--(i) In general. The term 
aggregate foreign cash position means, with respect to a section 958(a) 
U.S. shareholder that is not a member of a consolidated group, the 
greater of--
    (A) The aggregate of the section 958(a) U.S. shareholder's pro rata 
share of the cash position of each specified foreign corporation 
determined as of the final cash measurement date of the specified 
foreign corporation; or
    (B) One half of the sum of--
    (1) The aggregate described in paragraph (f)(8)(i)(A) of this 
section determined as of the second cash measurement date of each 
specified foreign corporation, plus
    (2) The aggregate described in paragraph (f)(8)(i)(A) of this 
section determined as of the first cash measurement

[[Page 508]]

date of each specified foreign corporation.
    (ii) Other rules. For rules for determining the aggregate foreign 
cash position for a section 958(a) U.S. shareholder inclusion year of 
the section 958(a) U.S. shareholder, see Sec. 1.965-3(c). For the rule 
for determining the aggregate foreign cash position of a section 958(a) 
U.S. shareholder that is a member of a consolidated group, see Sec. 
1.965-8(e)(3). For rules disregarding certain assets for purposes of 
determining the aggregate foreign cash position of a section 958(a) U.S. 
shareholder, see Sec. 1.965-3(b).
    (9) Aggregate foreign E&P deficit. The term aggregate foreign E&P 
deficit means, with respect to a section 958(a) U.S. shareholder, the 
lesser of--
    (i) The aggregate of the section 958(a) U.S. shareholder's pro rata 
share of the specified E&P deficit of each E&P deficit foreign 
corporation, translated (if necessary) into U.S. dollars using the spot 
rate on December 31, 2017, or
    (ii) The aggregate of the section 958(a) U.S. shareholder's pro rata 
share of the section 965(a) earnings amount of each deferred foreign 
income corporation, translated (if necessary) into U.S. dollars using 
the spot rate on December 31, 2017.
    (10) Aggregate section 965(a) inclusion amount. The term aggregate 
section 965(a) inclusion amount means, with respect to a section 958(a) 
U.S. shareholder, the sum of all of the section 958(a) U.S. 
shareholder's section 965(a) inclusion amounts.
    (11) Allocable share. The term allocable share means, with respect 
to a deferred foreign income corporation and an aggregate foreign E&P 
deficit of a section 958(a) U.S. shareholder, the product of the 
aggregate foreign E&P deficit and the ratio determined by dividing--
    (i) The section 958(a) U.S. shareholder's pro rata share of the 
section 965(a) earnings amount of the deferred foreign income 
corporation, translated (if necessary) into U.S. dollars using the spot 
rate on December 31, 2017, by
    (ii) The amount described in paragraph (f)(9)(ii) of this section 
with respect to the section 958(a) U.S. shareholder.
    (12) Bona fide hedging transaction. The term bona fide hedging 
transaction means a hedging transaction that meets (or that would meet 
if the specified foreign corporation were a controlled foreign 
corporation) the requirements of a bona fide hedging transaction 
described in Sec. 1.954-2(a)(4)(ii), except that in the case of a 
specified foreign corporation that is not a controlled foreign 
corporation, the identification requirements of Sec. 1.954-
2(a)(4)(ii)(B) do not apply.
    (13) Cash-equivalent asset--(i) In general. The term cash-equivalent 
asset means any of the following assets--
    (A) Personal property which is of a type that is actively traded and 
for which there is an established financial market, other than a 
specified commodity;
    (B) Commercial paper, certificates of deposit, the securities of the 
Federal government and of any State or foreign government;
    (C) Any foreign currency;
    (D) A short-term obligation; or
    (E) Derivative financial instruments, other than bona fide hedging 
transactions.
    (ii) Specified commodity. The term specified commodity means a 
commodity held, or, for purposes of paragraph (f)(18) of this section, 
to be held, by a specified foreign corporation that, in the hands of the 
specified foreign corporation, is property described in section 
1221(a)(1) or 1221(a)(8). This paragraph (f)(13)(ii) does not apply with 
respect to commodities held by a specified foreign corporation in its 
capacity as a dealer or trader in commodities.
    (14) Cash-equivalent asset hedging transaction--(i) In general. The 
term cash-equivalent asset hedging transaction means a bona fide hedging 
transaction identified on a specified foreign corporation's books and 
records as hedging a cash-equivalent asset.
    (ii) Aggregate hedging transactions. For purposes of paragraph 
(f)(14)(i) of this section, the amount of a bona fide hedging 
transaction described in Sec. 1.1221-2(c)(3) (an aggregate hedging 
transaction) that is treated as a cash-equivalent asset hedging 
transaction is the amount that bears the same proportion to the fair 
market value of the aggregate hedging transaction as the value of the 
cash-equivalent assets being hedged by the aggregate hedging

[[Page 509]]

transaction bears to the value of all assets being hedged by the 
aggregate hedging transaction.
    (15) Cash measurement dates. The term cash measurement dates means, 
with respect to a specified foreign corporation, the first cash 
measurement date, the second cash measurement date, and the final cash 
measurement date, collectively, and each a cash measurement date.
    (16) Cash position--(i) General rule. The term cash position means, 
with respect to a specified foreign corporation, the sum of--
    (A) Cash held by the corporation;
    (B) The net accounts receivable of the corporation; and
    (C) The fair market value of the cash-equivalent assets held by the 
corporation.
    (ii) Fair market value of cash-equivalent assets. For purposes of 
determining the fair market value of a cash-equivalent asset of a 
specified foreign corporation, the value of the cash-equivalent asset 
must be adjusted by the fair market value of any cash- equivalent asset 
hedging transaction with respect to the cash-equivalent asset, but only 
to the extent that the cash-equivalent asset hedging transaction does 
not reduce the fair market value of the cash-equivalent asset below 
zero.
    (iii) Measurement of derivative financial instruments. The amount of 
derivative financial instruments taken into account in determining the 
cash position of a specified foreign corporation is the aggregate fair 
market value of its derivative financial instruments that constitute 
cash-equivalent assets, provided such amount is not less than zero.
    (iv) Translation of cash position amounts. The cash position of a 
specified foreign corporation with respect to a cash measurement date 
must be expressed in U.S. dollars. For this purpose, the amounts 
described in paragraph (f)(16)(i) of this section must be translated (if 
necessary) into U.S. dollars using the spot rate on the relevant cash 
measurement date.
    (17) Deferred foreign income corporation--(i) In general. The term 
deferred foreign income corporation means a specified foreign 
corporation that has accumulated post-1986 deferred foreign income 
greater than zero as of an E&P measurement date.
    (ii) Priority rule. If a specified foreign corporation satisfies the 
definition of a deferred foreign income corporation under section 
965(d)(1) and paragraph (f)(17)(i) of this section, it is classified 
solely as a deferred foreign income corporation and not also as an E&P 
deficit foreign corporation even if it otherwise satisfies the 
requirements of section 965(b)(3)(B) and paragraph (f)(22) of this 
section.
    (18) Derivative financial instrument. The term derivative financial 
instrument includes a financial instrument that is one of the 
following--
    (i) A notional principal contract,
    (ii) An option contract,
    (iii) A forward contract, other than a forward contract with respect 
to a specified commodity (as defined in paragraph (f)(13)(ii) of this 
section), but solely to the extent that the specified foreign 
corporation identified, or could have identified, the forward contract 
as a hedging transaction (within the meaning of Sec. 1.1221-2(b)) with 
respect to one or more specified commodities held by the specified 
foreign corporation,
    (iv) A futures contract,
    (v) A short position in securities or commodities, other than a 
forward contract with respect to a specified commodity, but solely to 
the extent that the specified foreign corporation identified, or could 
have identified, the forward contract as a hedging transaction (within 
the meaning of Sec. 1.1221-2(b)) with respect to one or more specified 
commodities held by the specified foreign corporation, or
    (vi) Any financial instrument similar to one described in paragraphs 
(f)(18)(i) through (v) of this section.
    (19) Domestic pass-through entity. The term domestic pass-through 
entity means a pass-through entity that is a United States person (as 
defined in section 7701(a)(30)).
    (20) Domestic pass-through owner. The term domestic pass-through 
owner means, with respect to a domestic pass-through entity, a United 
States person (as defined in section 7701(a)(30)) that is a partner, 
shareholder, beneficiary, grantor, or owner, as the case may be, in the 
domestic pass-through entity.

[[Page 510]]

Notwithstanding the preceding sentence, the term does not include a 
partner, shareholder, beneficiary, grantor, or owner of the domestic 
pass-through entity that is itself a domestic pass-through entity but 
does include any other United States person that is an indirect partner, 
shareholder, beneficiary, grantor, or owner of the domestic pass-through 
entity through one or more other pass-through entities.
    (21) Domestic pass-through owner share. The term domestic pass-
through owner share means, with respect to a domestic pass-through owner 
and a domestic pass-through entity, the domestic pass-through owner's 
share of the aggregate section 965(a) inclusion amount and the section 
965(c) deduction amount, as applicable, of the domestic pass-through 
entity, including the domestic pass-through owner's share of the 
aggregate section 965(a) inclusion amount and section 965(c) deduction 
amount, as applicable, of a domestic pass-through entity owned 
indirectly by the domestic pass-through owner through one or more other 
pass-through entities.
    (22) E&P deficit foreign corporation--(i) In general. The term E&P 
deficit foreign corporation means, with respect to a section 958(a) U.S. 
shareholder, a specified foreign corporation, other than a deferred 
foreign income corporation, if, as of November 2, 2017--
    (A) The specified foreign corporation had a deficit in post-1986 
earnings and profits,
    (B) The corporation was a specified foreign corporation, and
    (C) The shareholder was a United States shareholder of the 
corporation.
    (ii) Determination of deficit in post-1986 earnings and profits. In 
the case of a specified foreign corporation that has post-1986 earnings 
and profits that include earnings and profits described in section 
959(c)(1) or 959(c)(2) (or both) and a deficit in earnings and profits 
(including hovering deficits, as defined in Sec. 1.367(b)-7(d)(2)(i)), 
the specified foreign corporation has a deficit in post-1986 earnings 
and profits described in paragraph (f)(22)(i)(A) of this section only to 
the extent the deficit in post-1986 earnings and profits exceeds the 
aggregate of its post-1986 earnings and profits described in section 
959(c)(1) and 959(c)(2).
    (23) E&P measurement dates. The term E&P measurement dates means 
November 2, 2017, and December 31, 2017, collectively, and each an E&P 
measurement date.
    (24) Final cash measurement date. The term final cash measurement 
date means, with respect to a specified foreign corporation, the close 
of the last taxable year of the specified foreign corporation that 
begins before January 1, 2018, and ends on or after November 2, 2017, if 
any.
    (25) First cash measurement date. The term first cash measurement 
date means, with respect to a specified foreign corporation, the close 
of the last taxable year of the specified foreign corporation that ends 
after November 1, 2015, and before November 2, 2016, if any.
    (26) Inclusion year. The term inclusion year means, with respect to 
a deferred foreign income corporation, the last taxable year of the 
deferred foreign income corporation that begins before January 1, 2018.
    (27) Net accounts receivable. The term net accounts receivable 
means, with respect to a specified foreign corporation, the excess (if 
any) of--
    (i) The corporation's accounts receivable, over
    (ii) The corporation's accounts payable (determined consistent with 
the rules of section 461).
    (28) Pass-through entity. The term pass-through entity means a 
partnership, S corporation, or any other person (whether domestic or 
foreign) other than a corporation to the extent that the income or 
deductions of the person are included in the income of one or more 
direct or indirect owners or beneficiaries of the person. For example, 
if a domestic trust is subject to federal income tax on a portion of its 
section 965(a) inclusion amount and its domestic pass-through owners are 
subject to tax on the remaining portion, the domestic trust is treated 
as a domestic pass-through entity with respect to such remaining 
portion.
    (29) Post-1986 earnings and profits--(i) General rule. The term 
post-1986 earnings and profits means, with respect to a specified 
foreign corporation and an E&P measurement date, the earnings

[[Page 511]]

and profits (including earnings and profits described in section 
959(c)(1) and 959(c)(2)) of the specified foreign corporation (computed 
in accordance with sections 964(a) and 986, subject to Sec. 1.965-4(f), 
and by taking into account only periods when the foreign corporation was 
a specified foreign corporation) accumulated in taxable years beginning 
after December 31, 1986, and determined--
    (A) As of the E&P measurement date, except as provided in paragraph 
(f)(29)(ii) of this section, and
    (B) Without diminution by reason of dividends distributed during the 
last taxable year of the foreign corporation that begins before January 
1, 2018, other than dividends distributed to another specified foreign 
corporation to the extent the dividends increase the post-1986 earnings 
and profits of the distributee specified foreign corporation.
    (ii) Foreign income taxes. For purposes of determining a specified 
foreign corporation's post-1986 earnings and profits as of the E&P 
measurement date on November 2, 2017, in the case in which foreign 
income taxes (as defined in section 901(m)(5)) of the specified foreign 
corporation accrue after November 2, 2017, but on or before December 31, 
2017, and during the specified foreign corporation's U.S. taxable year 
that includes November 2, 2017, the specified foreign corporation's 
post-1986 earnings and profits as of November 2, 2017, are reduced by 
the applicable portion of such foreign income taxes. For purposes of the 
preceding sentence, the applicable portion of the foreign income taxes 
is the amount of the taxes that are attributable to the portion of the 
taxable income (as determined under foreign law) that accrues on or 
before November 2, 2017.
    (iii) Deficits in earnings and profits. Any deficit related to post-
1986 earnings and profits, including a hovering deficit (as defined in 
Sec. 1.367(b)-7(d)(2)(i)), of a specified foreign corporation is taken 
into account for purposes of determining the post-1986 earnings and 
profits (including a deficit) of the specified foreign corporation.
    (30) Pro rata share. The term pro rata share means, with respect to 
a section 958(a) U.S. shareholder of a specified foreign corporation, a 
deferred foreign income corporation, or an E&P deficit foreign 
corporation, as applicable--
    (i) With respect to the section 965(a) earnings amount of a deferred 
foreign income corporation, the portion of the section 965(a) earnings 
amount that would be treated as distributed to the section 958(a) U.S. 
shareholder under Sec. 1.951-1(e), determined as of the last day of the 
inclusion year of the deferred foreign income corporation on which it is 
a specified foreign corporation;
    (ii) With respect to the specified E&P deficit of an E&P deficit 
foreign corporation, the portion of the specified E&P deficit allocated 
to the section 958(a) U.S. shareholder, determined by allocating the 
specified E&P deficit among the shareholders of the corporation's common 
stock in proportion to the liquidation value of the common stock held by 
the shareholders, determined as of the last day of the last taxable year 
of the E&P deficit foreign corporation that begins before January 1, 
2018, provided that--
    (A) If the corporation's common stock has a liquidation value of 
zero and there is at least one other class of equity with a liquidation 
preference relative to the common stock, then the specified E&P deficit 
is allocated as if it were distributed in a hypothetical distribution 
described in Sec. 1.951-1(e)(1)(i) with respect to the most junior 
class of equity with a positive liquidation value to the extent of such 
liquidation value, and then to the next most junior class of equity to 
the extent of its liquidation value, and so on, applying Sec. 1.951-
1(e) by substituting ``specified E&P deficit'' for ``subpart F income'' 
each place it appears and treating the amount of current earnings and 
profits of the corporation for the year as being equal to the specified 
E&P deficit of the corporation for the year; and
    (B) If the corporation's common stock has a liquidation value of 
zero and there is no other class of equity with a liquidation preference 
relative to the common stock, the specified E&P deficit is allocated 
among the common stock using any reasonable method consistently applied; 
and

[[Page 512]]

    (iii) With respect to the cash position of a specified foreign 
corporation on a cash measurement date, the portion of the cash position 
that would be treated as distributed to the section 958(a) U.S. 
shareholder under Sec. 1.951-1(e) if the cash position were subpart F 
income, determined as of the close of the cash measurement date and 
without regard to whether the section 958(a) U.S. shareholder is a 
section 958(a) U.S. shareholder of the specified foreign corporation as 
of any other cash measurement date of the specified foreign corporation, 
including the final cash measurement date of the specified foreign 
corporation.
    (31) Second cash measurement date. The term second cash measurement 
date means, with respect to a specified foreign corporation, the close 
of the last taxable year of the specified foreign corporation that ends 
after November 1, 2016, and before November 2, 2017, if any.
    (32) Section 958(a) stock. The term section 958(a) stock means, with 
respect to a specified foreign corporation, a deferred foreign income 
corporation, or an E&P deficit foreign corporation, as applicable, stock 
of the corporation owned (directly or indirectly) by a United States 
shareholder within the meaning of section 958(a).
    (33) Section 958(a) U.S. shareholder. The term section 958(a) U.S. 
shareholder means, with respect to a specified foreign corporation, a 
deferred foreign income corporation, or an E&P deficit foreign 
corporation, as applicable, a United States shareholder of such 
corporation that owns section 958(a) stock of the corporation.
    (34) Section 958(a) U.S. shareholder inclusion year. The term 
section 958(a) U.S. shareholder inclusion year means the taxable year of 
a section 958(a) U.S. shareholder in which or with which the last day of 
the inclusion year of a deferred foreign income corporation on which it 
is a specified foreign corporation occurs.
    (35) Section 965 regulations. The term section 965 regulations means 
the regulations under Sec. Sec. 1.965-1 through 1.965-9, collectively.
    (36) Section 965(a) earnings amount. The term section 965(a) 
earnings amount means, with respect to a deferred foreign income 
corporation, the greater of the accumulated post-1986 deferred foreign 
income of the deferred foreign income corporation as of the E&P 
measurement date on November 2, 2017, or the accumulated post-1986 
deferred foreign income of the deferred foreign income corporation as of 
the E&P measurement date on December 31, 2017, determined in each case 
in the functional currency of the specified foreign corporation. If the 
functional currency of a specified foreign corporation changes between 
the two E&P measurement dates, the comparison must be made in the 
functional currency of the specified foreign corporation as of December 
31, 2017, by translating the specified foreign corporation's accumulated 
post-1986 deferred foreign income as of November 2, 2017, into the new 
functional currency using the spot rate on November 2, 2017.
    (37) Section 965(a) inclusion. The term section 965(a) inclusion 
means, with respect to a person and a deferred foreign income 
corporation, an amount included in income by the person by reason of 
section 965 with respect to the deferred foreign income corporation, 
whether because the person is a section 958(a) U.S. shareholder of the 
deferred foreign income corporation with a section 965(a) inclusion 
amount with respect to the deferred foreign income corporation or 
because the person is a domestic pass-through owner with respect to a 
domestic pass-through entity that is a section 958(a) U.S. shareholder 
of the deferred foreign income corporation and the person includes in 
income its domestic pass-through owner share of the section 965(a) 
inclusion amount of the domestic pass-through entity with respect to the 
deferred foreign income corporation.
    (38) Section 965(a) inclusion amount. The term section 965(a) 
inclusion amount has the meaning provided in paragraph (b)(1) of this 
section.
    (39) Section 965(a) previously taxed earnings and profits. The term 
section 965(a) previously taxed earnings and profits has the meaning 
provided in Sec. 1.965-2(c).
    (40) Section 965(b) previously taxed earnings and profits. The term 
section

[[Page 513]]

965(b) previously taxed earnings and profits has the meaning provided in 
Sec. 1.965-2(d).
    (41) Section 965(c) deduction. The term section 965(c) deduction 
means, with respect to a person, an amount allowed as a deduction to the 
person by reason of section 965(c), whether because the person is a 
section 958(a) U.S. shareholder with a section 965(c) deduction amount 
or because the person is a domestic pass-through owner with respect to a 
domestic pass-through entity that is a section 958(a) U.S. shareholder 
and the person takes into account its domestic pass-through owner share 
of the section 965(c) deduction amount of the domestic pass-through 
entity.
    (42) Section 965(c) deduction amount. The term section 965(c) 
deduction amount means an amount equal to the sum of--
    (i) A section 958(a) U.S. shareholder's 8 percent rate equivalent 
percentage of the section 958(a) U.S. shareholder's 8 percent rate 
amount for the section 958(a) U.S. shareholder inclusion year, plus
    (ii) The section 958(a) U.S. shareholder's 15.5 percent rate 
equivalent percentage of the section 958(a) U.S. shareholder's 15.5 
percent rate amount for the section 958(a) U.S. shareholder inclusion 
year.
    (43) Short-term obligation. The term short-term obligation means any 
obligation with a term upon issuance that is less than one year and any 
loan that must be repaid at the demand of the lender (or that must be 
repaid within one year of such demand), but does not include any 
accounts receivable.
    (44) Specified E&P deficit. The term specified E&P deficit means, 
with respect to an E&P deficit foreign corporation, the amount of the 
deficit described in paragraph (f)(22)(i)(A) of this section.
    (45) Specified foreign corporation--(i) General rule. Except as 
provided in paragraph (f)(45)(iii) of this section, the term specified 
foreign corporation means--
    (A) A controlled foreign corporation, or
    (B) A foreign corporation of which one or more domestic corporations 
is a United States shareholder.
    (ii) Special attribution rule--(A) In general. Solely for purposes 
of determining whether a foreign corporation is a specified foreign 
corporation within the meaning of section 965(e)(1)(B) and paragraph 
(f)(45)(i)(B) of this section, stock owned, directly or indirectly, by 
or for--
    (1) A partner (tested partner) will not be considered as being owned 
by a partnership under sections 958(b) and 318(a)(3)(A) and Sec. 1.958-
2(d)(1)(i) if the tested partner owns less than ten percent of the 
interests in the partnership's capital and profits; and
    (2) A beneficiary (tested beneficiary) will not be considered as 
being owned by a trust under sections 958(b) and 318(a)(3)(B) and Sec. 
1.958-2(d)(1)(ii) if the value of the interest of the tested 
beneficiary, computed actuarially, whether vested or contingent, current 
or remainder, is less than ten percent of the value of the trust 
property, assuming the maximum exercise of discretion in favor of the 
beneficiary.
    (B) Attribution for purposes of the ten percent standard. For 
purposes of paragraph (f)(45)(ii)(A) of this section, an interest in a 
partnership or trust owned by a partner or beneficiary other than the 
tested partner or tested beneficiary will be considered as being owned 
by the tested partner or tested beneficiary under the principles of 
sections 958(b) and 318, as modified by this paragraph (f)(45)(ii), as 
if interests in a partnership or trust were stock.
    (iii) Passive foreign investment companies. A foreign corporation 
that is a passive foreign investment company (as defined in section 
1297) with respect to a United States shareholder and that is not a 
controlled foreign corporation is not a specified foreign corporation of 
the United States shareholder.
    (46) Spot rate. The term spot rate has the meaning provided in Sec. 
1.988-1(d).
    (47) United States shareholder. The term United States shareholder 
has the meaning provided in section 951(b).
    (g) Examples. The following examples illustrate the definitions and 
general rules set forth in this section.
    (1) Example 1. Definition of specified foreign corporation--(i) 
Facts. A, an individual, owns 1% of the interests in a partnership, PS, 
and 10% by vote and

[[Page 514]]

value of the stock of a foreign corporation, FC. PS owns 100% of the 
stock of a domestic corporation, DC. A United States citizen, USI, owns 
an additional 10% by vote and value of the stock of FC. The remaining 
80% by vote and value of the stock of FC is owned by non-United States 
persons that are unrelated to A, USI, DC, and PS.
    (ii) Analysis. (A) Absent the application of sections 958(b), 
318(a)(3)(A), and 318(a)(3)(C), and Sec. 1.958-2(d)(1)(i) and (iii), FC 
would not be a specified foreign corporation because FC is not a 
controlled foreign corporation and there would be no domestic 
corporation that is a United States shareholder of FC. However, under 
sections 958(b) and 318(a)(3)(A) and Sec. 1.958-2(d)(1)(i), absent the 
special attribution rule in paragraph (f)(45)(ii) of this section, PS 
would be treated as owning 10% of the stock of FC. As a result, under 
sections 958(b), 318(a)(5)(A), and 318(a)(3)(C), and Sec. 1.958-
2(f)(1)(i) and (d)(1)(iii), DC would be treated as owning the stock of 
FC treated as owned by PS, and thus DC would be a United States 
shareholder with respect to FC, causing FC to be a specified foreign 
corporation within the meaning of section 965(e)(1)(B) and paragraph 
(f)(45)(i)(B) of this section. The results would be the same whether A 
or PS or both are domestic or foreign persons.
    (B) Under the special attribution rule in paragraph (f)(45)(ii) of 
this section, solely for purposes of determining whether a foreign 
corporation is a specified foreign corporation within the meaning of 
section 965(e)(1)(B) and paragraph (f)(45)(i)(B) of this section, the 
stock of FC owned by A is not considered as being owned by PS under 
sections 958(b) and 318(a)(3)(A) and Sec. 1.958-2(d)(1)(i) because A 
owns less than 10% of the interests in PS's capital and profits. 
Accordingly, FC is not a specified foreign corporation within the 
meaning of section 965(e)(1)(B) and paragraph (f)(45)(i)(B) of this 
section.
    (2) Example 2. Definition of specified foreign corporation--(i) 
Facts. The facts are the same as in paragraph(g)(1)(i) of this section 
(the facts in Example 1), except that A is a foreign corporation wholly 
owned by B, a foreign corporation, and B directly owns 9% of the 
interests in PS.
    (ii) Analysis. Applying the principles of sections 958(b) and 318, 
as modified by paragraph (f)(45)(ii) of this section, as if the interest 
in PS were stock, A is treated as owning the interests in PS owned by B 
(in addition to the 1% interest in PS that A owns directly), and thus A 
is not treated as owning less than 10% of the interests in PS's capital 
and profits. Accordingly, the special attribution rule in paragraph 
(f)(45)(ii) of this section does not apply, and PS is treated as owning 
A's stock of FC for purposes of determining whether FC is a specified 
foreign corporation within the meaning of section 965(e)(1)(B) and 
paragraph (f)(45)(i)(B) of this section. Accordingly, under the analysis 
described in paragraph (ii)(A) of Example 1 of paragraph (g)(1) of this 
section, FC is a specified foreign corporation within the meaning of 
section 965(e)(1)(B) and paragraph (f)(45)(i)(B) of this section.
    (3) Example 3. Determination of accumulated post-1986 deferred 
foreign income--(i) Facts. USP, a domestic corporation, and FP, a 
foreign corporation unrelated to USP, have owned 70% and 30% 
respectively, by vote and value, of the only class of stock of FS, a 
foreign corporation, from January 1, 2016, until December 31, 2017. USP 
and FS both have a calendar year taxable year. FS had no income until 
its taxable year ending December 31, 2016, in which it had 100u of 
income, all of which constituted subpart F income, and USP included 70u 
in income with respect to FS under section 951(a)(1) for such year. FS 
earned no income in 2017. Therefore, FS's post-1986 earnings and profits 
are 100u as of both E&P measurement dates.
    (ii) Analysis. Because USP included 70u in income with respect to FS 
under section 951(a)(1), 70u of such post-1986 earnings and profits 
would, if distributed, be excluded from the gross income of USP under 
section 959. Thus, FS's accumulated post-1986 deferred foreign income 
would be reduced by 70u pursuant to section 965(d)(2)(B) and paragraph 
(f)(7)(i)(B) of this section. Furthermore, under paragraph (f)(7)(i)(C) 
of this section, the accumulated post-1986 deferred foreign income of FS 
is reduced by amounts that

[[Page 515]]

would be excluded from the gross income of FP if FP were a United States 
shareholder, consistent with the principles of Revenue Ruling 82-16. 
Accordingly, FS's accumulated post-1986 deferred foreign income is 
reduced by the remaining 30u of the 100u of post-1986 earnings and 
profits to which USP's 70u of section 951(a)(1) income inclusions were 
attributable. As a result, FS's accumulated post-1986 deferred foreign 
income is 0u (100u minus 70u minus 30u).
    (4) Example 4. Determination of status as a deferred foreign income 
corporation or an E&P deficit foreign corporation; specified foreign 
corporation is solely a deferred foreign income corporation--(i) Facts. 
USP, a domestic corporation, owns all of the stock of FS, a foreign 
corporation. As of November 2, 2017, FS has a deficit in post-1986 
earnings and profits of 150u. As of December 31, 2017, FS has 200u of 
post-1986 earnings and profits. FS does not have earnings and profits 
that are attributable to income of the specified foreign corporation 
that is effectively connected with the conduct of a trade or business 
within the United States and subject to tax under chapter 1, or that, if 
distributed, would be excluded from the gross income of a United States 
shareholder under section 959 or from the gross income of another 
shareholder if such shareholder were a United States shareholder.
    (ii) Analysis. FS's accumulated post-1986 deferred foreign income is 
equal to its post-1986 earnings and profits because no adjustment to 
post-1986 earnings and profits is made under section 965(d)(2) or Sec. 
1.965-1(f)(7). Under paragraph (f)(17)(i) of this section, FS is a 
deferred foreign income corporation because FS has accumulated post-1986 
deferred foreign income greater than zero as of the E&P measurement date 
on December 31, 2017. In addition, under paragraph (f)(17)(ii) of this 
section, because FS is a deferred foreign income corporation, FS is not 
also an E&P deficit foreign corporation, notwithstanding that FS has a 
deficit in post-1986 earnings and profits as of the E&P measurement date 
on November 2, 2017.
    (5) Example 5. Determination of status as a deferred foreign income 
corporation or an E&P deficit foreign corporation; specified foreign 
corporation is neither a deferred foreign income corporation nor an E&P 
deficit foreign corporation--(i) Facts. USP, a domestic corporation, 
owns all of the stock of FS, a foreign corporation. As of both November 
2, 2017, and December 31, 2017, FS has 100u of earnings and profits 
described in section 959(c)(2) and a deficit of 90u in earnings and 
profits described in section 959(c)(3), all of which were accumulated in 
taxable years beginning after December 31, 1986, while FS was a 
specified foreign corporation. Accordingly, as of both November 2, 2017, 
and December 31, 2017, FS has 10u of post-1986 earnings and profits.
    (ii) Analysis--(A) Determination of status as a deferred foreign 
income corporation. Under paragraph (f)(17) of this section, for 
purposes of determining whether FS is a deferred foreign income 
corporation, a determination must be made whether FS has accumulated 
post-1986 deferred foreign income greater than zero as of either the E&P 
measurement date on November 2, 2017, or the E&P measurement date on 
December 31, 2017. Under section 965(d)(2) and paragraph (f)(7) of this 
section, FS's accumulated post-1986 deferred foreign income is its post-
1986 earnings and profits, except to the extent such earnings and 
profits are attributable to income of the specified foreign corporation 
that is effectively connected with the conduct of a trade or business 
within the United States and subject to tax under chapter 1, or that, if 
distributed, would be excluded from the gross income of a United States 
shareholder under section 959 or from the gross income of another 
shareholder if such shareholder were a United States shareholder. 
Disregarding FS's 100u of post-1986 earnings and profits described in 
paragraph (f)(7)(i)(B) of this section, FS has a 90u deficit in 
accumulated post-1986 deferred foreign income as of both E&P measurement 
dates. Accordingly, FS does not have accumulated post-1986 deferred 
foreign income greater than zero as of either E&P measurement date, and, 
therefore, FS is not a deferred foreign income corporation.

[[Page 516]]

    (B) Determination of status as an E&P deficit foreign corporation. 
Under paragraph (f)(22)(i) of this section, for purposes of determining 
whether FS is an E&P deficit foreign corporation, a determination must 
be made whether FS has a deficit in post-1986 earnings and profits as of 
the E&P measurement date on November 2, 2017. Under paragraph 
(f)(22)(ii) of this section, because the deficit in the earnings and 
profits of FS described in section 959(c)(3) of 90u does not exceed the 
earnings and profits of FS described in section 959(c)(2) of 100u, FS 
does not have a deficit in post-1986 earnings and profits as of the E&P 
measurement date on November 2, 2017, and, therefore, FS is not an E&P 
deficit foreign corporation. Accordingly, FS is neither a deferred 
foreign income corporation nor an E&P deficit foreign corporation.
    (6) Example 6. Application of currency translation rules--(i) Facts. 
As of November 2, 2017, and December 31, 2017, USP, a domestic 
corporation, owns all of the stock of CFC1, an E&P deficit foreign 
corporation with the ``u'' as its functional currency; CFC2, an E&P 
deficit foreign corporation with the ``v'' as its functional currency; 
CFC3, a deferred foreign income corporation with the ``y'' as its 
functional currency; and CFC4, a deferred foreign income corporation 
with the ``z'' as its functional currency. USP, CFC1, CFC2, CFC3, and 
CFC4 each have a calendar year taxable year. As of December 31, 2017, 
1u=$1, .75v=$1, .50y=$1, and .25z=$1. CFC1 has a specified E&P deficit 
of 100u, CFC2 has a specified E&P deficit of 120v, CFC3 has a section 
965(a) earnings amount of 50y, and CFC4 has a section 965(a) earnings 
amount of 75z.
    (ii) Analysis. (A) Under paragraph (f)(38) of this section, for 
purposes of determining USP's section 965(a) inclusion amounts with 
respect to CFC3 and CFC4, the section 965(a) earnings amount of each of 
CFC3 and CFC4 is translated into U.S. dollars at the spot rate on 
December 31, 2017, which equals $100 (50y at .50y=$1) and $300 (75z at 
.25z=$1), respectively. Furthermore, USP's pro rata share of the section 
965(a) earnings amounts, as translated, is $100 and $300, respectively, 
or 100% of each section 965(a) earnings amount.
    (B) Under paragraph (f)(9) of this section, for purposes of 
determining USP's aggregate foreign E&P deficit, the specified E&P 
deficit of each of CFC1 and CFC2 is translated into U.S. dollars at the 
spot rate on December 31, 2017, which equals $100 (100u at 1u=$1) and 
$160 (120v at .75v=$1), respectively. Furthermore USP's pro rata share 
of each specified E&P deficit, as translated, is $100 and $160, 
respectively, or 100% of each specified E&P deficit. Therefore, USP's 
aggregate foreign E&P deficit is $260.
    (C) Under section 965(b)(1) and paragraph (b)(2) of this section, 
for purposes of determining USP's section 965(a) inclusion amount with 
respect to each of CFC3 and CFC4, the U.S. dollar amount of USP's pro 
rata share of the section 965(a) earnings amount of each of CFC3 and 
CFC4 is reduced by each of CFC3 and CFC4's allocable share of USP's 
aggregate foreign E&P deficit. Under section 965(b)(2) and paragraph 
(f)(11) of this section, CFC3's allocable share of USP's aggregate 
foreign E&P deficit of $260 is $65 ($260 x ($100/$400)) and CFC4's 
allocable share of USP's aggregate foreign E&P deficit is $195 ($260 x 
($300/400)). After reduction under section 965(b)(1) and paragraph 
(b)(2) of this section, the section 965(a) inclusion amount of USP with 
respect to CFC3 is $35 ($100-$65) and the section 965(a) inclusion 
amount of USP with respect to CFC4 is $105 ($300-$195). Under Sec. 
1.965-2(c), the section 965(a) previously taxed earnings and profits of 
each of CFC3 and CFC4, translated into the respective functional 
currencies of CFC3 and CFC4 at the spot rate on December 31, 2017, are 
17.5y ($35 at .50y=$1) and 26.25z ($105 at .25z=$1), respectively. Under 
Sec. 1.965-6(b)(1), for purposes of applying section 960(a)(1), the 
amounts treated as a dividend paid by each of CFC3 and CFC4, translated 
into the respective functional currencies of CFC3 and CFC4 at the spot 
rate on December 31, 2017, are 17.5y ($35 at .50y=$1) and 26.25z ($105 
at .25z=$1).
    (D) For purposes of determining the section 965(b) previously taxed 
earnings and profits of each of CFC3 and CFC4 under section 965(b)(4)(A) 
and Sec. 1.965-2(d)(1) as a result of the reduction to USP's section 
965(a) inclusion amounts with respect to CFC3 and CFC4, the

[[Page 517]]

amount of the aggregate foreign E&P deficit of USP allocated to each of 
CFC3 and CFC4 under section 965(b)(2) and paragraph (f)(11) of this 
section, translated into the respective functional currencies of CFC3 
and CFC4 at the spot rate on December 31, 2017, is 32.5y ($65 at 
.50y=$1) and 48.75z ($195 at .25z=$1), respectively.
    (7) Example 7. Determination of cash measurement dates and pro rata 
shares of cash positions--(i) Facts. Except as otherwise provided, for 
all relevant periods, USP, a domestic corporation, has owned directly at 
least 10% of the stock of CFC1, CFC2, CFC3, and CFC4, each a foreign 
corporation. CFC1 and CFC2 have calendar year taxable years. CFC3 and 
CFC4 have taxable years that end on November 30. No entity has a short 
taxable year, except as a result of the transactions described below.
    (A) USP transferred all of its stock of CFC2 to an unrelated person 
on June 30, 2016, at which point USP ceased to be a United States 
shareholder with respect to CFC2.
    (B) CFC4 dissolved on December 30, 2010, and, as a result, its final 
taxable year ended on December 30, 2010.
    (ii) Analysis. Each of CFC1, CFC2, CFC3, and CFC4 is a specified 
foreign corporation of USP, subject to the sale of CFC2 on June 30, 
2016, and the dissolution of CFC4 on December 30, 2010. Under the 
definition of aggregate foreign cash position in paragraph (f)(8)(i) of 
this section, the definition of pro rata share of a cash position in 
paragraph (f)(30)(iii) of this section, and the definitions of the final 
cash measurement date, second cash measurement date, and first cash 
measurement date in paragraphs (f)(24), (25), and (31) of this section, 
the cash measurement dates of the specified foreign corporations to be 
taken into account by USP in determining its aggregate foreign cash 
position are summarized in the following table:

                                             Cash Measurement Dates
----------------------------------------------------------------------------------------------------------------
                                                Final                    Second                   First
----------------------------------------------------------------------------------------------------------------
CFC1.................................  December 31, 2017......  December 31, 2016......  December 31, 2015.
CFC2.................................  N/A....................  N/A....................  December 31, 2015.
CFC3.................................  November 30, 2018......  November 30, 2016......  November 30, 2015.
CFC4.................................  N/A....................  N/A....................  N/A.
----------------------------------------------------------------------------------------------------------------

    (8) Example 8. Determination of section 958(a) U.S. shareholder in 
case of a controlled domestic partnership--(i) Facts. USP, a domestic 
corporation, owns all of the stock of CFC1 and CFC2. CFC1 and CFC2 own 
60% and 40%, respectively, of the interests in the capital and profits 
of DPS, a domestic partnership. DPS owns all of the stock of CFC3 and 
CFC4. This ownership structure has existed since the date of formation 
of CFC1, CFC2, CFC3, and CFC4. CFC1, CFC2, CFC3, and CFC4 are each a 
foreign corporation. USP, DPS, CFC1, CFC2, CFC3, and CFC4 have calendar 
year taxable years. On both E&P measurement dates, CFC3 has 50u of 
accumulated post-1986 deferred foreign income. On both E&P measurement 
dates, CFC4 has a deficit in post-1986 earnings and profits of 30u. On 
all cash measurement dates, CFC1, CFC2, and CFC3 each have a cash 
position of 0u, and CFC4 has a cash position of 200u.
    (ii) Analysis. DPS is a controlled domestic partnership with respect 
to USP within the meaning of paragraph (e)(2) of this section because 
more than 50% of the interests in its capital and profits are owned by 
persons related to USP within the meaning of section 267(b), CFC1 and 
CFC2, and thus DPS is controlled by USP and related persons. Without 
regard to paragraph (e) of this section, DPS is a section 958(a) U.S. 
shareholder of CFC3 and CFC4, each of which is a controlled foreign 
corporation. If DPS were treated as foreign, CFC3 and CFC4 would each 
continue to be a controlled foreign corporation, and USP would be 
treated as a section 958(a) U.S. shareholder of each of CFC3 and CFC4, 
and would be treated as owning (within the meaning of section 958(a)) 
tested section 958(a) stock of each of CFC3 and CFC4 through CFC1 and 
CFC2, which are both partners in DPS. Thus, under paragraph (e)(1) of

[[Page 518]]

this section, DPS is treated as a foreign partnership for purposes of 
determining the section 958(a) U.S. shareholder of both CFC3 and CFC4 
and the section 958(a) stock of both CFC3 and CFC4 owned by the section 
958(a) U.S. shareholder. Thus, USP's pro rata share of CFC3's section 
965(a) earnings amount is 50u, and its pro rata share of CFC4's 
specified E&P deficit is 30u. USP's aggregate foreign cash position is 
200u. DPS is not a section 958(a) U.S. shareholder with respect to 
either CFC3 or CFC4.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9846, 84 FR 
14260, Apr. 10, 2019]



Sec. 1.965-2  Adjustments to earnings and profits and basis.

    (a) Scope. This section provides rules relating to adjustments to 
earnings and profits and basis to determine and account for the 
application of section 965(a) and (b) and Sec. 1.965-1(b) and a rule 
that limits the amount of gain recognized under section 961(b)(2) by 
reason of distributions attributable to section 965 previously taxed 
earnings and profits (as defined in paragraph (g)(1)(ii) of this 
section) in the inclusion year. Paragraph (b) of this section provides 
rules relating to adjustments to earnings and profits of a specified 
foreign corporation for purposes of applying sections 902, 959, 960, and 
965. Paragraph (c) of this section provides rules regarding adjustments 
to earnings and profits by reason of section 965(a). Paragraph (d) of 
this section provides rules regarding adjustments to earnings and 
profits by reason of section 965(b). Paragraph (e) provides rules 
regarding adjustments to basis by reason of section 965(a). Paragraph 
(f) of this section provides an election to make certain adjustments to 
basis corresponding to adjustments to earnings and profits by reason of 
section 965(b). Paragraph (g) of this section provides rules that limit 
the amount of gain recognized in connection with the application of 
section 961(b)(2) and that require related reductions in basis. 
Paragraph (h) of this section provides rules regarding basis 
adjustments. Paragraph (i) of this section provides definitions that 
apply for purposes of this section. Paragraph (j) of this section 
provides examples illustrating the application of this section.
    (b) Determination of and adjustments to earnings and profits of a 
specified foreign corporation for purposes of applying sections 902, 
959, 960, and 965. For the taxable year of a specified foreign 
corporation in which an E&P measurement date occurs, and the last 
taxable year of a specified foreign corporation that begins before 
January 1, 2018, and the taxable year of a section 958(a) U.S. 
shareholder in which or with which any such year ends, the adjustments 
to earnings and profits described in paragraphs (b)(1) through (b)(5) of 
this section apply in sequence. For purposes of determining the 
consequences under sections 902 and 960 of a distribution or an 
inclusion under section 951(a)(1), after the application of those 
paragraphs, the ordering rule in Sec. 1.960-1(i)(2) applies except that 
section 902 is applied with respect to any distributions from the 
specified foreign corporation described in paragraph (b)(2) of this 
section that are not disregarded under Sec. 1.965-4 before section 960 
is applied with respect to an inclusion or distribution described in 
paragraph (b)(3), (b)(4), or (b)(5) of this section.
    (1) Each of the subpart F income of the specified foreign 
corporation and the amount required to be included in income under 
section 1248, if any, are determined without regard to section 965(a), 
but taking into account any relevant distributions, and earnings and 
profits of the specified foreign corporation that are described in 
section 959(c)(2) with respect to the section 958(a) U.S. shareholder 
are increased to the extent of the section 958(a) U.S. shareholder's 
inclusion under section 951(a)(1)(A) without regard to section 965(a) 
(including to the extent provided in section 959(e)).
    (2) The treatment of a distribution by the specified foreign 
corporation to another specified foreign corporation that is made before 
January 1, 2018, and, in the case of a taxable year of a specified 
foreign corporation before its last taxable year that begins before 
January 1, 2018, any other distribution from the specified foreign 
corporation made before the relevant E&P measurement date, is determined 
under section 959.

[[Page 519]]

    (3) Each of the post-1986 earnings and profits (including a deficit) 
of the specified foreign corporation, the accumulated post-1986 deferred 
foreign income of the specified foreign corporation, the section 965(a) 
earnings amount of the specified foreign corporation, and the section 
965(a) inclusion amount with respect to the specified foreign 
corporation, if any, is determined, taking into account the rules of 
Sec. 1.965-4, and the earnings and profits (including a deficit) of the 
specified foreign corporation are adjusted as provided in paragraphs (c) 
and (d) of this section. For a rule disregarding subpart F income earned 
after an E&P measurement date for purposes of calculating accumulated 
post-1986 deferred foreign income as of the E&P measurement date, see 
Sec. 1.965-1(f)(7)(ii).
    (4) The treatment of distributions described in paragraph (b)(2) of 
this section that are disregarded under Sec. 1.965-4 is redetermined 
(if necessary) and the treatment of all distributions from the specified 
foreign corporation other than those described in paragraph (b)(2) of 
this section is determined under section 959.
    (5) An amount is determined under section 956 with respect to the 
specified foreign corporation and the section 958(a) U.S. shareholder; 
earnings and profits of the specified foreign corporation described in 
section 959(c)(2) with respect to the section 958(a) U.S. shareholder 
are reclassified as earnings and profits described in section 959(c)(1) 
with respect to the section 958(a) U.S. shareholder to the extent the 
amount determined under section 956 would, but for section 959(a)(2), be 
included by the section 958(a) U.S. shareholder under section 
951(a)(1)(B); and earnings and profits described in section 959(c)(1) 
with respect to the section 958(a) U.S. shareholder are further 
increased to the extent of the section 958(a) U.S. shareholder's 
inclusion under section 951(a)(1)(B).
    (c) Adjustments to earnings and profits by reason of section 965(a). 
The earnings and profits of a deferred foreign income corporation 
described in section 959(c)(2) with respect to a section 958(a) U.S. 
shareholder are increased by an amount equal to the section 965(a) 
inclusion amount of the section 958(a) U.S. shareholder with respect to 
the deferred foreign income corporation, if any, translated (if 
necessary) into the functional currency of the deferred foreign income 
corporation using the spot rate on December 31, 2017, provided the 
section 965(a) inclusion amount is included in income by the section 
958(a) U.S. shareholder. For purposes of the section 965 regulations, 
the earnings and profits described in section 959(c)(2) by reason of 
this paragraph (c) and the earnings and profits initially described in 
section 959(c)(2) by reason of this paragraph (c) but subsequently 
reclassified as earnings and profits described in section 959(c)(1), if 
any, are referred to as section 965(a) previously taxed earnings and 
profits. Furthermore, the earnings and profits (including a deficit) of 
the deferred foreign income corporation that are described in section 
959(c)(3) (or that would be described in section 959(c)(3) but for the 
application of section 965(a) and the section 965 regulations) are 
reduced (or, in the case of a deficit, increased) by an amount equal to 
the section 965(a) previously taxed earnings and profits.
    (d) Adjustments to earnings and profits by reason of section 
965(b)--(1) Adjustments to earnings and profits described in section 
959(c)(2) and (c)(3) of deferred foreign income corporations. The 
earnings and profits of a deferred foreign income corporation described 
in section 959(c)(2) with respect to a section 958(a) U.S. shareholder 
are increased by an amount equal to the reduction to the section 958(a) 
U.S. shareholder's pro rata share of the section 965(a) earnings amount 
of the deferred foreign income corporation under section 965(b), Sec. 
1.965-1(b)(2), and Sec. 1.965-8(b), as applicable, translated (if 
necessary) into the functional currency of the deferred foreign income 
corporation using the spot rate on December 31, 2017, provided the 
section 958(a) U.S. shareholder includes the section 965(a) inclusion 
amount (if any) with respect to the deferred foreign income corporation 
in income. For purposes of the section 965 regulations, the earnings and 
profits described in section 959(c)(2) by reason of this paragraph (d) 
and the earnings and profits initially described in section 959(c)(2) by 
reason of this paragraph (d)

[[Page 520]]

but subsequently reclassified as earnings and profits described in 
section 959(c)(1) are referred to as section 965(b) previously taxed 
earnings and profits, and are treated as having been previously included 
in the gross income of the section 958(a) U.S. shareholder under section 
951 for purposes of section 1248(d)(1). Furthermore, the earnings and 
profits (including a deficit) described in section 959(c)(3) of the 
deferred foreign income corporation (or that would be described in 
section 959(c)(3) but for the application of section 965(b) and the 
section 965 regulations) are reduced (or, in the case of a deficit, 
increased) by an amount equal to the section 965(b) previously taxed 
earnings and profits.
    (2) Adjustments to earnings and profits described in section 
959(c)(3) of E&P deficit foreign corporations--(i) Increase in earnings 
and profits by an amount equal to the portion of the section 958(a) U.S. 
shareholder's pro rata share of the specified E&P deficit taken into 
account--(A) In general. For an E&P deficit foreign corporation's last 
taxable year that begins before January 1, 2018, the earnings and 
profits of the E&P deficit foreign corporation described in section 
959(c)(3) are increased by an amount equal to the portion of a section 
958(a) U.S. shareholder's pro rata share of the specified E&P deficit of 
the E&P deficit foreign corporation taken into account under section 
965(b), Sec. 1.965-1(b)(2), and Sec. 1.965-8(b), as determined under 
paragraph (d)(2)(ii) of this section, translated (if necessary) into the 
functional currency of the E&P deficit foreign corporation using the 
spot rate on December 31, 2017. For purposes of section 316, the 
earnings and profits of the E&P deficit foreign corporation attributable 
to the increase described in the preceding sentence are not treated as 
earnings and profits of the taxable year described in section 316(a)(2). 
See also Sec. 1.965-6(b)(3) for the timing of this adjustment for 
purposes of determining foreign taxes deemed paid under sections 902 and 
960.
    (B) Reduction of a qualified deficit. For purposes of section 952, a 
section 958(a) U.S. shareholder's pro rata share of the earnings and 
profits of an E&P deficit foreign corporation is increased by an amount 
equal to the portion of the section 958(a) U.S. shareholder's pro rata 
share of the specified E&P deficit of the E&P deficit foreign 
corporation taken into account under section 965(b), Sec. 1.965-
1(b)(2), or Sec. 1.965-8(b), as applicable, as determined under 
paragraph (d)(2)(ii) of this section, translated (if necessary) into the 
functional currency of the E&P deficit foreign corporation using the 
spot rate on December 31, 2017, and such increase is attributable to the 
same activity to which the deficit so taken into account was 
attributable.
    (ii) Determination of portion of a section 958(a) U.S. shareholder's 
pro rata share of a specified E&P deficit taken into account--(A) In 
general. The portion of a section 958(a) U.S. shareholder's pro rata 
share of a specified E&P deficit of an E&P deficit foreign corporation 
taken into account under section 965(b), Sec. 1.965-1(b)(2), or Sec. 
1.965-8(b), as applicable, is 100 percent of the section 958(a) U.S. 
shareholder's pro rata share of the specified E&P deficit if either of 
the following conditions is satisfied:
    (1) The section 958(a) U.S. shareholder (including a consolidated 
group of which the section 958(a) U.S. shareholder is a member) does not 
have an excess aggregate foreign E&P deficit (as defined in Sec. 1.965-
8(f)(7)(i)), or
    (2) If the section 958(a) U.S. shareholder is a member of an 
affiliated group in which not all members are members of the same 
consolidated group, the amount described in Sec. 1.965-8(f)(1)(i)(B) 
with respect to the affiliated group is equal to or greater than the 
amount described Sec. 1.965-8(f)(1)(i)(A).
    (B) Designation of portion of a section 958(a) U.S. shareholder's 
pro rata share of a specified E&P deficit taken into account. If neither 
the condition in paragraph (d)(2)(ii)(A)(1) nor the condition in 
paragraph (d)(2)(ii)(A)(2) is satisfied with respect to a section 958(a) 
U.S. shareholder, then the section 958(a) U.S. shareholder must 
designate the portion taken into account by reporting to each E&P 
deficit foreign corporation of the section 958(a) U.S. shareholder, and 
maintaining, in its books and records, a statement setting forth the 
following information--
    (1) The portion of the section 958(a) U.S. shareholder's pro rata 
share of the

[[Page 521]]

specified E&P deficit of the E&P deficit foreign corporation taken into 
account under section 965(b), Sec. 1.965-1(b)(2), or Sec. 1.965-8(b), 
as designated under Sec. 1.965-8(c), as applicable, and
    (2) In the case of an E&P deficit foreign corporation that has a 
qualified deficit (as determined under section 952 and Sec. 1.952-1), 
the portion (if any) of the section 958(a) shareholder's pro rata share 
of the specified E&P deficit of the E&P deficit foreign corporation 
taken into account under paragraph (d)(2)(ii)(B)(1) of this section that 
is attributable to a qualified deficit, including the qualified 
activities to which such portion is attributable.
    (e) Adjustments to basis by reason of section 965(a)--(1) General 
rule. Except as provided in paragraph (e)(2) of this section, a section 
958(a) U.S. shareholder's basis in section 958(a) stock of a deferred 
foreign income corporation, or a section 958(a) U.S. shareholder's basis 
in applicable property with respect to a deferred foreign income 
corporation, is increased by the section 958(a) U.S. shareholder's 
section 965(a) inclusion amount with respect to the deferred foreign 
income corporation included in income by the section 958(a) U.S. 
shareholder. See section 961(a).
    (2) Section 962 election. In the case of a section 958(a) U.S. 
shareholder who has made an election under section 962 for a section 
958(a) U.S. shareholder's inclusion year, the increase in basis in the 
section 958(a) U.S. shareholder's section 958(a) stock of, or applicable 
property with respect to, a deferred foreign income corporation cannot 
exceed an amount equal to the amount of tax paid under chapter 1 of the 
Code with respect to the section 958(a) U.S. shareholder's section 
965(a) inclusion amount with respect to the deferred foreign income 
corporation, taking into account any section 965(h) election made by the 
section 958(a) U.S. shareholder.
    (f) Adjustments to basis by reason of section 965(b)--(1) In 
general. Except as provided in paragraph (f)(2) of this section, no 
adjustments to basis of stock or property are made under section 961 (or 
any other provision of the Code) to take into account the reduction to a 
section 958(a) U.S. shareholder's pro rata share of the section 965(a) 
earnings amount of a deferred foreign income corporation under section 
965(b), Sec. 1.965-1(b)(2), or Sec. 1.965-8(b), as applicable.
    (2) Election to make adjustments to basis to account for the 
application of section 965(b)--(i) In general. If a section 958(a) U.S. 
shareholder makes the election as provided in this paragraph (f)(2), the 
adjustments to basis described in paragraph (f)(2)(ii) of this section 
are made with respect to each deferred foreign income corporation and 
each E&P deficit foreign corporation in which the section 958(a) U.S. 
shareholder owns section 958(a) stock.
    (ii) Basis adjustments--(A) Increase in basis with respect to a 
deferred foreign income corporation--(1) In general. Except as provided 
in paragraphs (f)(2)(ii)(A)(2) and (C) of this section, a section 958(a) 
U.S. shareholder's basis in section 958(a) stock of a deferred foreign 
income corporation, or a section 958(a) U.S. shareholder's basis in 
applicable property with respect to a deferred foreign income 
corporation, is increased by an amount equal to the section 965(b) 
previously taxed earnings and profits of the deferred foreign income 
corporation with respect to the section 958(a) U.S. shareholder, 
translated (if necessary) into U.S. dollars using the spot rate on 
December 31, 2017.
    (2) Limited basis adjustment. A section 958(a) U.S. shareholder may, 
in lieu of applying paragraph (f)(2)(ii)(A)(1) of this section, 
designate the amount by which it increases its basis in section 958(a) 
stock of, or applicable property with respect to, a deferred foreign 
income corporation, provided that--
    (i) The increase does not exceed the section 965(b) previously taxed 
earnings and profits of the deferred foreign income corporation with 
respect to the section 958(a) U.S. shareholder, translated (if 
necessary) into U.S. dollars using the spot rate on December 31, 2017; 
and
    (ii) The aggregate amount of a section 958(a) U.S. shareholder's 
increases in basis with respect to stock or applicable property pursuant 
to paragraph (f)(2)(ii)(A)(2) of this section does not exceed the 
aggregate amount of the section 958(a) U.S. shareholder's reductions in 
basis pursuant to paragraph (f)(2)(ii)(B) of this section subject to

[[Page 522]]

the limitation under paragraph (f)(2)(ii)(B)(2) of this section.
    (B) Reduction in basis with respect to an E&P deficit foreign 
corporation--(1) In general. Except as provided in paragraphs 
(f)(2)(ii)(B)(2) and (f)(2)(ii)(C) of this section, a section 958(a) 
U.S. shareholder's basis in section 958(a) stock of an E&P deficit 
foreign corporation, or a section 958(a) U.S. shareholder's basis in 
applicable property with respect to an E&P deficit foreign corporation, 
is reduced by an amount equal to the portion of the section 958(a) U.S. 
shareholder's pro rata share of the specified E&P deficit of the E&P 
deficit foreign corporation taken into account under section 965(b), 
Sec. 1.965-1(b)(2), and Sec. 1.965-8(b), as applicable, as determined 
under paragraph (d)(2)(ii) of this section, translated (if necessary) 
into U.S. dollars using the spot rate on December 31, 2017. For rules 
requiring gain recognition, see paragraph (h)(3) of this section.
    (2) Limited basis adjustment. If a section 958(a) U.S. shareholder 
adjusts its basis in section 958(a) stock of, or applicable property 
with respect to, one or more deferred foreign income corporations under 
paragraph (f)(2)(ii)(A)(2) of this section, the section 958(a) U.S. 
shareholder's aggregate reductions in basis in section 958(a) stock of, 
or applicable property with respect to, an E&P deficit foreign 
corporation pursuant to paragraph (f)(2)(ii)(B)(1) of this section on a 
day may not exceed the amount of the section 958(a) U.S. shareholder's 
basis in the section 958(a) stock of, or applicable property with 
respect to, such E&P deficit foreign corporation, determined without 
taking into account specified basis adjustments to the section 958(a) 
stock of, or applicable property with respect to, such E&P deficit 
foreign corporation.
    (C) Section 962 election. In the case of a section 958(a) U.S. 
shareholder who has made an election under section 962 for a section 
958(a) U.S. shareholder's inclusion year, the adjustments provided in 
paragraphs (f)(2)(ii)(A) and (B) of this section do not apply.
    (iii) Rules regarding the election--(A) Consistency requirement. In 
order for the election described in this paragraph (f)(2) to be 
effective, a section 958(a) U.S. shareholder and each section 958(a) 
U.S. shareholder of an E&P deficit foreign corporation or of a deferred 
foreign income corporation with respect to which the second section 
958(a) U.S. shareholder's pro rata share of the section 965(a) earnings 
amount is reduced under section 965(b), Sec. 1.965-1(b)(2), or Sec. 
1.965-8(b) that is related to the first section 958(a) U.S. shareholder 
must make the election described in this paragraph (f)(2). For purposes 
of this paragraph (f)(2)(iii)(A), a person is treated as related to a 
section 958(a) U.S. shareholder if the person bears a relationship to 
the section 958(a) U.S. shareholder described in section 267(b) or 
707(b).
    (B) Manner of making election--(1) Timing--(i) In general. Except as 
provided in paragraph (f)(2)(iii)(B)(1)(ii) of this section, the 
election provided in this paragraph (f)(2) must be made no later than 
the due date (taking into account extensions, if any) for the section 
958(a) U.S. shareholder's return for the first taxable year that 
includes the last day of the last taxable year of a deferred foreign 
income corporation or E&P deficit foreign corporation of the shareholder 
that begins before January 1, 2018. Relief is not available under Sec. 
301.9100-2 or 301.9100-3 to file a late election. Except as provided in 
paragraph (f)(2)(iii)(B)(1)(ii) of this section, the election provided 
in this paragraph (f)(2) is irrevocable.
    (ii) Transition rule. If the due date referred to in paragraph 
(f)(2)(iii)(B)(1)(i) of this section occurs before May 6, 2019, the 
election must be made by May 6, 2019. In the case of an election made 
before February 5, 2019, the election may be revoked by attaching a 
statement, signed under penalties of perjury, to an amended return filed 
by May 6, 2019. The statement must contain the section 958(a) U.S. 
shareholder's name and taxpayer identification number and a statement 
that the section 958(a) U.S. shareholder and all related persons, as 
defined in paragraph (f)(2)(iii)(A) of this section, that are section 
958(a) U.S. shareholders of E&P deficit foreign corporations or of 
deferred foreign income corporations with respect to which the section 
958(a) U.S. shareholder's pro rata share of the

[[Page 523]]

section 965(a) earnings amount is reduced under section 965(b), Sec. 
1.965-1(b)(2), or Sec. 1.965-8(b) revoke the election provided in this 
paragraph (f)(2).
    (2) Election statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, to make the 
election provided in this paragraph (f)(2), a section 958(a) U.S. 
shareholder must attach a statement, signed under penalties of perjury 
consistent with the rules for signatures applicable to the section 
958(a) U.S. shareholders return, to its return for the first taxable 
year that includes the last day of the last taxable year of a deferred 
foreign income corporation or E&P deficit foreign corporation of the 
shareholder that begins before January 1, 2018. The statement must 
include the section 958(a) U.S. shareholder's name, taxpayer 
identification number, and a statement that the section 958(a) U.S. 
shareholder and all related persons, as defined in paragraph 
(f)(2)(iii)(A) of this section, that are section 958(a) U.S. 
shareholders of E&P deficit foreign corporations or of deferred foreign 
income corporations with respect to which the section 958(a) U.S. 
shareholder's pro rata share of the section 965(a) earnings amount is 
reduced under section 965(b), Sec. 1.965-1(b)(2), or Sec. 1.965-8(b) 
make the election provided in this paragraph (f)(2). If the section 
958(a) U.S. shareholder increases its basis in stock or applicable 
property under paragraph (f)(2)(ii)(A)(2) of this section and decreases 
its basis in stock or applicable property pursuant to paragraph 
(f)(2)(ii)(B) of this section subject to the limitation under paragraph 
(f)(2)(ii)(B)(2) of this section, the election statement must so 
indicate. The attachment of an unsigned copy of the election statement 
to the timely-filed return for the relevant taxable year satisfies the 
signature requirement of this paragraph (f)(2)(iii)(B)(2) if the section 
958(a) U.S. shareholder retains the original signed election statement 
in the manner specified by Sec. 1.6001-1(e).
    (g) Gain reduction rule--(1) Reduction in gain recognized under 
section 961(b)(2) by reason of distributions attributable to section 965 
previously taxed earnings and profits in the inclusion year--(i) In 
general. If a section 958(a) U.S. shareholder receives a distribution 
from a deferred foreign income corporation (including through a chain of 
ownership described under section 958(a)) during the inclusion year of 
the deferred foreign income corporation that is attributable to section 
965 previously taxed earnings and profits of the deferred foreign income 
corporation, then the amount of gain that otherwise would be recognized 
under section 961(b)(2) by the section 958(a) U.S. shareholder with 
respect to the section 958(a) U.S. shareholder's section 958(a) stock of 
the deferred foreign income corporation or interest in applicable 
property with respect to the deferred foreign income corporation is 
reduced (but not below zero) by an amount equal to the section 965 
previously taxed earnings and profits of the deferred foreign income 
corporation with respect to the section 958(a) U.S. shareholder, 
translated (if necessary) into U.S. dollars at the spot rate on December 
31, 2017.
    (ii) Definition of section 965 previously taxed earnings and 
profits. For purposes of paragraph (g)(1)(i) of this section, the term 
section 965 previously taxed earnings and profits means, with respect to 
a deferred foreign income corporation and a section 958(a) U.S. 
shareholder, the sum of the section 965(a) previously taxed earnings and 
profits of the deferred foreign income corporation with respect to the 
section 958(a) U.S. shareholder, and, if the section 958(a) U.S. 
shareholder has made the election described in paragraph (f)(2) of this 
section, the section 965(b) previously taxed earnings and profits of the 
deferred foreign income corporation with respect to the section 958(a) 
U.S. shareholder.
    (2) Reduction in basis by an amount equal to the gain reduction 
amount. If a section 958(a) U.S. shareholder does not recognize gain 
under section 961(b)(2) by reason of paragraph (g)(1) of this section 
with respect to a distribution from a deferred foreign income 
corporation (including through a chain of ownership described under 
section 958(a)), the section 958(a) U.S. shareholder's basis in the 
section 958(a) stock of the deferred foreign income corporation, or the 
section 958(a) U.S. shareholder's basis in the applicable property with 
respect to the deferred

[[Page 524]]

foreign income corporation, is reduced by the amount of gain that would 
otherwise be recognized by the section 958(a) U.S. shareholder without 
regard to paragraph (g)(1) of this section.
    (h) Rules of application for specified basis adjustments. This 
paragraph (h) applies for purposes of making any adjustment to the basis 
of section 958(a) stock or applicable property with respect to a 
specified foreign corporation described in paragraph (e), (f)(2), or 
(g)(2) of this section (collectively, specified basis adjustments, and 
each a specified basis adjustment).
    (1) Timing of basis adjustments. Except as provided in paragraph 
(e)(2) of this section, a specified basis adjustment to section 958(a) 
stock or applicable property with respect to a specified foreign 
corporation is made as of the last day of the last taxable year of the 
specified foreign corporation that begins before January 1, 2018, on 
which it is a specified foreign corporation.
    (2) Netting of basis adjustments. If one or more specified basis 
adjustments occur on the same day with respect to the same section 
958(a) stock or applicable property, a single basis adjustment is made 
as of the close of such day with respect to such stock or applicable 
property in an amount equal to the net amount, if any, of the increase 
or reduction, as applicable.
    (3) Gain recognition for reduction in excess of basis. The excess 
(if any) of a net reduction in basis with respect to section 958(a) 
stock or applicable property of a section 958(a) U.S. shareholder by 
reason of one or more specified basis adjustments over the section 
958(a) U.S. shareholder's basis in such stock or applicable property 
without regard to the specified basis adjustments is treated as gain 
from the sale or exchange of property.
    (4) Adjustments with respect to each share--(i) Section 958(a) 
stock. If a specified basis adjustment is made with respect to section 
958(a) stock, the specified basis adjustment is made with respect to 
each share of the section 958(a) stock in a manner consistent with the 
section 958(a) U.S. shareholder's pro rata share of the section 965(a) 
earnings amount or specified E&P deficit, as applicable, by reason of 
such share.
    (ii) Applicable property. If a specified basis adjustment is made 
with respect to applicable property, the adjustment is made with respect 
to the applicable property in a manner consistent with the application 
of paragraph (h)(4)(i) of this section.
    (5) Stock or property for which adjustments are made--(i) In 
general. Except as provided in paragraph (h)(5)(ii) of this section, a 
specified basis adjustment is made solely with respect to section 958(a) 
stock owned by the section 958(a) U.S. shareholder within the meaning of 
section 958(a)(1)(A) or applicable property owned directly by the 
section 958(a) U.S. shareholder.
    (ii) Special rule for an interest in a foreign pass-through entity. 
If the applicable property of the section 958(a) U.S. shareholder 
described in paragraph (h)(5)(i) of this section is an interest in a 
foreign pass-through entity, then, for purposes of determining the 
foreign pass-through entity's basis in section 958(a) stock or 
applicable property, as applicable, with respect to the section 958(a) 
U.S. shareholder, a specified basis adjustment is made with respect to 
section 958(a) stock or applicable property of the section 958(a) U.S. 
shareholder owned through the foreign pass-through entity in the same 
manner as if the section 958(a) stock or applicable property were owned 
directly by the section 958(a) U.S. shareholder. In the case of tiered 
foreign pass-through entities, this paragraph (h)(5)(ii) applies with 
respect to each foreign pass-through entity.
    (i) Definitions. This paragraph (i) provides definitions that apply 
for purposes of this section.
    (1) Applicable property. The term applicable property means, with 
respect to a section 958(a) U.S. shareholder and a specified foreign 
corporation, property owned by the section 958(a) U.S. shareholder 
(including through one or more foreign pass-through entities) by reason 
of which the section 958(a) U.S. shareholder is considered under section 
958(a)(2) as owning section 958(a) stock of the specified foreign 
corporation.
    (2) Foreign pass-through entity. The term foreign pass-through 
entity means a foreign partnership or a foreign estate or trust (as 
defined in section

[[Page 525]]

7701(a)(31)) (including a controlled domestic partnership treated as a 
foreign partnership pursuant to Sec. 1.965-1(e)).
    (3) Property. The term property has the meaning provided in Sec. 
1.961-1(b)(1).
    (j) Examples. The following examples illustrate the application of 
this section.
    (1) Example 1. Determination of accumulated post-1986 deferred 
foreign income with subpart F income earned before E&P measurement date 
on November 2, 2017--(i) Facts. USP, a domestic corporation, owns all of 
the stock of CFC1, a foreign corporation, which owns all of the stock of 
CFC2, also a foreign corporation. USP, CFC1, and CFC2 all have taxable 
years ending December 31, 2017. As of January 1, 2017, CFC1 has no 
earnings and profits, and CFC2 has 100u of earnings and profits 
described in section 959(c)(3) that were accumulated in taxable years 
beginning after December 31, 1986, while CFC2 was a specified foreign 
corporation, and $21x of post-1986 foreign income taxes. None of CFC2's 
earnings and profits are attributable to income treated as effectively 
connected with the conduct of a trade or business within the United 
States. On March 1, 2017, CFC1 earns 30u of subpart F income (as defined 
in section 952), and CFC2 earns 20u of subpart F income. No foreign 
income tax is imposed on CFC1's or CFC2's subpart F income. For purposes 
of section 904, the post-1986 undistributed earnings, subpart F income, 
and post-1986 foreign income taxes are in the general category. On July 
1, 2017, CFC2 distributes 40u to CFC1. On November 1, 2017, CFC1 
distributes 60u to USP. USP does not have an aggregate foreign E&P 
deficit. USP includes in gross income all amounts that it is required to 
include under section 951. No foreign income tax is imposed or withheld 
on the distribution by CFC2 to CFC1 or the distribution by CFC1 to USP.
    (ii) Analysis--(A) Adjustments to section 959(c) classification of 
earnings and profits for inclusion under section 951(a)(1)(A) without 
regard to section 965. The distribution from CFC2 to CFC1 does not give 
rise to subpart F income to CFC1 due to the application of section 
954(c)(6). Accordingly, USP's inclusion under section 951(a)(1)(A) 
without regard to section 965(a) is 30u with respect to CFC1 and 20u 
with respect to CFC2 for their taxable years ending December 31, 2017. 
As a result of the inclusions under section 951(a)(1)(A), CFC1 and CFC2 
increase their earnings and profits described in section 959(c)(2) by 
30u and 20u, respectively.
    (B) Distributions between specified foreign corporations before 
January 1, 2018. The distribution of 40u from CFC2 to CFC1 is treated as 
a distribution of 20u out of earnings and profits described in section 
959(c)(2) (attributable to inclusions under section 951(a)(1)(A) without 
regard to section 965(a)) and 20u out of earnings and profits described 
in section 959(c)(3).
    (C) Section 965(a) inclusion amount. USP determines whether CFC1 and 
CFC2 are deferred foreign income corporations and, if so, determines its 
section 965(a) inclusion amounts with respect to CFC1 and CFC2. CFC1 and 
CFC2 are specified foreign corporations, and CFC1 and CFC2 each have 
accumulated post-1986 deferred foreign income greater than zero as of an 
E&P measurement date. Accordingly, CFC1 and CFC2 are deferred foreign 
income corporations. USP's section 965(a) inclusion amount with respect 
to each of CFC1 and CFC2, respectively, equals the section 965(a) 
earnings amount of CFC1 and CFC2, respectively.
    (1) CFC1 section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC1 is 20u, the amount of its accumulated post-
1986 deferred foreign income as of both November 2, 2017, and December 
31, 2017, which is equal to 70u of post-1986 earnings and profits (30u 
earned and 40u attributable to the CFC2 distribution) reduced by 50u of 
such post-1986 earnings and profits described in section 959(c)(2) (30u 
earned and 20u attributable to the CFC2 distribution) under section 
965(d)(2)(B) and Sec. 1.965-1(f)(7)(i)(B). Under section 965(d)(3)(B) 
and Sec. 1.965-1(f)(29)(i)(B), the post-1986 earnings and profits of 
CFC1 are not reduced by the 60u distribution to USP.
    (2) CFC2 section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC2 is 80u, the amount of its accumulated post-
1986 deferred foreign income as of both November 2, 2017, and December 
31, 2017, which is equal to the amount of

[[Page 526]]

CFC2's post-1986 earnings and profits of 80u. CFC2's accumulated post-
1986 deferred foreign income is equal to its post-1986 earnings and 
profits because CFC2 does not have earnings and profits that are 
attributable to income of the specified foreign corporation that is 
effectively connected with the conduct of a trade or business within the 
United States and subject to tax under chapter 1, or that, if 
distributed, would be excluded from the gross income of a United States 
shareholder under section 959 or from the gross income of another 
shareholder if such shareholder were a United States shareholder, and, 
therefore, no adjustment is made under section 965(d)(2) or Sec. 1.965-
1(f)(7). CFC2's 80u of post-1986 earnings and profits consists of 120u 
of earnings and profits that it earned, reduced by the 40u distribution 
to CFC1 under section 965(d)(3)(B) and Sec. 1.965-1(f)(29)(i)(B). The 
amount of the reduction to the post-1986 earnings and profits of CFC2 
for the 40u distribution is not limited by Sec. 1.965-1(f)(29)(i)(B) 
because CFC1's post-1986 earnings and profits are increased by 40u as a 
result of the distribution. Furthermore, because the 40u distribution 
was made on July 1, 2017, which is before the E&P measurement date on 
November 2, 2017, Sec. 1.965-4(f) is not relevant.
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3). CFC1 and CFC2 increase their earnings and profits described in 
section 959(c)(2) by USP's section 965(a) inclusion amounts with respect 
to CFC1 and CFC2, 20u and 80u, respectively, and reduce their earnings 
and profits described in section 959(c)(3) by an equivalent amount.
    (D) Distribution to United States shareholder. The distribution from 
CFC1 to USP is treated as a distribution of 60u out of the earnings and 
profits of CFC1 described in section 959(c)(2), which include earnings 
and profits attributable to the section 965(a) inclusion amount taken 
into account by USP.
    (E) Section 902 and section 960 consequences--(1) Distribution by 
and inclusions with respect to CFC2. Under section 960, USP is deemed to 
pay $3.50x ($21x x (20u/120u)) of CFC2's post-1986 foreign income taxes 
as a result of its inclusion under section 951(a)(1)(A) without regard 
to section 965(a) with respect to CFC2. As a result of the distribution 
from CFC2 to CFC1, CFC2's post-1986 foreign income taxes are reduced, 
and CFC1's post-1986 foreign income taxes are increased, by the foreign 
income taxes deemed paid by CFC1 under section 902 of $3.50x (($21x-
$3.50x) x (20u/120u-20u)). Under section 960, USP is deemed to pay $14x 
(($21x-$3.50x-$3.50x) x 80u/(120u-40u)) of CFC2's post-1986 foreign 
income taxes as a result of its section 965(a) inclusion with respect to 
CFC2. The taxes deemed paid by USP as a result of its section 965(a) 
inclusion with respect to CFC2 are subject to the applicable percentage 
disallowance under section 965(g).
    (2) Inclusions with respect to CFC1. As determined in paragraph 
(j)(1)(ii)(E)(1) of this section (paragraph (E)(1) in the analysis in 
this Example 1), as a result of the distribution from CFC2 to CFC1, CFC1 
is deemed under section 902 to pay $3.50x of CFC2's post-1986 foreign 
income taxes. Under section 960, USP is deemed to pay $2.10x ($3.50x x 
(30u/(30u + 20u))) of CFC1's post-1986 foreign income taxes as a result 
of its inclusion under section 951(a)(1)(A) without regard to section 
965(a) with respect to CFC1. Under section 960, USP is deemed to pay 
$1.40x (($3.50x-$2.10x) x 20u/(30u + 20u-30u)) of CFC1's post-1986 
foreign income taxes as a result of its section 965(a) inclusion with 
respect to CFC1. The taxes deemed paid by USP as a result of its section 
965(a) inclusion with respect to CFC1 are subject to the applicable 
percentage disallowance under section 965(g).
    (2) Example 2. Determination of accumulated post-1986 deferred 
foreign income with subpart F income earned after E&P measurement date 
on November 2, 2017--(i) Facts. The facts are the same as in paragraph 
(j)(1)(i) of this section (the facts in Example 1), except that on 
December 1, 2017, CFC1 earns an additional 50u of subpart F income (as 
defined in section 952), and neither CFC1 nor CFC2 has any post-1986 
foreign income taxes.
    (ii) Analysis--(A) Adjustments to section 959(c) classification of 
earnings and profits for inclusion under section 951(a)(1)(A) without 
regard to section 965. USP determines its inclusion under section 
951(a)(1)(A) without regard to

[[Page 527]]

section 965(a), which is 80u with respect to CFC1 and 20u with respect 
to CFC2 for their taxable years ending December 31, 2017. As a result of 
the inclusions under section 951(a)(1)(A), CFC1 and CFC2 increase their 
earnings and profits described in section 959(c)(2) by 80u and 20u, 
respectively.
    (B) Distributions between specified foreign corporations before 
January 1, 2018. The analysis is the same as in paragraph (j)(1)(ii)(B) 
of this section (paragraph (B) in the analysis in Example 1).
    (C) Section 965(a) inclusion amount. USP determines whether CFC1 and 
CFC2 are deferred foreign income corporations and, if so, determines its 
section 965(a) inclusion amounts with respect to CFC1 and CFC2. CFC1 and 
CFC2 are specified foreign corporations, and CFC1 and CFC2 each have 
accumulated post-1986 deferred foreign income greater than zero as of an 
E&P measurement date. Accordingly, CFC1 and CFC2 are deferred foreign 
income corporations. USP's section 965(a) inclusion amount with respect 
to each of CFC1 and CFC2, respectively, equals the section 965(a) 
earnings amount of CFC1 and CFC2, respectively.
    (1) CFC1 section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC1 is 20u, the greater of--
    (i) The amount of its accumulated post-1986 deferred foreign income 
as of November 2, 2017, 20u, which is equal to 70u of post-1986 earnings 
and profits (30u earned and 40u attributable to the CFC2 distribution) 
reduced by 50u of such post-1986 earnings and profits described in 
section 959(c)(2) without regard to the subpart F income earned after 
November 2, 2017 (30u earned and 20u attributable to the CFC2 
distribution) under section 965(d)(2)(B) and Sec. 1.965-1(f)(7)(i)(B) 
and (ii), and
    (ii) The amount of its accumulated post-1986 deferred foreign income 
as of December 31, 2017, 20u, which is equal to 120u of post-1986 
earnings and profits (80u earned and 40u attributable to the CFC2 
distribution) reduced by 100u of such post-1986 earnings and profits 
described in section 959(c)(2) with regard to the subpart F income 
earned on or before December 31, 2017 (80u earned and 20u attributable 
to the CFC2 distribution) under section 965(d)(2)(B) and Sec. 1.965-
1(f)(7)(i)(B) and (ii).
    (2) CFC2 section 965(a) earnings amount. The analysis is the same as 
in paragraph (j)(1)(ii)(C)(2) of this section (paragraph (C)(2) in the 
analysis in Example 1)).
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3). The analysis is the same as in paragraph (j)(1)(ii)(C)(3) of 
this section (paragraph (C)(3) in the analysis in Example 1).
    (D) Distribution to United States shareholder. The analysis is the 
same as in paragraph (j)(1)(ii)(D) of this section (paragraph (D) in the 
analysis in Example 1).
    (3) Example 3. Determination of accumulated post-1986 deferred 
foreign income with subpart F income earned after E&P measurement date 
on November 2, 2017, but previously taxed earnings and profits 
attributable to the subpart F income distributed before E&P measurement 
date on November 2, 2017--(i) Facts. The facts are the same as in 
paragraph (j)(1)(i) of this section (the facts in Example 1), except 
that on December 1, 2017, CFC2 earns an additional 50u of subpart F 
income (as defined in section 952), and neither CFC1 nor CFC2 has any 
post-1986 foreign income taxes.
    (ii) Analysis--(A) Adjustments to section 959(c) classification of 
earnings and profits for inclusion under section 951(a)(1)(A) without 
regard to section 965. USP determines its inclusion under section 
951(a)(1)(A) without regard to section 965(a), which is 30u with respect 
to CFC1 and 70u with respect to CFC2 for their taxable years ending 
December 31, 2017. As a result of the inclusions under section 
951(a)(1)(A), CFC1 and CFC2 increase their earnings and profits 
described in section 959(c)(2) by 30u and 70u, respectively.
    (B) Distributions between specified foreign corporations before 
January 1, 2018. The distribution of 40u from CFC2 to CFC1 is treated as 
a distribution of 40u out of earnings and profits described in section 
959(c)(2) (attributable to inclusions under section 951(a)(1)(A) without 
regard to section 965(a)).
    (C) Section 965(a) inclusion amount. USP determines whether CFC1 and 
CFC2 are deferred foreign income corporations, and, if so, determines 
its section 965(a) inclusion amounts with

[[Page 528]]

respect to CFC1 and CFC2. Because USP wholly owns CFC1 and CFC2 under 
section 958(a) and USP does not have an aggregate foreign E&P deficit, 
USP's section 965(a) inclusion amount with respect to each of CFC1 and 
CFC2, respectively, equals the section 965(a) earnings amount, if any, 
of CFC1 and CFC2, respectively.
    (1) CFC1 section 965(a) earnings amount. CFC1 is not a deferred 
foreign income corporation and does not have a section 965(a) earnings 
amount because the amount of its accumulated post-1986 deferred foreign 
income as of both November 2, 2017, and December 31, 2017, is 0u, which 
is equal to 70u of post-1986 earnings and profits (30u earned and 40u 
attributable to the CFC2 distribution) reduced by 70u of such post-1986 
earnings and profits described in section 959(c)(2) (30u earned and 40u 
attributable to the CFC2 distribution) under section 965(d)(2)(B) and 
Sec. 1.965-1(f)(7)(i)(B).
    (2) CFC2 section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC2 is 100u, the greater of the amounts in 
paragraph (j)(3)(ii)(C)(2)(i) and (ii) of this section (paragraph 
(C)(2)(i) and (ii) in the analysis in this Example 3)--
    (i) The amount of its accumulated post-1986 deferred foreign income 
as of November 2, 2017, 80u. CFC2's 80u of accumulated post-1986 
deferred foreign income as of November 2, 2017, is equal to its 80u of 
post-1986 earnings and profits because no adjustment is made under 
section 965(d)(2) or Sec. 1.965-1(f)(7), as CFC2 does not have earnings 
and profits that are attributable to income of the specified foreign 
corporation that is effectively connected with the conduct of a trade or 
business within the United States and subject to tax under chapter 1, or 
that, if distributed, would be excluded from the gross income of a 
United States shareholder under section 959 or from the gross income of 
another shareholder if such shareholder were a United States 
shareholder, without regard to the subpart F income earned after 
November 2, 2017. CFC2's 80u of post-1986 earnings and profits consists 
of 120u of earnings and profits that it earned, reduced by the 40u 
distribution to CFC1 under section 965(d)(3)(B) and Sec. 1.965-
1(f)(29)(i)(B). The amount of the reduction to the post-1986 earnings 
and profits of CFC2 for the 40u distribution is not limited by Sec. 
1.965-1(f)(29)(i)(B) because CFC1's post-1986 earnings and profits are 
increased by 40u as a result of the distribution. Furthermore, because 
the 40u distribution was made on July 1, 2017, which is before any E&P 
measurement date, Sec. 1.965-4(f) is not relevant.
    (ii) The amount of its accumulated post-1986 deferred foreign income 
as of December 31, 2017, 100u, which is equal to 130u of post-1986 
earnings and profits reduced by 30u of such post-1986 earnings and 
profits described in section 959(c)(2) with regard to the subpart F 
income earned before December 31, 2017, under section 965(d)(2)(B) and 
Sec. 1.965-1(f)(7)(i)(B) and (ii). CFC2's 130u of post-1986 earnings 
and profits consists of 170u of earnings and profits that it earned, 
reduced by the 40u distribution to CFC1 under section 965(d)(3)(B) and 
Sec. 1.965-1(f)(29)(i)(B).
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3). CFC2 increases its earnings and profits described in section 
959(c)(2) by USP's section 965(a) inclusion amount with respect to CFC2, 
100u, and reduces its earnings and profits described in section 
959(c)(3) by an equivalent amount.
    (D) Distribution to United States shareholder. The analysis is the 
same as in paragraph (j)(1)(ii)(D) of this section (paragraph (D) in the 
analysis in Example 1).
    (4) Example 4. Determination of accumulated post-1986 deferred 
foreign income with distribution made after E&P measurement date on 
November 2, 2017--(i) Facts. USP, a domestic corporation, owns all of 
the stock of CFC1, a foreign corporation, which owns all of the stock of 
CFC2, also a foreign corporation. USP, CFC1, and CFC2 all have taxable 
years ending December 31, 2017. As of January 1, 2017, CFC1 has 10u of 
earnings and profits described in section 959(c)(3) that were 
accumulated in taxable years beginning after December 31, 1986, while 
CFC1 was a specified foreign corporation, and $2x of post-1986 foreign 
income taxes; and CFC2 has 100u of earnings and profits described in 
section 959(c)(3) that were accumulated in taxable years beginning after 
December 31, 1986, while

[[Page 529]]

CFC2 was a specified foreign corporation and $10x of post-1986 foreign 
income taxes. For purposes of section 904, the post-1986 undistributed 
earnings and post-1986 foreign income taxes are in the general category. 
None of CFC1's or CFC2's earnings and profits are attributable to income 
treated as effectively connected with the conduct of a trade or business 
within the United States. On December 1, 2017, CFC2 distributes 100u to 
CFC1, and CFC1 distributes 10u to USP. USP does not have an aggregate 
foreign E&P deficit. USP includes in gross income all amounts that it is 
required to include under section 951. No foreign income tax is imposed 
or withheld on the distribution by CFC2 to CFC1 or the distribution by 
CFC1 to USP. USP does not apply Sec. 1.965-4(f)(3) to determine the 
post-1986 earnings and profits of CFC1 and CFC2.
    (ii) Analysis--(A) Adjustments to section 959(c) classification of 
earnings and profits for inclusion under section 951(a)(1)(A) without 
regard to section 965. The distribution from CFC2 to CFC1 does not give 
rise to subpart F income to CFC1 due to the application of section 
954(c)(6). Accordingly, USP does not have an inclusion under section 
951(a)(1)(A) without regard to section 965(a) with respect to CFC1 or 
CFC2 for their taxable years ending December 31, 2017. As a result, 
neither CFC1 nor CFC2 has earnings and profits described in section 
959(c)(2).
    (B) Distributions between specified foreign corporations before 
January 1, 2018. The distribution of 100u from CFC2 to CFC1 is initially 
treated as a distribution out of earnings and profits described in 
section 959(c)(3).
    (C) Section 965(a) inclusion amount. USP determines whether CFC1 and 
CFC2 are deferred foreign income corporations, and, if so, determines 
its section 965(a) inclusion amounts with respect to CFC1 and CFC2. CFC1 
and CFC2 are specified foreign corporations, and CFC1 and CFC2 each have 
accumulated post-1986 deferred foreign income greater than zero as of an 
E&P measurement date. Accordingly, CFC1 and CFC2 are deferred foreign 
income corporations. USP's section 965(a) inclusion amount with respect 
to each of CFC1 and CFC2, respectively, equals the section 965(a) 
earnings amount of CFC1 and CFC2, respectively.
    (1) CFC1 section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC1 is 10u, the amount of its accumulated post-
1986 deferred foreign income as of both November 2, 2017, and December 
31, 2017, which is equal to the amount of CFC1's post-1986 earnings and 
profits of 10u. CFC1's accumulated post-1986 deferred foreign income is 
equal to its post-1986 earnings and profits because CFC1 does not have 
earnings and profits that are attributable to income of the specified 
foreign corporation that is effectively connected with the conduct of a 
trade or business within the United States and subject to tax under 
chapter 1, or that, if distributed, would be excluded from the gross 
income of a United States shareholder under section 959 or from the 
gross income of another shareholder if such shareholder were a United 
States shareholder, and therefore no adjustment is made under section 
965(d)(2) or Sec. 1.965-1(f)(7). But for Sec. 1.965-4(f), CFC1's post-
1986 earnings and profits as of December 31, 2017, would be 110u, but 
because the distribution from CFC2 is a specified payment, it is 
disregarded in determining CFC1's post-1986 earnings and profits as of 
December 31, 2017, under Sec. 1.965-4(f). Under section 965(d)(3)(B) 
and Sec. 1.965-1(f)(29)(i)(B), the post-1986 earnings and profits of 
CFC1 are not reduced by the 10u distribution to USP.
    (2) CFC2 section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC2 is 100u, the amount of its accumulated post-
1986 deferred foreign income as of both November 2, 2017, and December 
31, 2017, which is equal to the amount of CFC2's post-1986 earnings and 
profits of 100u. CFC2's accumulated post-1986 deferred foreign income is 
equal to its post-1986 earnings and profits because CFC2 does not have 
earnings and profits that are attributable to income of the specified 
foreign corporation that is effectively connected with the conduct of a 
trade or business within the United States and subject to tax under 
chapter 1, or that, if distributed, would be excluded from the gross 
income of a

[[Page 530]]

United States shareholder under section 959 or from the gross income of 
another shareholder if such shareholder were a United States 
shareholder, and therefore no adjustment is made under section 965(d)(2) 
or Sec. 1.965-1(f)(7). But for Sec. 1.965-4(f), CFC2's post-1986 
earnings and profits as of December 31, 2017, would be 0u, but because 
the distribution to CFC1 is a specified payment, it is disregarded in 
determining CFC2's post-1986 earnings and profits as of December 31, 
2017, under Sec. 1.965-4(f).
    (3) Effect on earnings and profits described in section 959(c)(2) 
and (3). CFC1 and CFC2 increase their earnings and profits described in 
section 959(c)(2) by USP's section 965(a) inclusion amounts with respect 
to CFC1 and CFC2, 10u and 100u, respectively, and reduce their earnings 
and profits described in section 959(c)(3) by an equivalent amount.
    (D) Distributions--(1) Distribution that is a specified payment. The 
distribution from CFC2 to CFC1 is recharacterized as a distribution of 
100u out of the earnings and profits of CFC2 described in section 
959(c)(2), which include earnings and profits attributable to the 
section 965(a) inclusion amount taken into account by USP.
    (2) Distribution to United States shareholder. The distribution from 
CFC1 to USP is treated as a distribution of 10u out of the earnings and 
profits of CFC1 described in section 959(c)(2), which include earnings 
and profits attributable to the section 965(a) inclusion amount taken 
into account by USP.
    (E) Section 902 and section 960 consequences. Under section 960, USP 
is deemed to pay $10x ($10x x (100u/100u)) of CFC2's post-1986 foreign 
income taxes as a result of its section 965(a) inclusion with respect to 
CFC2 and $2x ($2x x (10u/10u) of CFC1's post-1986 foreign income taxes 
as a result of its section 965(a) inclusion with respect to CFC1. Such 
taxes are subject to the applicable percentage disallowance under 
section 965(g).
    (5) Example 5. Determination of accumulated post-1986 deferred 
foreign income with section 951(a)(1)(B) inclusion after E&P measurement 
date on November 2, 2017--(i) Facts. USP, a domestic corporation, owns 
all of the stock of CFC, a foreign corporation. USP has a taxable year 
ending December 31, 2017, and CFC has a taxable year ending November 30, 
2017. As of December 1, 2016, CFC has 110u of earnings and profits 
described in section 959(c)(3) that were accumulated in taxable years 
beginning after December 31, 1986, while CFC was a specified foreign 
corporation. CFC holds 150u of United States property throughout its 
taxable year ending November 30, 2017, but disposes of it on December 1, 
2017, recognizing no gain or loss on the property. Between December 1, 
2017, and December 31, 2017, CFC earns an additional 10u of income that 
does not constitute subpart F income or income treated as effectively 
connected with the conduct of a trade or business within the United 
States that gives rise to 10u of earnings and profits. USP includes in 
income all amounts that it is required to include under section 951.
    (ii) Analysis--(A) Section 965(a) inclusion amount. USP determines 
whether CFC is a deferred foreign income corporation, and, if so, 
determines its section 965(a) inclusion amount with respect to CFC. CFC 
is a specified foreign corporation, and CFC has accumulated post-1986 
deferred foreign income greater than zero as of an E&P measurement date. 
Accordingly, CFC is a deferred foreign income corporation. USP's section 
965(a) inclusion amount with respect to CFC equals the section 965(a) 
earnings amount of CFC.
    (1) CFC section 965(a) earnings amount. The section 965(a) earnings 
amount with respect to CFC is 110u, the greater of the amount of its 
accumulated post-1986 deferred foreign income as of November 2, 2017, 
which is 110u, and the amount of its accumulated post-1986 deferred 
foreign income as of December 31, 2017, which is 10u. CFC's accumulated 
post-1986 deferred foreign income as of November 2, 2017, is equal to 
its 110u of post-1986 earnings and profits, which are not reduced by the 
110u of earnings and profits described in section 959(c)(1) as a result 
of USP's section 951(a)(1)(B) inclusion with respect to CFC as of 
December 31, 2017, because such amounts would not be excluded from the 
gross income of a United States shareholder under section 959 under 
section 965(d)(2) or Sec. 1.965-1(f)(7) if distributed on November 2, 
2017. CFC's accumulated post-1986 deferred foreign

[[Page 531]]

income as of December 31, 2017, is equal to its 120u of post-1986 
earnings and profits reduced by the 110u of earnings and profits 
described in section 959(c)(1) as a result of USP's section 951(a)(1)(B) 
inclusion with respect to CFC as of December 31, 2017, which would be 
excluded from the gross income of a United States shareholder under 
section 959 under section 965(d)(2) or Sec. 1.965-1(f)(7) if 
distributed on December 31, 2017.
    (2) Effect on earnings and profits described in section 959(c)(2) 
and (3). In USP's taxable year ending December 31, 2018, CFC increases 
its earnings and profits described in section 959(c)(2) by USP's section 
965(a) inclusion amount with respect to CFC, 110u, and reduces its 
earnings and profits described in section 959(c)(3) by an equivalent 
amount.
    (B) Section 956 inclusion. In USP's taxable year ending December 31, 
2017, USP increases its earnings and profits described in section 
959(c)(1) by USP's amount included under sections 951(a)(1)(B) and 956 
with respect to CFC, 110u, and reduces its earnings and profits 
described in section 959(c)(3) by an equivalent amount.
    (6) Example 6. Section 1248 inclusion--(i) Facts. USP1, a domestic 
corporation, owns all of the stock of CFC, a foreign corporation, until 
it sells all of such stock to USP2, a domestic corporation, on December 
1, 2017, in a sale on which USP1 recognizes $100x of gain. Throughout 
2017, 1u=$1x. USP1, USP2, and CFC all have taxable years ending December 
31, 2017. As of January 1, 2017, CFC has 100u of earnings and profits 
described in section 959(c)(3) that were accumulated in taxable years 
beginning after December 31, 1986, while CFC was wholly owned by USP1. 
On March 1, 2017, CFC distributes 20u to USP1. None of CFC's earnings 
and profits are attributable to income treated as effectively connected 
with the conduct of a trade or business within the United States. USP2 
does not have an aggregate foreign E&P deficit. USP1 and USP2 include in 
income all amounts that they are required to include under sections 951 
and 1248.
    (ii) Analysis--(A) Adjustments to section 959(c) classification of 
earnings and profits for section 1248 inclusion. USP1's inclusion under 
section 1248 with respect to CFC is $80x ($100x-$20x). As a result of 
the inclusion under section 1248, under section 959(e), CFC increases 
its earnings and profits described in section 959(c)(2) by 80u.
    (B) Section 965(a) inclusion amount. USP2 determines whether CFC is 
a deferred foreign income corporation and, if so, determines its section 
965(a) inclusion amount with respect to CFC. CFC is a specified foreign 
corporation, and CFC has accumulated post-1986 deferred foreign income 
greater than zero as of an E&P measurement date. Accordingly, CFC is a 
deferred foreign income corporation. USP2's section 965(a) inclusion 
amount with respect to CFC equals the section 965(a) earnings amount of 
CFC. The section 965(a) earnings amount with respect to CFC is 20u, the 
amount of its accumulated post-1986 deferred foreign income as of both 
November 2, 2017, and December 31, 2017, which is equal to 100u of post-
1986 earnings and profits reduced by 80u of such post-1986 earnings and 
profits described in section 959(c)(2) under section 965(d)(2)(B) and 
Sec. 1.965-1(f)(7)(i)(B). CFC increases its earnings and profits 
described in section 959(c)(2) by USP2's section 965(a) inclusion amount 
with respect to CFC, 20u, and reduces its earnings and profits that 
would be described in section 959(c)(3) but for the application of 
section 965(a) by an equivalent amount.
    (C) Distributions to United States shareholders. The distributions 
from CFC to USP1 (including the deemed dividend under section 1248) are 
treated as distributions out of the earnings and profits of CFC 
described in section 959(c)(3).
    (7) Example 7. Distribution attributable to section 965(a) 
previously taxed earnings and profits--(i) Facts. USP, a domestic 
corporation, owns all of the stock of CFC1, a specified foreign 
corporation that has no post-1986 earnings and profits (or deficit in 
post-1986 earnings and profits), and CFC1 owns all the stock of CFC2, a 
deferred foreign income corporation. USP is a calendar year taxpayer. 
CFC1's last taxable year beginning before January 1, 2018, ends on 
November 30, 2018; CFC2 has an inclusion year that ends on November 30, 
2018. The functional currency of CFC1 and CFC2 is the U.S. dollar. USP's 
adjusted

[[Page 532]]

basis in the stock of CFC1 is zero. On January 1, 2018, CFC2 distributes 
$100x to CFC1, and CFC1 distributes $100x to USP. USP has a section 
965(a) inclusion amount of $100x with respect to CFC2 that is taken into 
account for USP's taxable year ending December 31, 2018. CFC2 has no 
earnings and profits described in section 959(c)(1) or (2) other than 
section 965(a) previously taxed earnings and profits.
    (ii) Analysis. Under paragraph (c) of this section, CFC2 has $100x 
of section 965(a) previously taxed earnings and profits with respect to 
USP. USP receives a distribution from CFC2 through a chain of ownership 
described in section 958(a) during the inclusion year of CFC2 that is 
attributable to the $100x of section 965(a) previously taxed earnings 
and profits of CFC2. Under paragraph (g)(1) of this section, the amount 
of gain that USP otherwise would recognize with respect to the stock of 
CFC1 under section 961(b)(2) is reduced (but not below zero) by $100x, 
the amount of CFC2's section 965(a) previously taxed earnings and 
profits with respect to USP. As of the close of November 30, 2018, USP's 
basis in CFC1 is increased under paragraph (e) of this section by USP's 
section 965(a) inclusion amount with respect to CFC2 ($100x), and is 
reduced under paragraph (g)(2) of this section by the amount of gain 
that would have been recognized by USP under section 961(b)(2) but for 
the application of paragraph (g)(1) of this section ($100x).
    (8) Example 8. Distribution attributable to section 965(b) 
previously taxed earnings and profits; parent-subsidiary--(i) Facts. The 
facts are the same as in paragraph (j)(7)(i) of this section (the facts 
in Example 7), except that CFC1 has a specified E&P deficit of $100x. 
Because of the specified E&P deficit of CFC1, USP's section 965(a) 
inclusion amount with respect to CFC2 is reduced to zero pursuant to 
section 965(b)(1) and Sec. 1.965-1(b)(2). USP makes the election 
described in paragraph (f)(2) of this section.
    (ii) Analysis--(A) Application of the gain reduction rule. Under 
paragraph (d)(1) of this section, CFC2 has $100x of section 965(b) 
previously taxed earnings and profits with respect to USP, and, under 
paragraph (d)(2) of this section, CFC1's earnings and profits described 
in section 959(c)(3) are increased by $100x to $0. USP receives a 
distribution from CFC2 through a chain of ownership described in section 
958(a) during the inclusion year of CFC2 that is attributable to the 
$100x of section 965(b) previously taxed earnings and profits of CFC2. 
Under paragraph (g)(1) of this section, the amount of gain that USP 
otherwise would recognize with respect to the stock of CFC1 under 
section 961(b)(2) is reduced (but not below zero) by $100x, the amount 
of CFC2's section 965(b) previously taxed earnings and profits with 
respect to USP under paragraph (d)(1) of this section.
    (B) Adjustments to the basis of CFC1. Because USP makes the election 
described in paragraph (f)(2) of this section, as of the close of 
November 30, 2018, USP's basis in CFC1 is increased under paragraph 
(f)(2)(ii)(A) of this section by an amount equal to CFC2's section 
965(b) previously taxed earnings and profits with respect to USP under 
paragraph (d)(1) of this section ($100x), reduced under paragraph 
(f)(2)(ii)(B) of this section by an amount equal to the portion of the 
specified E&P deficit of CFC1 taken into account in determining USP's 
section 965(a) inclusion amount with respect to CFC2 ($100x), and 
reduced under paragraph (g)(2) of this section by the amount of gain 
that would have been recognized by USP with respect to the stock of CFC1 
under section 961(b)(2) but for the application of paragraph (g)(1) of 
this section ($100x). Under paragraph (h)(2) and (3) of this section, 
the excess of the net reduction from the adjustments under paragraphs 
(f) and (g) of this section over USP's basis in the stock of CFC1 (in 
this case, $100x) is treated as gain recognized by USP from the sale or 
exchange of property.
    (9) Example 9. Distribution attributable to section 965(b) 
previously taxed earnings and profits; brother-sister--(i) Facts. The 
facts are the same as in paragraph (j)(8)(i) of this section (the facts 
in Example 8), except that USP owns all the stock of CFC2, USP's 
adjusted basis in the stock of CFC2 is zero, CFC1 made no distributions, 
and on January 1, 2018, CFC2 distributes $100x to USP.
    (ii) Analysis--(A) Application of the gain reduction rule. Under 
paragraph

[[Page 533]]

(d)(1) of this section, CFC2 has $100x of section 965(b) previously 
taxed earnings and profits with respect to USP, and, under paragraph 
(d)(2) of this section, CFC1's earnings and profits described in section 
959(c)(3) (deficit of $100x) are increased by $100x to $0. USP receives 
a distribution from CFC2 during the inclusion year of CFC2 that is 
attributable to the $100x of section 965(b) previously taxed earnings 
and profits of CFC2. Under paragraph (g)(1) of this section, the amount 
of gain that USP otherwise would recognize with respect to the stock of 
CFC2 under section 961(b)(2) is reduced (but not below zero) by $100x, 
the amount of CFC2's section 965(b) previously taxed earnings and 
profits with respect to USP under paragraph (d)(1) of this section.
    (B) Adjustments to the basis of CFC1 and CFC2. Because USP makes the 
election described in paragraph (f)(2) of this section, as of the close 
of November 30, 2018, USP's basis in the stock of CFC2 is increased 
under paragraph (f)(2)(ii)(A) of this section by the amount of CFC2's 
section 965(b) previously taxed earnings and profits with respect to USP 
under paragraph (d)(1) of this section ($100x) and reduced under 
paragraph (g)(2) of this section by the amount of gain that would have 
been recognized by USP with respect to the stock of CFC2 under section 
961(b)(2) but for the application of paragraph (g)(1) of this section 
($100x). As of the close of November 30, 2018, USP's basis in CFC1 is 
reduced under paragraph (f)(2)(ii)(B) of this section by an amount equal 
to the portion of USP's pro rata share of the specified E&P deficit of 
CFC1 taken into account in determining USP's section 965(a) inclusion 
amount with respect to CFC2 ($100x). Under paragraph (h)(3) of this 
section, the excess of the reduction under paragraph (f) of this section 
over USP's basis in the stock of CFC1 (in this case, $100x) is treated 
as gain recognized by USP from the sale or exchange of property.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9846, 84 FR 
14260, Apr. 10, 2019]



Sec. 1.965-3  Section 965(c) deductions.

    (a) Scope. This section provides rules regarding section 965(c) 
deductions and section 965(c) deduction amounts. Paragraph (b) of this 
section provides rules for disregarding certain assets for purposes of 
determining the aggregate foreign cash position of a section 958(a) U.S. 
shareholder. Paragraph (c) of this section provides rules for 
determining the aggregate foreign cash position for a section 958(a) 
U.S. shareholder inclusion year. Paragraph (d) of this section provides 
a rule regarding certain expatriated entities. Paragraph (e) of this 
section provides a rule for the treatment of section 965(c) deductions 
in connection with an election under section 962. Paragraph (f) of this 
section provides rules regarding the treatment of a section 965(c) 
deduction under certain provisions of the Internal Revenue Code. 
Paragraph (g) of this section provides a rule for domestic pass-through 
entities.
    (b) Rules for disregarding certain assets for determining aggregate 
foreign cash position--(1) Disregard of certain obligations between 
related specified foreign corporations. In determining the aggregate 
foreign cash position of a section 958(a) U.S. shareholder, any account 
receivable, account payable, short-term obligation, or derivative 
financial instrument between a specified foreign corporation with 
respect to which the section 958(a) U.S. shareholder owns section 958(a) 
stock and a related specified foreign corporation on corresponding cash 
measurement dates is disregarded to the extent of the smallest of the 
product of the amount of the item on such corresponding cash measurement 
dates of each specified foreign corporation and the section 958(a) U.S. 
shareholder's ownership percentage of section 958(a) stock of the 
specified foreign corporation owned by the section 958(a) U.S. 
shareholder on such dates. For purposes of this paragraph (b)(1)(i), a 
specified foreign corporation is treated as a related specified foreign 
corporation with respect to another specified foreign corporation if, as 
of the cash measurement date referred to in the preceding sentence of 
each specified foreign corporation, the specified foreign corporations 
are related persons within the meaning of section 954(d)(3), 
substituting the term ``specified foreign corporation'' for ``controlled 
foreign corporation'' in each place that it appears.

[[Page 534]]

    (2) Disregard of other assets upon demonstration of double-counting. 
For purposes of determining the aggregate foreign cash position of a 
section 958(a) U.S. shareholder, the section 958(a) U.S. shareholder's 
pro rata share of the cash position of a specified foreign corporation 
on a cash measurement date is reduced by amounts of net accounts 
receivable, actively traded property, and short-term obligations to the 
extent such amounts are attributable to amounts taken into account in 
determining the section 958(a) U.S. shareholder's pro rata share of the 
cash position of another specified foreign corporation on the 
corresponding cash measurement date of such other specified corporation 
and to the extent not disregarded pursuant to paragraph (b)(1) of this 
section. However, the preceding sentence applies only if the section 
958(a) U.S. shareholder attaches a statement containing the information 
outlined in paragraphs (b)(2)(i) through (v) of this section to its 
timely filed return (taking into account extensions, if any) for the 
section 958(a) U.S. shareholder inclusion year, or, if the section 
958(a) U.S. shareholder has multiple section 958(a) U.S. shareholder 
inclusion years, the later of such years. Relief is not available under 
Sec. 301.9100-2 or 301.9100-3 to allow late filing of the statement. 
The statement must contain the following information with respect to 
each specified foreign corporation for which the cash position is 
reduced under this paragraph (b)(2)--
    (i) A description of the asset that would be taken into account with 
respect to both specified foreign corporations,
    (ii) A statement of the amount by which its pro rata share of the 
cash position of one specified foreign corporation is reduced,
    (iii) A detailed explanation of why there would otherwise be double-
counting, including the computation of the amount taken into account 
with respect to the other specified foreign corporation, and
    (iv) An explanation of why paragraph (b)(1) of this section does not 
apply to disregard such amount.
    (3) Disregard of portion of cash position of noncorporate entities 
treated as specified foreign corporations. If an entity is treated as a 
specified foreign corporation of a section 958(a) U.S. shareholder 
pursuant to section 965(c)(3)(E), for purposes of determining the 
aggregate foreign cash position of the section 958(a) U.S. shareholder, 
the section 958(a) U.S. shareholder's pro rata share of the cash 
position of the entity (determined taking into account paragraphs (b)(1) 
and (b)(2) of this section) is reduced by the amount of the pro rata 
share attributable to deemed stock of the entity not owned (within the 
meaning of section 958(a), applied by treating domestic pass-through 
entities as foreign) by a specified foreign corporation of the section 
958(a) U.S. shareholder (determined without taking into account section 
965(c)(3)(E)).
    (4) Examples. The following examples illustrate the application of 
this paragraph (b).
    (i) Example 1--(A) Facts. USP, a domestic corporation, owns all of 
the stock of CFC1, a foreign corporation. CFC1 owns 95% of the only 
class of stock of CFC2, also a foreign corporation, and 40% of the only 
class of stock of CFC3, also a foreign corporation. The remaining 5% of 
the only class of stock of CFC2 is owned by a person unrelated to USP, 
CFC1, and CFC2; and the remaining 60% of the only class of stock of CFC3 
is owned by a person unrelated to USP and CFC1. USP, CFC1, and CFC3 have 
calendar year taxable years. CFC2 has a taxable year ending on November 
30. On November 15, 2015, CFC1 makes a loan of $100x to CFC2, which is 
required to be and is, in fact, repaid on January 1, 2016. On November 
15, 2016, CFC2 sells inventory to CFC1 in exchange for an account 
receivable of $200x, which is required to be and is, in fact, repaid on 
December 15, 2016. On August 1, 2017, CFC1 makes a loan of $300x to 
CFC3, which is required to be and is, in fact, repaid on January 31, 
2018.
    (B) Analysis--(1) Loan from CFC1 to CFC2. For purposes of 
determining the aggregate foreign cash position of USP, a section 958(a) 
U.S. shareholder of CFC1, under paragraph (b)(1) of this section, 
because CFC1 and CFC2 are related within the meaning of paragraph

[[Page 535]]

(b)(1) of this section, the short-term obligation of CFC2 held by CFC1 
outstanding on the first cash measurement date of each specified foreign 
corporation, November 30, 2015, and December 31, 2015, respectively, is 
disregarded to the extent of 95%, the smallest ownership percentage of 
section 958(a) stock of CFC1 and CFC2 owned by USP on such first cash 
measurement dates. Accordingly, USP only takes into account $5 ($100-95% 
of $100) of the short-term obligation in determining CFC1's cash 
position for purposes of determining its aggregate foreign cash 
position.
    (2) Account receivable of CFC1 held by CFC2. Because the account 
receivable of CFC1 held by CFC2 on its second cash measurement date, 
November 30, 2016, is not outstanding on CFC1's second cash measurement 
date, December 31, 2016, paragraph (b)(1) of this section does not apply 
to disregard any portion of such account receivable.
    (3) Loan from CFC1 to CFC3. Because CFC3 is not related to CFC1 
within the meaning of paragraph (b)(1) of this section, paragraph (b)(1) 
of this section does not apply to disregard any portion of such short-
term obligation.
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(b)(4)(i)(A) of this section (the facts in Example 1), except that on 
December 1, 2015, CFC1 sells 5% of the stock of CFC2 to an unrelated 
person.
    (B) Analysis. The analysis is the same as in paragraph (b)(4)(i)(B) 
of this section (the analysis in Example 1), except that the short-term 
obligation of CFC2 held by CFC1 outstanding on both of their first cash 
measurement dates, November 30, 2015, and December 31, 2015, 
respectively, is disregarded under paragraph (b)(1) of this section to 
the extent of 90%, the smallest ownership percentage of section 958(a) 
stock of CFC1 and CFC2 by USP on such first cash measurement dates. 
Accordingly, USP takes into account $10 ($100-90% of $100) of the short-
term obligation in determining CFC1's cash position for purposes of 
determining its aggregate foreign cash position.
    (iii) Example 3--(A) Facts. USP, a domestic corporation, owns all of 
the stock of CFC1, a foreign corporation, which owns 45% of the only 
class of stock of CFC2, also a foreign corporation. The remainder of the 
CFC2 stock is actively traded on an established financial market but is 
not owned by any person related to USP or CFC1. USP, CFC1, and CFC2 have 
calendar year taxable years. The value of the CFC2 stock owned by CFC1 
is $500x on each of the cash measurement dates. Also on each of the cash 
measurement dates, CFC2 has $300x of assets described in section 
965(c)(3)(B) and Sec. 1.965-1(f)(16) that are taken into account in 
determining its cash position.
    (B) Analysis. For purposes of determining USP's aggregate foreign 
cash position, USP's pro rata share of the cash position of CFC1 on each 
cash measurement date may be reduced by the amount of the stock of CFC2 
to the extent attributable to amounts taken into account in determining 
USP's pro rata share of the cash position of CFC2 on such cash 
measurement date (that is, to the extent of the $135x taken into account 
with respect to CFC2), provided USP attaches a statement to its timely 
filed return (taking into account extensions, if any) containing the 
following: A description of the CFC2 stock and the assets of CFC2 taken 
into account in determining its cash position; a statement that USP's 
pro rata share of the cash position of CFC1 is being reduced by $135x; 
the computation of the $135x taken into account with respect to CFC2; 
and an explanation of why paragraph (b)(1) of this section does not 
apply to disregard such amount.
    (iv) Example 4--(A) Facts. USP, a domestic corporation, owns all of 
the stock of CFC1 and CFC2, each a foreign corporation. USP, CFC1, and 
CFC2 have calendar year taxable years. CFC1 buys goods on credit from a 
third party for $100x and thus has an account payable of $100x. CFC1 
modifies the goods and sells to CFC2 for $105x in exchange for an 
account receivable of $105x. CFC2 modifies the goods and sells to 
another third party for $110x in exchange for an account receivable of 
$110x. All of the accounts payable and accounts receivable are 
outstanding on the final cash measurement date.
    (B) Analysis. For purposes of determining USP's aggregate foreign 
cash

[[Page 536]]

position, on the final cash measurement date, CFC1 has net accounts 
receivable of $0 because, pursuant to paragraph (b)(1) of this section, 
CFC1's account receivable from CFC2 is disregarded, and CFC2 has net 
accounts receivable of $110x because, pursuant to paragraph (b)(1) of 
this section, CFC2's account payable to CFC1 is disregarded. USP cannot 
rely on the rule in paragraph (b)(2) of this section because no amounts 
attributable to CFC2's net accounts receivable are taken into account 
with respect to another specified foreign corporation.
    (v) Example 5--(A) Facts. USP, a domestic corporation, owns all of 
the stock of CFC1 and CFC2, each a foreign corporation. USP and CFC1 own 
60% and 40%, respectively, of the interests in the capital and profits 
of PS1, a partnership. PS1 and CFC2 own 70% and 30%, respectively, of 
the interests in the capital and profits of PS2, a partnership. On each 
cash measurement date, PS1's cash position of $100x consists entirely of 
cash, and PS2's cash position of $200x includes a $50x short-term 
obligation of CFC2.
    (B) Analysis--(1) Treatment of PS1. Because an interest in PS1 is 
held by CFC1, a specified foreign corporation of USP, and PS1 would be a 
specified foreign corporation of USP if it were a foreign corporation, 
PS1 is treated as a specified foreign corporation of USP for purposes of 
determining USP's aggregate foreign cash position. Without regard to 
paragraph (b)(3) of this section, USP must take into account $100x, its 
pro rata share of PS1's cash position, for purposes of determining its 
aggregate foreign cash position. However, 60% of that amount is 
attributable to deemed stock of PS1 that is not owned (within the 
meaning of section 958(a)) by a specified foreign corporation of USP. 
Accordingly, pursuant to paragraph (b)(3) of this section, the amount of 
PS1's cash position that USP must take into account for purposes of 
determining its aggregate foreign cash position is reduced by $60x (60% 
of $100x) to $40x ($100x-$60x).
    (2) Treatment of PS2. Because an interest in PS2 is held by CFC2, a 
specified foreign corporation of USP, and PS2 would be a specified 
foreign corporation of USP if it were a foreign corporation, PS2 is 
treated as a specified foreign corporation of USP for purposes of 
determining USP's aggregate foreign cash position. USP, CFC1, CFC2, PS1, 
and PS2 all have calendar year taxable years. For purposes of 
determining the aggregate foreign cash position of USP, a section 958(a) 
U.S. shareholder of PS2, under paragraph (b)(1) of this section, the 
short-term obligation of CFC2 held by PS2 outstanding on each cash 
measurement date of each specified foreign corporation is disregarded on 
such cash measurement dates. Accordingly, without regard to paragraph 
(b)(3) of this section, USP must take into account $150x ($200x-$50x) of 
PS2's cash position for purposes of determining its aggregate foreign 
cash position. However, 42% (60% x 70%) of that amount is attributable 
to deemed stock of PS2 that is not owned (within the meaning of section 
958(a), applied by treating PS1 as foreign if it is a domestic pass-
through entity) by a specified foreign corporation of USP (determined 
without taking into account section 965(c)(3)(E)). Accordingly, pursuant 
to paragraph (b)(3) of this section, the amount of PS2's cash position 
that USP must take into account for purposes of determining its 
aggregate foreign cash position is reduced by $63x (42% of $150x) to 
$87x ($150x-$63x).
    (c) Determination of aggregate foreign cash position for a section 
958(a) U.S. shareholder inclusion year--(1) Single section 958(a) U.S. 
shareholder inclusion year. If a section 958(a) U.S. shareholder has a 
single section 958(a) U.S. shareholder inclusion year, then the section 
958(a) U.S. shareholder's aggregate foreign cash position for the 
section 958(a) U.S. shareholder inclusion year is equal to the aggregate 
foreign cash position of the section 958(a) U.S. shareholder.
    (2) Multiple section 958(a) U.S. shareholder inclusion years. If a 
section 958(a) U.S. shareholder has multiple section 958(a) U.S. 
shareholder inclusion years, then the section 958(a) U.S. shareholder's 
aggregate foreign cash position for each section 958(a) U.S. shareholder 
inclusion year is determined by allocating the aggregate foreign cash

[[Page 537]]

position to a section 958(a) U.S. shareholder inclusion year under 
paragraphs (c)(2)(i) and (c)(2)(ii) of this section.
    (i) Allocation to first section 958(a) U.S. shareholder inclusion 
year. A portion of the aggregate foreign cash position of the section 
958(a) U.S. shareholder is allocated to the first section 958(a) U.S. 
shareholder inclusion year in an amount equal to the lesser of the 
section 958(a) U.S. shareholder's aggregate foreign cash position or the 
section 958(a) U.S. shareholder's aggregate section 965(a) inclusion 
amount for the section 958(a) U.S. shareholder inclusion year.
    (ii) Allocation to succeeding section 958(a) U.S. shareholder 
inclusion years. The amount of the section 958(a) U.S. shareholder's 
aggregate foreign cash position allocated to any succeeding section 
958(a) U.S. shareholder inclusion year equals the lesser of the excess, 
if any, of the section 958(a) U.S. shareholder's aggregate foreign cash 
position over the aggregate amount of its aggregate foreign cash 
position allocated to preceding section 958(a) U.S. shareholder 
inclusion years under paragraph (c)(2)(i) of this section and this 
paragraph (c)(2)(ii) or the section 958(a) U.S. shareholder's aggregate 
section 965(a) inclusion amount for such succeeding section 958(a) U.S. 
shareholder inclusion year.
    (3) Estimation of aggregate foreign cash position. For purposes of 
determining the aggregate foreign cash position of a section 958(a) U.S. 
shareholder, the section 958(a) U.S. shareholder may assume that its pro 
rata share of the cash position of any specified foreign corporation 
whose last taxable year beginning before January 1, 2018, ends after the 
date the return for such section 958(a) U.S. shareholder inclusion year 
(the estimated section 958(a) U.S. shareholder inclusion year) is timely 
filed (taking into account extensions, if any) is zero as of the cash 
measurement date with which the taxable year of such specified foreign 
corporation ends. If a section 958(a) U.S. shareholder's pro rata share 
of the cash position of a specified foreign corporation is treated as 
zero pursuant to the preceding sentence, the amount described in Sec. 
1.965-1(f)(8)(i)(A) with respect to such section 958(a) U.S. shareholder 
in fact exceeds the amount described in Sec. 1.965-1(f)(8)(i)(B) with 
respect to such section 958(a) U.S. shareholder, and the aggregate 
section 965(a) inclusion amount for the estimated section 958(a) U.S. 
shareholder inclusion year exceeds the amount described in Sec. 1.965-
1(f)(8)(i)(B) with respect to such section 958(a) U.S. shareholder, 
interest and penalties will not be imposed if such section 958(a) U.S. 
shareholder amends the return for the estimated section 958(a) U.S. 
shareholder inclusion year to account for the correct aggregate foreign 
cash position for the year. The amended return must be filed by the due 
date (taking into account extensions, if any) for the return for the 
year after the estimated section 958(a) U.S. shareholder inclusion year.
    (4) Examples. The following examples illustrate the application of 
this paragraph (c).
    (i) Example 1. Estimation of aggregate foreign cash position for a 
section 958(a) U.S. shareholder inclusion year--(A) Facts. USP, a 
domestic corporation, owns all of the stock of CFC1, a foreign 
corporation, which owns all of the stock of CFC2, also a foreign 
corporation. USP is a calendar year taxpayer. CFC1 has a taxable year 
ending on December 31, and CFC2 has a taxable year ending on November 
30. The cash position of CFC1 on each of December 31, 2015, December 31, 
2016, and December 31, 2017, is $100x. The cash position of CFC2 on each 
of November 30, 2015, and November 30, 2016, is $200x. USP has a section 
965(a) inclusion amount of $300x with respect to CFC1.
    (B) Analysis. In determining its aggregate foreign cash position for 
its 2017 taxable year, USP may assume that its pro rata share of the 
cash position of CFC2 will be zero as of November 30, 2018, for purposes 
of filing its return due on April 18, 2018 (or due on October 15, 2018, 
with extension). Therefore, USP's aggregate foreign cash position is 
treated as $300x, which is the greater of (a) $300x, 50% of the sum of 
USP's pro rata shares of the cash position of CFC1 as of December 31, 
2015, and December 31, 2016, and of the cash position of CFC2 as of 
November 30, 2015, and November 30, 2016, and (b) $100x, USP's pro rata 
share of the cash position of CFC1 as of December 31,

[[Page 538]]

2017. If USP's pro rata share of the cash position of CFC2 as of 
November 30, 2018, in fact exceeds $200x, USP must amend its return for 
its 2017 taxable year to reflect the correct aggregate foreign cash 
position by the due date for its return for its 2018 taxable year, April 
15, 2019 (or October 15, 2019, with extension).
    (ii) Example 2. Allocation of aggregate foreign cash position among 
section 958(a) U.S. shareholder inclusion years--(A) Facts. The facts 
are the same as in paragraph (c)(4)(i)(A) of this section (the facts in 
Example 1), except that the cash position of each of CFC1 and CFC2 on 
all relevant cash measurement dates is $200x, with the result that USP 
has an aggregate foreign cash position determined under Sec. 1.965-
1(f)(8)(i) of $400x. For its 2017 taxable year, USP has a section 965(a) 
inclusion amount with respect to CFC1 of $300x, and for its 2018 taxable 
year, USP has a section 965(a) inclusion amount with respect to CFC2 of 
$300x.
    (B) Analysis. Under paragraph (c)(2)(i) of this section, USP's 
aggregate foreign cash position for 2017 is $300x, which is the lesser 
of USP's aggregate foreign cash position determined under Sec. 1.965-
1(f)(8)(i) ($400x) or the section 965(a) inclusion amount ($300x) that 
USP takes into account in 2017. Under paragraph (c)(2)(ii) of this 
section, the amount of USP's aggregate foreign cash position for 2018 is 
$100x, USP's aggregate foreign cash position determined under Sec. 
1.965-1(f)(8)(i) ($400x) reduced by the amount of its aggregate foreign 
cash position for 2017 ($300x) under paragraph (c)(2)(i) of this 
section.
    (d) Increase of income by section 965(c) deduction of an expatriated 
entity--(1) In general. If a person is allowed a section 965(c) 
deduction and the person (or a successor) first becomes an expatriated 
entity, with respect to a surrogate foreign corporation, at any time 
during the 10-year period beginning on December 22, 2017, then the tax 
imposed by chapter 1 of the Internal Revenue Code is increased for the 
first taxable year in which such person becomes an expatriated entity by 
an amount equal to 35 percent of the person's section 965(c) deductions, 
and no credits are allowed against such increase in tax. The preceding 
sentence applies only if the surrogate foreign corporation first becomes 
a surrogate foreign corporation on or after December 22, 2017.
    (2) Definition of expatriated entity. For purposes of paragraph 
(d)(1) of this section, the term expatriated entity has the same meaning 
given such term under section 7874(a)(2), except that such term does not 
include an expatriated entity if the surrogate foreign corporation with 
respect to the expatriated entity is treated as a domestic corporation 
under section 7874(b).
    (3) Definition of surrogate foreign corporation. For purposes of 
paragraph (d)(1) of this section, the term surrogate foreign corporation 
has the meaning given such term in section 7874(a)(2)(B).
    (e) Section 962 election--(1) In general. In the case of an 
individual (including a trust or estate) that makes an election under 
section 962, any section 965(c) deduction taken into account under Sec. 
1.962-1(b)(1)(i)(B) in determining taxable income as used in section 11 
is not taken into account for purposes of determining the individual's 
taxable income under section 1.
    (2) Example.The following example illustrates the application of the 
rule in this paragraph (e).
    (i) Facts. USI, a United States citizen, owns 10% of the capital and 
profits of USPRS, a domestic partnership that has a calendar year 
taxable year, the remainder of which is owned by foreign persons 
unrelated to USI or USPRS. USPRS owns all of the stock of FS, a foreign 
corporation that is a controlled foreign corporation with a calendar 
year taxable year. USPRS has a section 965(a) inclusion amount with 
respect to FS of $1,000x and has a section 965(c) deduction amount of 
$700x. FS has no post-1986 foreign income taxes. USI makes a valid 
election under section 962 for 2017.
    (ii) Analysis. USI's ``taxable income'' described in Sec. 1.962-
1(b)(1)(i) equals $100x (USI's domestic pass-through owner share of 
USPRS's section 965(a) inclusion amount) minus $70x (USI's domestic 
pass-through owner share of USPRS's section 965(c) deduction amount), or 
$30x. No other deductions are allowed in determining this amount. USI's 
tax on the $30x section 965(a) inclusion will be equal to the tax that 
would be imposed on such amount

[[Page 539]]

under section 11 if USI were a domestic corporation. Under paragraph 
(e)(1) of this section, USI cannot deduct $70x for purposes of 
determining USI's taxable income that is subject to tax under section 1.
    (f) Treatment of section 965(c) deduction under certain provisions 
of the Internal Revenue Code--(1) Sections 62(a) and 63(d). A section 
965(c) deduction is treated as a deduction described in section 62(a) 
and is not treated as an itemized deduction for any purpose of the 
Internal Revenue Code.
    (2) Sections 705, 1367, and 1368--(i) Adjustments to basis. In the 
case of a domestic partnership or S corporation--
    (A) The aggregate amount of its section 965(a) inclusions net of the 
aggregate amount of its section 965(c) deductions is treated as a 
separately stated item of net income solely for purposes of calculating 
basis under section 705(a) and Sec. 1.705-1(a) and section 1367(a)(1) 
and Sec. 1.1367-1(f), and
    (B) The aggregate amount of its section 965(a) inclusions equal to 
the aggregate amount of its section 965(c) deductions is treated as 
income exempt from tax solely for purposes of calculating basis under 
sections 705(a)(1)(B), 1367(a)(1)(A), and Sec. 1.1367-1(f).
    (ii) S corporation accumulated adjustments account. In the case of 
an S corporation, the aggregate amount of its section 965(a) inclusions 
equal to the aggregate amount of its section 965(c) deductions is 
treated as income not exempt from tax solely for purposes of determining 
whether an adjustment is made to an accumulated adjustments account 
under section 1368(e)(1)(A) and Sec. 1.1368-2(a)(2).
    (iii) Example. The following example illustrates the application of 
this paragraph (f)(2).
    (A) Facts. USI, a United States citizen, owns all of the stock of S 
Corp, an S corporation, which owns all of the stock of FS, a foreign 
corporation. S Corp has a section 965(a) inclusion of $1,000x with 
respect to FS and has a $700x section 965(c) deduction.
    (B) Analysis. As a result of the application of paragraph 
(f)(2)(i)(A) of this section, solely for purposes of calculating basis 
under section 1367(a)(1) and Sec. 1.1367-1(f), USI treats as a 
separately stated item of net income $300x (its pro rata share of the 
net of S Corp's $1,000x aggregate section 965(a) inclusion and S Corp's 
$700x aggregate section 965(c) deduction). Accordingly, USI's basis in S 
Corp is increased under section 1367(a)(1) by $300x. As a result of the 
application of paragraph (f)(2)(i)(B) of this section, an amount of S 
Corp's aggregate section 965(a) inclusion equal to its aggregate section 
965(c) deduction, $700x, is treated as tax exempt income solely for 
purposes of calculating basis under section 1367(a)(1)(A) and Sec. 
1.1367-1(f), and accordingly, USI's basis in S Corp is further increased 
by its pro rata share of such amount, $700x. S Corp's accumulated 
adjustments account (``AAA'') is increased under section 1368(e)(1)(A) 
by the $1,000x section 965(a) inclusion taken into account and reduced 
by the $700x section 965(c) deduction taken into account. In addition, 
as a result of the application of paragraph (f)(2)(ii) of this section, 
S Corp's AAA is further increased by an amount of S Corp's aggregate 
section 965(a) inclusion equal to its aggregate section 965(c) 
deduction, $700x, which is not treated as tax-exempt income for purposes 
of Sec. 1.1368-2(a)(2).
    (3) Section 1411. For purposes of section 1411 and Sec. 1.1411-
4(f)(6), a section 965(c) deduction is not treated as being properly 
allocable to any section 965(a) inclusion.
    (4) Section 4940. For purposes of section 4940(c)(3)(A), a section 
965(c) deduction is not treated as an ordinary and necessary expense 
paid or incurred for the production or collection of gross investment 
income.
    (g) Domestic pass-through entities. For purposes of determining a 
domestic pass-through owner share, a section 965(c) deduction amount of 
a domestic pass-through entity must be allocated to a domestic pass-
through owner in the same proportion as an aggregate section 965(a) 
inclusion amount of the domestic pass-through entity for a section 
958(a) U.S. shareholder inclusion year is allocated to the domestic 
pass-through owner.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019]

[[Page 540]]



Sec. 1.965-4  Disregard of certain transactions.

    (a) Scope. This section provides rules that disregard certain 
transactions for purposes of applying section 965 to a United States 
shareholder. Paragraph (b) of this section provides rules that disregard 
transactions undertaken with a principal purpose of changing the amount 
of a section 965 element of a United States shareholder. Paragraph (c) 
of this section provides rules that disregard certain changes in method 
of accounting and entity classification elections that would otherwise 
change the amount of a section 965 element. Paragraph (d) of this 
section defines the term section 965 element. Paragraph (e) of this 
section provides rules of application concerning paragraphs (b) and (c) 
of this section. Paragraph (f) of this section provides rules that 
disregard certain transactions occurring between E&P measurement dates. 
Paragraph (g) of this section provides examples illustrating the 
application of this section.
    (b) Transactions undertaken with a principal purpose of changing the 
amount of a section 965 element--(1) General rule. Except as otherwise 
provided in paragraph (e)(3) of this section, a transaction is 
disregarded for purposes of determining the amounts of all section 965 
elements of a United States shareholder if each of the following 
conditions is satisfied with respect to any section 965 element of the 
United States shareholder--
    (i) The transaction occurs, in whole or in part, on or after 
November 2, 2017 (the specified date);
    (ii) The transaction is undertaken with a principal purpose of 
changing the amount of a section 965 element of the United States 
shareholder; and
    (iii) The transaction would, without regard to this paragraph 
(b)(1), change the amount of the section 965 element of the United 
States shareholder.
    (2) Presumptions and exceptions for the application of the general 
rule--(i) Overview. Under paragraphs (b)(2)(iii) through (v) of this 
section, certain transactions are presumed to be undertaken with a 
principal purpose of changing the amount of a section 965 element of a 
United States shareholder for purposes of paragraph (b)(1) of this 
section. The presumptions described in paragraphs (b)(2)(iii) through 
(v) of this section may be rebutted only if facts and circumstances 
clearly establish that the transaction was not undertaken with a 
principal purpose of changing the amount of a section 965 element of a 
United States shareholder. A taxpayer that takes the position that the 
presumption is rebutted must attach a statement to its return for its 
taxable year in which or with which the relevant taxable year of the 
relevant specified foreign corporation ends disclosing that it has 
rebutted the presumption. In the case of a transaction described in 
paragraph (b)(2)(iii) or (iv) of this section, if the presumption does 
not apply because the transaction occurs in the ordinary course of 
business, whether the transaction was undertaken with a principal 
purpose of changing the amount of a section 965 element of a United 
States shareholder must be determined under all the facts and 
circumstances. Under paragraphs (b)(2)(iii) through (v) of this section, 
certain transactions are treated per se as being undertaken with a 
principal purpose of changing the amount of a section 965 element of a 
United States shareholder, and, therefore, such transactions are 
disregarded under paragraph (b)(1) of this section if the conditions of 
paragraphs (b)(1)(i) and (iii) of this section are satisfied. Further, 
under paragraph (b)(2)(iii) of this section, certain distributions are 
treated per se as not being undertaken with a principal purpose of 
changing the amount of a section 965 element of a United States 
shareholder and therefore are not disregarded under paragraph (b)(1) of 
this section.
    (ii) Definitions--(A) Relatedness. For purposes of paragraphs 
(b)(2)(iii) through (v) of this section, a person is treated as related 
to a United States shareholder if, either immediately before or 
immediately after the transaction (or series of related transactions), 
the person bears a relationship to the United States shareholder 
described in section 267(b) or section 707(b).
    (B) Transfer--(1) In general. For purposes of paragraphs (b)(2)(iii) 
and (v) of this section, the term transfer includes any disposition of 
stock or property,

[[Page 541]]

including a sale or exchange, contribution, distribution, issuance, 
redemption, recapitalization, or loan of stock or property, and includes 
an indirect transfer of stock or property.
    (2) Indirect transfer. For purposes of paragraph (b)(2)(ii)(B)(1) of 
this section, the term indirect transfer includes a transfer of property 
or stock owned by an entity through a transfer of an interest in such 
entity (or an interest in an entity that has a direct or indirect 
interest in such entity), and a transfer of property or stock to a 
person through a transfer of property or stock to a pass-through entity 
of which such person is a direct or indirect owner.
    (iii) Cash reduction transactions--(A) General rule. For purposes of 
paragraph (b)(1) of this section, a cash reduction transaction is 
presumed to be undertaken with a principal purpose of changing the 
amount of a section 965 element of a United States shareholder. For this 
purpose, the term cash reduction transaction means a transfer of cash, 
accounts receivable, or cash-equivalent assets by a specified foreign 
corporation to a United States shareholder of the specified foreign 
corporation or a person related to a United States shareholder of the 
specified foreign corporation, or an assumption by a specified foreign 
corporation of an account payable of a United States shareholder of the 
specified foreign corporation or a person related to a United States 
shareholder of the specified foreign corporation, if such transfer or 
assumption would, without regard to paragraph (b)(1) of this section, 
reduce the aggregate foreign cash position of the United States 
shareholder. The presumption described in this paragraph (b)(2)(iii) 
does not apply to a cash reduction transaction that occurs in the 
ordinary course of business.
    (B) Per se rules for certain distributions. Notwithstanding the 
presumption described in paragraph (b)(2)(iii)(A) of this section, 
except in the case of a specified distribution, a cash reduction 
transaction that is a distribution by a specified foreign corporation to 
a United States shareholder of the specified foreign corporation is 
treated per se as not being undertaken with a principal purpose of 
changing the amount of a section 965 element of the United States 
shareholder for purposes of paragraph (b)(1) of this section. A 
specified distribution is treated per se as being undertaken with a 
principal purpose of changing the amount of a section 965 element of a 
United States shareholder for purposes of paragraph (b)(1) of this 
section. For purposes of this paragraph (b)(2)(iii)(B), the term 
specified distribution means a cash reduction transaction that is a 
distribution by a specified foreign corporation of a United States 
shareholder if and to the extent that, at the time of the distribution, 
there was a plan or intention for the distributee to transfer cash, 
accounts receivable, or cash-equivalent assets to any specified foreign 
corporation of the United States shareholder or a distribution that is a 
non pro rata distribution to a foreign person that is related to the 
United States shareholder. For purposes of the preceding sentence, there 
is no plan or intention for the distributee to transfer cash, accounts 
receivable, or cash-equivalent assets to any specified foreign 
corporation of the United States shareholder if the transfer is pursuant 
to a legal obligation entered into before November 2, 2017. A taxpayer 
that takes the position that a cash reduction transaction is not a 
specified distribution because a transfer of cash, accounts receivable, 
or cash-equivalent asset is pursuant to a legal obligation entered into 
before November 2, 2017, must attach a statement to its return for its 
taxable year in which or with which the relevant taxable year of the 
relevant specified foreign corporation ends disclosing the position.
    (iv) E&P reduction transactions--(A) General rule. For purposes of 
paragraph (b)(1) of this section, an E&P reduction transaction is 
presumed to be undertaken with a principal purpose of changing the 
amount of a section 965 element of a United States shareholder. For 
purposes of this paragraph (b)(2)(iv), the term E&P reduction 
transaction means a transaction between a specified foreign corporation 
and any of a United States shareholder of the specified foreign 
corporation, another specified foreign corporation of a United States 
shareholder of the specified foreign corporation, or any person

[[Page 542]]

related to a United States shareholder of the specified foreign 
corporation, if the transaction would, without regard to paragraph 
(b)(1) of this section, reduce either the accumulated post-1986 deferred 
foreign income or the post-1986 undistributed earnings (as defined in 
section 902(c)(1)) of the specified foreign corporation or another 
specified foreign corporation of any United States shareholder of such 
specified foreign corporation. The presumption described in this 
paragraph (b)(2)(iv)(A) does not apply to an E&P reduction transaction 
that occurs in the ordinary course of business.
    (B) Per se rule for specified transactions. A specified transaction 
is treated per se as being undertaken with a principal purpose of 
changing the amount of a section 965 element of a United States 
shareholder for purposes of paragraph (b)(1) of this section. For 
purposes of the preceding sentence, the term specified transaction means 
an E&P reduction transaction that involves one or more of the following: 
A complete liquidation of a specified foreign corporation to which 
section 331 applies; a sale or other disposition of stock by a specified 
foreign corporation; or a distribution by a specified foreign 
corporation that reduces the earnings and profits of the specified 
foreign corporation pursuant to section 312(a)(3).
    (v) Pro rata share transactions--(A) General rule. For purposes of 
paragraph (b)(1) of this section, a pro rata share transaction is 
presumed to be undertaken with a principal purpose of changing the 
amount of a section 965 element of a United States shareholder. For this 
purpose, the term pro rata share transaction means either a pro rata 
share reduction transaction or an E&P deficit transaction.
    (1) Definition of pro rata share reduction transaction. For purposes 
of this paragraph (b)(2)(v)(A), the term pro rata share reduction 
transaction means a transfer of the stock of a specified foreign 
corporation by either a United States shareholder of the specified 
foreign corporation or a person related to a United States shareholder 
of the specified foreign corporation (including by the specified foreign 
corporation itself) to a person related to the United States shareholder 
if the transfer would, without regard to paragraph (b)(1) of this 
section, reduce the United States shareholder's pro rata share of the 
section 965(a) earnings amount of the specified foreign corporation, 
reduce the United States shareholder's pro rata share of the cash 
position of the specified foreign corporation, or both.
    (2) Definition of E&P deficit transaction. For purposes of this 
paragraph (b)(2)(v)(A), the term E&P deficit transaction means a 
transfer to either a United States shareholder or a person related to 
the United States shareholder of the stock of an E&P deficit foreign 
corporation by a person related to the United States shareholder 
(including by the E&P deficit foreign corporation itself) if the 
transfer would, without regard to paragraph (b)(1) of this section, 
increase the United States shareholder's pro rata share of the specified 
E&P deficit of the E&P deficit foreign corporation.
    (B) Per se rule for internal group transactions. An internal group 
transaction is treated per se as being undertaken with a principal 
purpose of changing the amount of a section 965 element of a United 
States shareholder for purposes of paragraph (b)(1) of this section. For 
purposes of the preceding sentence, the term internal group transaction 
means a pro rata share transaction if, immediately before or after the 
transfer, the transferor of the stock of the specified foreign 
corporation and the transferee of such stock are members of an 
affiliated group in which the United States shareholder is a member. For 
this purpose, the term affiliated group has the meaning set forth in 
section 1504(a), determined without regard to paragraphs (1) through (8) 
of section 1504(b), and the term members of an affiliated group means 
entities included in the same affiliated group. For purposes of 
identifying an affiliated group and the members of such group, each 
partner in a partnership, as determined without regard to this sentence, 
is treated as holding its proportionate share of the stock held by the 
partnership, as determined under the rules and principles of sections 
701 through 777, and if one or more members of an affiliated group

[[Page 543]]

own, in the aggregate, at least 80 percent of the interests in a 
partnership's capital or profits, the partnership will be treated as a 
corporation that is a member of the affiliated group.
    (C) Example. The following example illustrates the application of 
the rules in this paragraph (b)(2)(v).
    (1) Facts. FP, a foreign corporation, owns all of the stock of USP, 
a domestic corporation. USP owns all of the stock of FS, a foreign 
corporation. USP has a calendar year taxable year; FS's taxable year 
ends November 30. On January 2, 2018, USP transfers all of the stock of 
FS to FP in exchange for cash. On January 3, 2018, FS makes a 
distribution with respect to the stock transferred to FP. USP treats the 
transaction as a taxable sale of the FS stock and claims a dividends 
received deduction under section 245A with respect to its deemed 
dividend under section 1248(j) as a result of the sale. FS has post-1986 
earnings and profits as of December 31, 2017, and no post-1986 earnings 
and profits that are attributable to income effectively connected with 
the conduct of a trade or business within the United States and subject 
to tax under chapter 1 or that, if distributed, would be excluded from 
the gross income of a United States shareholder under section 959.
    (2) Analysis. The transfer of the stock of FS is a pro rata share 
reduction transaction and thus a pro rata share transaction because such 
transfer is by USP, a United States shareholder, to FP, a person related 
to USP, and the transfer would, without regard to the rule in paragraph 
(b)(1) of this section, reduce USP's pro rata share of the section 
965(a) earnings amount of FS. Because USP and FP are also members of an 
affiliated group within the meaning of paragraph (b)(2)(v)(B) of this 
section, the transfer of the stock of FS is also an internal group 
transaction and is treated per se as being undertaken with a principal 
purpose of changing the amount of a section 965 element of USP. 
Accordingly, because the transfer occurs after the specified date and 
reduces USP's section 965(a) inclusion amount with respect to FS, the 
transfer is disregarded for purposes of determining any section 965 
element of USP with the result that, among other things, USP's pro rata 
share of FS's section 965(a) earnings amount is determined as if USP 
owned (within the meaning of section 958(a)) 100% of the stock of FS on 
the last day of FS's inclusion year and no other person received a 
distribution with respect to such stock during such year. See section 
951(a)(2)(A) and (B).
    (c) Disregard of certain changes in method of accounting and entity 
classification elections--(1) Changes in method of accounting. Any 
change in method of accounting made for a taxable year of a specified 
foreign corporation that ends in 2017 or 2018 is disregarded for 
purposes of determining the amounts of all section 965 elements with 
respect to a United States shareholder if the change in method of 
accounting would, without regard to this paragraph (c)(1), change the 
amount of any section 965 element described in paragraph (d)(1) or (2) 
of this section with respect to the United States shareholder, or change 
the amount of the section 965 element described in paragraph (d)(3) of 
this section other than by reason of an increase in a section 965(a) 
inclusion amount with respect to the specified foreign corporation, 
regardless of whether the change in method of accounting is made with a 
principal purpose of changing the amount of a section 965 element with 
respect to the United States shareholder. The rule described in the 
preceding sentence applies regardless of whether the change in method of 
accounting was made in accordance with the procedures described in Rev. 
Proc. 2015-13, 2015-5 I.R.B. 419 (or successor), and regardless of 
whether the change in method of accounting was properly made, but it 
does not apply to a change in method of accounting for which the 
original and/or duplicate copy of any Form 3115, ``Application for 
Change in Accounting Method,'' requesting the change was filed before 
the specified date (as defined in paragraph (b)(1) of this section).
    (2) Entity classification elections. Except as otherwise provided in 
paragraph (e)(3) of this section, an election under Sec. 301.7701-3 to 
change the classification of an entity that is filed on or after the 
specified date (as defined in

[[Page 544]]

paragraph (b)(1) of this section) is disregarded for purposes of 
determining the amounts of all section 965 elements of a United States 
shareholder if the election would, without regard to this paragraph 
(c)(2), change the amount of any section 965 element of the United 
States shareholder, regardless of whether the election is made with a 
principal purpose of changing the amount of a section 965 element of the 
United States shareholder. An election filed on or after the specified 
date is subject to the preceding sentence even if the election was filed 
with an effective date that is before the specified date.
    (d) Definition of a section 965 element. For purposes of paragraphs 
(b) and (c) of this section, the term section 965 element means, with 
respect to a United States shareholder, any of the following amounts 
(collectively, section 965 elements)--
    (1) The United States shareholder's section 965(a) inclusion amount 
with respect to a specified foreign corporation;
    (2) The aggregate foreign cash position of the United States 
shareholder; or
    (3) The amount of foreign income taxes of a specified foreign 
corporation deemed paid by the United States shareholder under section 
960 as a result of a section 965(a) inclusion.
    (e) Rules for applying paragraphs (b) and (c) of this section--(1) 
Determination of whether there is a change in the amount of a section 
965 element. For purposes of paragraphs (b) and (c) of this section, 
there is a change in the amount of a section 965 element of a United 
States shareholder as a result of a transaction, change in accounting 
method, or election to change an entity's classification, if, without 
regard to paragraph (b)(1), (c)(1), or (c)(2) of this section, the 
transaction, change in accounting method, or change in entity 
classification would--
    (i) Reduce the amount described in paragraph (d)(1) of this section,
    (ii) Reduce the amount described in paragraph (d)(2) of this 
section, but only if such amount is less than the United States 
shareholder's aggregate section 965(a) inclusion amount, or
    (iii) Increase the amount described in paragraph (d)(3) of this 
section.
    (2) Treatment of domestic pass-through owners as United States 
shareholders. For purposes of paragraphs (b) and (c) of this section, if 
a domestic pass-through entity is a United States shareholder, then a 
domestic pass-through owner with respect to the domestic pass-through 
entity that is not otherwise a United States shareholder is treated as a 
United States shareholder.
    (3) Exception for certain incorporation transactions--(i) In 
general. Paragraphs (b) and (c)(2) of this section do not apply to 
disregard a transfer of stock of a specified foreign corporation by a 
United States shareholder to a domestic corporation (for this purpose, 
including an S corporation), provided that--
    (A) The transferee's section 965(a) inclusion amount with respect to 
the transferred stock of the specified foreign corporation is no lower 
than the transferor's section 965(a) inclusion amount with respect to 
the transferred stock of the specified foreign corporation, determined 
without regard to the transfer; and
    (B) The transferee and the transferor determine their aggregate 
foreign cash position under paragraph (e)(3)(ii) of this section.
    (ii) Aggregate foreign cash position. In the case of a transfer 
described in paragraph (e)(3)(i) of this section, in order to rely on 
the exception in paragraph (e)(3)(i) of this section--
    (A) The transferee must treat its pro rata share of the cash 
position of a specified foreign corporation as of a cash measurement 
date as of which it did not own the transferred stock of the specified 
foreign corporation as including the transferor's pro rata share of the 
cash position of the specified foreign corporation with respect to the 
transferred stock of the specified foreign corporation as of such cash 
measurement date for purposes of determining its aggregate foreign cash 
position; and
    (B) The transferor must treat its pro rata share of the cash 
position of a specified foreign corporation as of a cash measurement 
date as of which it did not own the transferred stock of

[[Page 545]]

the specified foreign corporation as including the transferee's pro rata 
share of the cash position of the specified foreign corporation with 
respect to the transferred stock of the specified foreign corporation as 
of such cash measurement date for purposes of determining its aggregate 
foreign cash position.
    (4) Consequences of liquidation--(i) In general. In the case of a 
liquidation of a specified foreign corporation that is disregarded for 
purposes of determining the section 965 elements of a United States 
shareholder pursuant to paragraph (b) or (c)(2) of this section, for 
purposes of determining the amounts of the section 965 elements of the 
United States shareholder, the date that is treated as the last day of 
the taxable year of the specified foreign corporation is the later of--
    (A) The date of the liquidation; and
    (B) The specified liquidation date, if any.
    (ii) Specified liquidation date. The term specified liquidation date 
means, in the case of a liquidation of a specified foreign corporation 
pursuant to an entity classification election that is disregarded for 
purposes of determining the section 965 elements of a United States 
shareholder--
    (A) November 30, 2017, with respect to a United States shareholder 
that must include in income under Sec. 1.367(b)-3 as a deemed dividend 
the all earnings and profits amount with respect to the United States 
shareholder's stock of the liquidating specified foreign corporation; or
    (B) The date of filing of the entity classification election, with 
respect to all other United States shareholders.
    (f) Disregard of certain transactions occurring between E&P 
measurement dates--(1) Disregard of specified payments. Except as 
provided in paragraph (f)(3) of this section, a specified payment made 
by a specified foreign corporation (payor specified foreign corporation) 
to another specified foreign corporation (payee specified foreign 
corporation) is disregarded for purposes of determining the post-1986 
earnings and profits of each of the payor specified foreign corporation 
and the payee specified foreign corporation as of the E&P measurement 
date on December 31, 2017.
    (2) Definition of specified payment. For purposes of paragraph 
(f)(1) of this section, the term specified payment means any amount paid 
or accrued by the payor specified foreign corporation, including a 
distribution by the payor specified foreign corporation with respect to 
its stock, if each of the following conditions are satisfied:
    (i) Immediately before or immediately after the payment or accrual 
of the amount, the payor specified foreign corporation and the payee 
specified foreign corporation are related within the meaning of section 
954(d)(3), substituting the term ``specified foreign corporation'' for 
``controlled foreign corporation'' in each place that it appears;
    (ii) The payment or accrual of the amount occurs after November 2, 
2017, and on or before December 31, 2017; and
    (iii) The payment or accrual of the amount would, without regard to 
the application of paragraph (f)(1) of this section, reduce the post-
1986 earnings and profits of the payor specified foreign corporation as 
of the E&P measurement date on December 31, 2017.
    (3) Non-application of disregard rule. A section 958(a) U.S. 
shareholder may determine the post-1986 earnings and profits of a 
specified foreign corporation without regard to paragraph (f)(1) of this 
section, provided that it and every section 958(a) U.S. shareholder 
related to the first section 958(a) U.S. shareholder determines the 
post-1986 earnings and profits of each of its specified foreign 
corporations without regard to paragraph (f)(1) of this section. For 
purposes of this paragraph (f)(3), a person is treated as related to a 
section 958(a) U.S. shareholder if the person bears a relationship to 
the section 958(a) U.S. shareholder described in section 267(b) or 
707(b).
    (4) Examples. The following examples illustrate the application of 
the rules in this paragraph (f).
    (i) Example 1. Deductible payment between wholly owned specified 
foreign corporations is a specified payment--(A) Facts. USP, a domestic 
corporation, owns all of the stock of CFC1, a foreign corporation, which 
owns all of the

[[Page 546]]

stock of CFC2, also a foreign corporation. USP, CFC1, and CFC2 have 
calendar year taxable years. On November 2, 2017, each of CFC1 and CFC2 
has post-1986 earnings and profits of 100u. Neither CFC1 nor CFC2 has 
post-1986 earnings and profits that are attributable to income of the 
specified foreign corporation that is effectively connected with the 
conduct of a trade or business within the United States and subject to 
tax under chapter 1 or that, if distributed, would be excluded from the 
gross income of a United States shareholder under section 959 or from 
the gross income of another shareholder if such shareholder were a 
United States shareholder; therefore, no adjustment is made under 
section 965(d)(2) or Sec. 1.965-1(f)(7), and each of CFC1's and CFC2's 
accumulated post-1986 deferred foreign income is equal to such 
corporation's post-1986 earnings and profits. On November 3, 2017, CFC2 
makes a deductible payment of 10u to CFC1. The payment does not 
constitute subpart F income. CFC1 and CFC2 have no other items of income 
or deduction.
    (B) Analysis. The payment from CFC2 to CFC1 is a specified payment 
because (1) CFC1 and CFC2 are related specified foreign corporations; 
(2) the payment occurs after November 2, 2017, and on or before December 
31, 2017; and (3) the payment would, without regard to the application 
of the rule in paragraph (f)(1) of this section, reduce the post-1986 
earnings and profits of CFC2 as of the E&P measurement date on December 
31, 2017. Under paragraph (f)(1) of this section, the payment is 
disregarded, and CFC1 and CFC2 each have post-1986 earnings and profits 
of 100u as of December 31, 2017. Accordingly, the section 965(a) 
earnings amount of each of CFC1 and CFC2 is 100u.
    (ii) Example 2. Distribution is a specified payment--(A) Facts. The 
facts are the same as in paragraph (f)(4)(i)(A) of this section (the 
facts in Example 1), except instead of a deductible payment to CFC1, 
CFC2 makes a 10u distribution on November 3, 2017, that, without regard 
to paragraph (f)(1) of this section would reduce the post-1986 earnings 
and profits of CFC2 as of the E&P measurement date on December 31, 2017, 
and increase the post-1986 earnings and profits of CFC1 as of the E&P 
measurement date on December 31, 2017, by 10u.
    (B) Analysis. The distribution is a specified payment because (1) 
CFC1 and CFC2 are related specified foreign corporations; (2) the 
distribution occurs after November 2, 2017, and on or before December 
31, 2017; and (3) the distribution would, without regard to the 
application of the rule in paragraph (f)(1) of this section, reduce the 
post-1986 earnings and profits of CFC2 as of the E&P measurement date on 
December 31, 2017. Under paragraph (f)(1) of this section, the 
distribution is disregarded with the result that CFC1 and CFC2 each have 
post-1986 earnings and profits of 100u as of the E&P measurement date on 
December 31, 2017, and a section 965(a) earnings amount of 100u.
    (iii) Example 3. Deductible payment between related (but not wholly 
owned) specified foreign corporations is a specified payment--(A) Facts. 
The facts are the same as in paragraph (f)(4)(i)(A) of this section (the 
facts in Example 1), except that CFC1 owns only 51% of the only class of 
stock of CFC2, the remainder of which is owned by USI, a United States 
citizen unrelated to USP, CFC1, and CFC2.
    (B) Analysis. The analysis is the same as in paragraph (f)(4)(i)(B) 
of this section (the analysis in Example 1); thus, the payment is 
disregarded with the result that CFC1 and CFC2 each have post-1986 
earnings and profits of 100u as of the E&P measurement date on December 
31, 2017, and a section 965(a) earnings amount of 100u.
    (iv) Example 4. Deductible payment between unrelated specified 
foreign corporations is not a specified payment--(A) Facts. The facts 
are the same as in paragraph (f)(4)(i)(A) of this section (the facts in 
Example 1), except that CFC1 owns only 50% of the only class of stock of 
CFC2, the remainder of which is owned by USI, a United States citizen 
unrelated to USP, CFC1, and CFC2.
    (B) Analysis. Paragraph (f)(1) of this section does not apply 
because CFC1 and CFC2 are not related. Thus, the payment is taken into 
account with the result that CFC1 has post-1986 earnings and profits of 
110u as of the E&P measurement date on December 31,

[[Page 547]]

2017, and a section 965(a) earnings amount of 110u.
    (v) Example 5. Deductible payment and income accrued from unrelated 
persons are not specified payments--(A) Facts. The facts are the same as 
in paragraph (f)(4)(i)(A) of this section (the facts in Example 1), 
except that CFC2 does not make a deductible payment to CFC1, and, 
between E&P measurement dates, CFC2 accrues gross income of 20u from a 
person that is not related to CFC2, and CFC1 incurs a deductible expense 
of 20u to a person that is not related to CFC1.
    (B) Analysis. Paragraph (f)(1) of this section does not apply 
because neither the deductible expense of CFC1 nor the income accrual by 
CFC2 are attributable to a specified payment.
    (vi) Example 6. Deductible payment and income accrued with respect 
to unrelated persons are not specified payments; deductible payment 
between wholly specified foreign corporations is a specified payment--
(A) Facts. The facts are the same as in paragraph (f)(4)(v)(A) of this 
section (the facts in Example 5), except that CFC2 also makes a 
deductible payment of 10u to CFC1 on November 3, 2017.
    (B) Analysis. The deductible payment is a specified payment because 
(1) CFC1 and CFC2 are related specified foreign corporations; (2) the 
payment occurs after November 2, 2017, and on or before December 31, 
2017; and (3) the deductible payment would, without regard to the 
application of the rule in paragraph (f)(1) of this section, reduce the 
post-1986 earnings and profits of CFC2 as of the E&P measurement date on 
December 31, 2017. Accordingly, under paragraph (f)(1) of this section, 
the deductible payment is disregarded with the result that CFC1 and CFC2 
have 80u and 120u of post-1986 earnings and profits as of the E&P 
measurement date on December 31, 2017, respectively. Accordingly, CFC1 
and CFC2 have section 965(a) earnings amounts of 100u and 120u, 
respectively.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019]



Sec. 1.965-5  Allowance of credit or deduction for foreign income taxes.

    (a) Scope. This section provides rules for the allowance of a credit 
or deduction for foreign income taxes in connection with the application 
of section 965. Paragraph (b) of this section provides rules under 
section 965(g) for the allowance of a credit or deduction for foreign 
income taxes paid or accrued. Paragraph (c) of this section provides 
rules for the allowance of a credit or deduction for foreign income 
taxes treated as paid or accrued in connection with the application of 
section 965. Paragraph (d) of this section defines the term applicable 
percentage.
    (b) Rules for foreign income taxes paid or accrued--(1) In general. 
Neither a deduction (including under section 164) nor a credit under 
section 901 is allowed for the applicable percentage of any foreign 
income taxes paid or accrued with respect to any amount for which a 
section 965(c) deduction is allowed for a section 958(a) U.S. 
shareholder inclusion year. Neither a deduction (including under section 
164) nor a credit under section 901 is allowed for the applicable 
percentage of any foreign income taxes attributable to a distribution of 
section 965(a) previously taxed earnings and profits or section 965(b) 
previously taxed earnings and profits. Accordingly, for example, no 
deduction or credit is allowed for the applicable percentage of any 
withholding taxes imposed on a United States shareholder by the 
jurisdiction of residence of the distributing foreign corporation with 
respect to a distribution of section 965(a) previously taxed earnings 
and profits or section 965(b) previously taxed earnings and profits. 
Similarly, for example, no deduction or credit is allowed for the 
applicable percentage of foreign income taxes imposed on a United States 
citizen by the citizen's jurisdiction of residence upon receipt of a 
distribution of section 965(a) previously taxed earnings and profits or 
section 965(b) previously taxed earnings and profits.
    (2) Attributing taxes to section 959(a) distributions of section 965 
previously taxed earnings and profits. For purposes of paragraph (b)(1) 
of this section, foreign income taxes are attributable to a distribution 
of section 965(a) previously taxed earnings and profits or section 
965(b) previously taxed earnings and profits if such taxes would be 
allocated and apportioned to a distribution of such previously taxed 
earnings and

[[Page 548]]

profits under the principles of Sec. 1.904-6(a)(1)(iv), regardless of 
whether an actual distribution is made or recognized for Federal income 
tax purposes. Therefore, for example, a credit or deduction for the 
applicable percentage of foreign income taxes imposed on a United States 
shareholder that pays foreign tax on a distribution that is not 
recognized for Federal income tax purposes (for example, in the case of 
a consent dividend or stock dividend upon which a withholding tax is 
imposed) is not allowed under paragraph (b)(1) of this section to the 
extent it is attributable to a distribution of section 965(a) previously 
taxed earnings and profits or section 965(b) previously taxed earnings 
and profits under the principles of Sec. 1.904-6(a)(1)(iv). For taxable 
years of foreign corporations beginning after December 31, 2019, in lieu 
of applying the principles of Sec. 1.904-6 under this paragraph (b)(2), 
the rules in Sec. 1.861-20 apply by treating the portion of a 
distribution attributable to section 965(a) previously taxed earnings 
and profits and the portion of a distribution attributable to section 
965(b) previously taxed earnings and profits each as a statutory 
grouping, and the portion of the distribution that is attributable to 
other earnings and profits as the residual grouping. See Sec. 1.861-
20(g)(7) (Example 6).
    (c) Rules for foreign income taxes treated as paid or accrued--(1) 
Disallowed credit--(i) In general. A credit under section 901 is not 
allowed for the applicable percentage of any foreign income taxes 
treated as paid or accrued with respect to any amount for which a 
section 965(c) deduction is allowed for a section 958(a) U.S. 
shareholder inclusion year. For purposes of the preceding sentence, 
taxes treated as paid or accrued include foreign income taxes deemed 
paid under section 960(a)(1) with respect to a section 965(a) inclusion, 
foreign income taxes deemed paid under section 960(a)(3) (as in effect 
on December 21, 2017) or section 960(b) (as applicable to taxable years 
of controlled foreign corporations beginning after December 31, 2017) 
with respect to distributions of section 965(a) previously taxed 
earnings and profits or section 965(b) previously taxed earnings and 
profits, foreign income taxes allocated to an entity under Sec. 1.901-
2(f)(4), and a distributive share of foreign income taxes paid or 
accrued by a partnership.
    (ii) Foreign income taxes deemed paid under section 960(a)(3) (as in 
effect on December 21, 2017). Foreign income taxes deemed paid by a 
domestic corporation under section 960(a)(3) with respect to a 
distribution of section 965(a) previously taxed earnings and profits or 
section 965(b) previously taxed earnings and profits include only the 
foreign income taxes paid or accrued by an upper-tier foreign 
corporation with respect to a distribution of section 965(a) previously 
taxed earnings and profits or section 965(b) previously taxed earnings 
and profits from a lower-tier foreign corporation. No credit is allowed 
under section 960(a)(3) or any other section for foreign income taxes 
that would have been deemed paid under section 960(a)(1) with respect to 
the portion of a section 965(a) earnings amount that is reduced under 
Sec. 1.965-1(b)(2) or Sec. 1.965-8(b).
    (iii) Foreign income taxes deemed paid under section 960(b) (as 
applicable to taxable years of controlled foreign corporations beginning 
after December 31, 2017, and to taxable years of United States persons 
in which or with which such taxable years of foreign corporations end). 
Paragraph (c)(1)(i) of this section applies to foreign income taxes 
deemed paid under section 960(b) (as in effect for a taxable year of a 
controlled foreign corporation beginning after December 31, 2017, and a 
taxable year of a United States person in which or with which such 
controlled foreign corporation's taxable year ends) only if such taxes 
are deemed paid under Sec. 1.960-3(b)(1) with respect to distributions 
to a domestic corporation of section 965(a) previously taxed earnings 
and profits or section 965(b) previously taxed earnings and profits. See 
also Sec. 1.960-3(c)(2)(i), (ii), (vi), or (vii). Foreign income taxes 
that would have been deemed paid under section 960(a)(1) (as in effect 
on December 21, 2017) with respect to the portion of a section 965(a) 
earnings amount that was reduced under Sec. 1.965-1(b)(2) or Sec. 
1.965-8(b) are not eligible to be deemed paid under section 960(b) and 
Sec. 1.960-3(b) or any other section of the Code.

[[Page 549]]

    (2) Disallowed deduction. No deduction (including under section 164) 
is allowed for the applicable percentage of any foreign income taxes 
treated as paid or accrued with respect to any amount for which a 
section 965(c) deduction is allowed. Such taxes include foreign income 
taxes allocated to an entity under Sec. 1.901-2(f)(4) and a 
distributive share of foreign income taxes paid or accrued by a 
partnership.
    (3) Coordination with section 78--(i) In general. With respect to 
foreign income taxes deemed paid by a domestic corporation with respect 
to its section 965(a) inclusion amount for a section 958(a) U.S. 
shareholder inclusion year, section 78 applies only to so much of such 
taxes as bears the same proportion to the amount of such taxes as--
    (A) The excess of--
    (1) The section 965(a) inclusion amount for a section 958(a) U.S. 
shareholder inclusion year, over
    (2) The section 965(c) deduction amount allowable with respect to 
such section 965(a) inclusion amount, bears to
    (B) Such section 965(a) inclusion amount.
    (ii) Domestic corporation that is a domestic pass-through owner. 
With respect to foreign income taxes deemed paid by a domestic 
corporation attributable to such corporation's domestic pass-through 
owner share of a section 965(a) inclusion amount of a domestic pass-
through entity, section 78 applies only to so much of such taxes as 
bears the same proportion to the amount of such taxes as the proportion 
determined under paragraph (c)(3)(i) of this section as applied to the 
domestic pass-through entity's section 965(a) inclusion amount for a 
section 958(a) U.S. shareholder inclusion year.
    (d) Applicable percentage--(1) In general. For purposes of this 
section, except as provided in paragraph (d)(2) and (d)(3) of this 
section, the term applicable percentage means, with respect to a section 
958(a) U.S. shareholder and a section 958(a) U.S. shareholder inclusion 
year, the amount (expressed as a percentage) equal to the sum of--
    (i) 0.771 multiplied by the ratio of--
    (A) The section 958(a) U.S. shareholder's 8 percent rate amount for 
the section 958(a) U.S. shareholder inclusion year, divided by
    (B) The sum of the section 958(a) U.S. shareholder's 8 percent rate 
amount for the section 958(a) U.S. shareholder inclusion year plus the 
section 958(a) U.S. shareholder's 15.5 percent rate amount for the 
section 958(a) U.S. shareholder inclusion year; plus
    (ii) 0.557 multiplied by the ratio of--
    (A) The section 958(a) U.S. shareholder's 15.5 percent rate amount 
for the section 958(a) U.S. shareholder inclusion year, divided by
    (B) The amount described in paragraph (d)(1)(i)(B) of this section.
    (2) No section 965(a) inclusion amount. If a section 958(a) U.S. 
shareholder does not have an aggregate section 965(a) inclusion amount, 
the section 958(a) U.S. shareholder's applicable percentage is 55.7 
percent.
    (3) Applicable percentage for domestic pass-through owners. In the 
case of a domestic pass-through owner with respect to a domestic pass-
through entity, the domestic pass-through owner's applicable percentage 
that is applied to foreign income taxes attributable to the domestic 
pass-through owner share of the section 965(a) inclusion amount or of 
distributions of section 965(a) previously taxed earnings and profits or 
section 965(b) previously taxed earnings and profits is equal to the 
applicable percentage determined under paragraph (d)(1) or (2) of this 
section, as applicable, with respect to the domestic pass-through 
entity.
    (4) Applicable percentage with respect to certain distributions of 
previously taxed earnings and profits. In the case of a distribution of 
section 965(a) previously taxed earnings and profits or section 965(b) 
previously taxed earnings and profits (other than with respect to a 
section 958(a) U.S. shareholder described in paragraph (d)(2) of this 
section), the applicable percentage that is applied to foreign income 
taxes attributable to the distribution is the applicable percentage that 
applied with respect to the section 958(a) U.S. shareholder and the 
section 958(a) U.S. inclusion year in which, or with which, the 
inclusion year of the relevant deferred foreign income corporation ends. 
For this purpose, the relevant deferred foreign income corporation is 
the deferred

[[Page 550]]

foreign income corporation with respect to which the section 958(a) U.S. 
shareholder had the section 965(a) inclusion as a result of which the 
section 965(a) previously taxed earnings and profits first arose (as 
described in Sec. 1.965-2(c)) or the section 965(b) previously taxed 
earnings and profits first arose (as described in Sec. 1.965-2(d)).

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9882, 84 FR 
69120, Dec. 17, 2019; T.D. 9922, 85 FR 72072, Nov. 12, 2020]



Sec. 1.965-6  Computation of foreign income taxes deemed paid and 
allocation and apportionment of deductions.

    (a) Scope. This section provides rules for the computation of 
foreign income taxes deemed paid and the allocation and apportionment of 
deductions. Paragraph (b) of this section provides the general rules for 
the computation of foreign income taxes deemed paid under sections 902 
and 960. Paragraph (c) of this section provides rules for allocation and 
apportionment of expenses. Paragraph (d) of this section provides rules 
for foreign income taxes associated with hovering deficits.
    (b) Computation of foreign incomes taxes deemed paid--(1) In 
general. For purposes of determining foreign income taxes deemed paid 
under section 960(a)(1) with respect to a section 965(a) inclusion 
attributable to a deferred foreign income corporation that is a member 
of a qualified group (as defined in section 902(b)(2)), section 902 
applies as if the section 965(a) inclusion, translated (if necessary) 
into the functional currency of the deferred foreign income corporation 
using the spot rate on December 31, 2017, were a dividend paid by the 
deferred foreign income corporation. For purposes of computing the 
amount of foreign income taxes deemed paid under section 960(a)(1), 
Sec. Sec. 1.965-2(b), 1.965-5, sections 902 and 960, the regulations 
under those sections, and this section apply.
    (2) Dividend or inclusion in excess of post-1986 undistributed 
earnings. When the denominator of the section 902 fraction is positive 
but less than the numerator of such fraction, the section 902 fraction 
is one. When the denominator of the section 902 fraction is zero or less 
than zero, the section 902 fraction is zero, and no foreign taxes are 
deemed paid.
    (3) Treatment of adjustment under section 965(b)(4)(B). For purposes 
of section 902(c)(1), the post-1986 undistributed earnings of an E&P 
deficit foreign corporation are increased under section 965(b)(4)(B) and 
Sec. 1.965-2(d)(2)(i)(A) as of the first day of the foreign 
corporation's first taxable year following the E&P deficit foreign 
corporation's last taxable year that begins before January 1, 2018.
    (4) Section 902 fraction. The term section 902 fraction means, with 
respect to either a deferred foreign income corporation or an E&P 
deficit foreign corporation, the fraction that is--
    (i) The dividends paid by, or the inclusion under section 951(a)(1) 
(including a section 965(a) inclusion) with respect to, the foreign 
corporation, as applicable (the numerator), divided by
    (ii) The foreign corporation's post-1986 undistributed earnings or 
pre-1987 accumulated profits, as applicable (the denominator).
    (c) Allocation and apportionment of deductions. For purposes of 
allocating and apportioning expenses, a section 965(c) deduction does 
not result in any gross income, including a section 965(a) inclusion, 
being treated as exempt, excluded, or eliminated income within the 
meaning of section 864(e)(3) or Sec. 1.861-8T(d). Similarly, a section 
965(c) deduction does not result in the treatment of stock as an exempt 
asset within the meaning of section 864(e)(3) or Sec. 1.861-8T(d). In 
addition, consistent with the general inapplicability of Sec. 1.861-
8T(d)(2) to earnings and profits described in section 959(c)(1) or 
959(c)(2), neither section 965(a) previously taxed earnings and profits 
nor section 965(b) previously taxed earnings and profits are treated as 
giving rise to gross income that is exempt, excluded, or eliminated 
income. Similarly, the asset that gives rise to a section 965(a) 
inclusion, section 965(a) previously taxed earnings and profits, or 
section 965(b) previously taxed earnings and profits is not treated as a 
tax-exempt asset.
    (d) Hovering deficits. In the last taxable year that begins before 
January 1,

[[Page 551]]

2018, of a deferred foreign income corporation that is also a foreign 
surviving corporation, as defined in Sec. 1.367(b)-7(a), solely for 
purposes of determining the amount of related taxes that are included in 
post-1986 foreign income taxes under Sec. 1.367(b)-7(d)(2)(iii)--
    (1) The post-transaction earnings described in Sec. 1.367(b)-
7(d)(2)(ii) that can be offset by a hovering deficit include any post-
transaction earnings earned in that year that were not considered 
accumulated because they were included in income under section 965 and 
Sec. 1.965-1(b)(1) by a section 958(a) U.S. shareholder; and
    (2) Any offset for purposes of Sec. 1.367(b)-7(d)(2)(ii) is treated 
as occurring on the last day of the foreign surviving corporation's 
inclusion year.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019]



Sec. 1.965-7  Elections, payment, and other special rules.

    (a) Scope. This section provides rules regarding certain elections 
and payments. Paragraph (b) of this section provides rules regarding the 
section 965(h) election. Paragraph (c) of this section provides rules 
regarding the section 965(i) election. Paragraph (d) of this section 
provides rules regarding the section 965(m) election and a special rule 
for real estate investment trusts. Paragraph (e) of this section 
provides rules regarding the section 965(n) election. Paragraph (f) of 
this section provides rules regarding the election to use the 
alternative method for calculating post-1986 earnings and profits. 
Paragraph (g) of this section provides definitions that apply for 
purposes of this section.
    (b) Section 965(h) election--(1) In general. Any person with a 
section 965(h) net tax liability (that is, a section 958(a) U.S. 
shareholder or a domestic pass-through owner with respect to a domestic 
pass-through entity that is a section 958(a) U.S. shareholder, but not a 
domestic pass-through entity itself) may elect under section 965(h) and 
this paragraph (b) to pay its section 965(h) net tax liability in eight 
installments. This election may be revoked only by paying the full 
amount of the remaining unpaid section 965(h) net tax liability.
    (i) Amount of installments. Except as provided in paragraph (b)(3) 
of this section, if a person makes a section 965(h) election, the 
amounts of the installments are--
    (A) Eight percent of the section 965(h) net tax liability in the 
case of each of the first five installments;
    (B) Fifteen percent of the section 965(h) net tax liability in the 
case of the sixth installment;
    (C) Twenty percent of the section 965(h) net tax liability in the 
case of the seventh installment; and
    (D) Twenty-five percent of the section 965(h) net tax liability in 
the case of the eighth installment.
    (ii) Increased installments due to a deficiency or a timely filed or 
amended return--(A) In general. If a person makes a section 965(h) 
election, except as provided in paragraph (b)(1)(ii)(C) of this section, 
any deficiency or additional liability will be prorated to the 
installments described under paragraph (b)(1)(i) of this section if any 
of the following occur:
    (1) A deficiency is assessed with respect to the person's section 
965(h) net tax liability;
    (2) The person files a return by the due date of the return (taking 
into account extensions, if any) increasing the amount of its section 
965(h) net tax liability beyond that taken into account in paying the 
first installment described under paragraph (b)(1)(i) of this section; 
or
    (3) The person files an amended return that reflects an increase in 
the amount of its section 965(h) net tax liability.
    (B) Timing. If the due date for the payment of an installment to 
which the deficiency is prorated has passed, the amount prorated to such 
installment must be paid on notice and demand by the Secretary, or, in 
the case of an additional liability reported on a return increasing the 
amount of the section 965(h) net tax liability after payment of the 
first installment or on an amended return, with the filing of the 
return. If the due date for the payment of an installment to which the 
deficiency or additional liability is prorated has not passed, then such 
amount will be due at the same time as, and as part of, the relevant 
installment.

[[Page 552]]

    (C) Exception for negligence, intentional disregard, or fraud. If a 
deficiency or additional liability is due to negligence, intentional 
disregard of rules and regulations, or fraud with intent to evade tax, 
the proration rule of this paragraph (b)(1)(ii) will not apply, and the 
deficiency or additional liability (as well as any applicable interest 
and penalties) must be paid on notice and demand by the Secretary or, in 
the case of an additional liability reported on a return increasing the 
amount of the section 965(h) net tax liability after payment of the 
first installment or on an amended return, with the filing of the 
return.
    (iii) Due date of installments--(A) In general. If a person makes a 
section 965(h) election, the first installment payment is due on the due 
date (without regard to extensions) for the return for the relevant 
taxable year. For purposes of this paragraph (b), the term relevant 
taxable year means, in the case in which the person is a section 958(a) 
U.S. shareholder, the section 958(a) U.S. shareholder inclusion year, 
or, in the case in which the person is a domestic pass-through owner, 
the taxable year in which the person has the section 965(a) inclusion to 
which the section 965(h) net tax liability is attributable. Each 
succeeding installment payment is due on the due date (without regard to 
extensions) for the return for the taxable year following the taxable 
year with respect to which the previous installment payment was made.
    (B) Extension for specified individuals. If a person is a specified 
individual with respect to a taxable year within which an installment 
payment is due pursuant to paragraph (b)(1)(iii)(A) of this section, 
then, for purposes of determining the due date of an installment payment 
under paragraph (b)(1)(iii)(A) of this section, the due date of the 
return (without regard to extensions) due within the taxable year will 
be treated as the fifteenth day of the sixth month following the close 
of the prior taxable year. This paragraph (b)(1)(iii)(B) is applicable 
regardless of whether the person is a specified individual with respect 
to the relevant taxable year.
    (2) Manner of making election--(i) Eligibility. Any person with a 
section 965(h) net tax liability may make the section 965(h) election, 
provided that, with respect to the person, none of the acceleration 
events described in paragraph (b)(3)(ii) of this section has occurred 
before the election is made. Notwithstanding the preceding sentence, a 
person that would be eligible to make the section 965(h) election but 
for the occurrence of an event described in paragraph (b)(3)(ii) of this 
section may make the section 965(h) election if the exception described 
in paragraph (b)(3)(iii)(A) of this section applies.
    (ii) Timing. A section 965(h) election must be made no later than 
the due date (taking into account extensions, if any, or any additional 
time that would have been granted if the person had made an extension 
request) for the return for the relevant taxable year. Relief is not 
available under Sec. 301.9100-2 or Sec. 301.9100-3 to file a late 
election.
    (iii) Election statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, to make a section 
965(h) election, a person must attach a statement, signed under 
penalties of perjury consistent with the rules for signatures applicable 
to the person's return, to its return for the relevant taxable year. The 
statement must include the person's name, taxpayer identification 
number, total net tax liability under section 965, section 965(h) net 
tax liability, section 965(i) net tax liability with respect to which a 
section 965(i) election is effective (if applicable), and the 
anticipated amounts of each installment described under paragraph 
(b)(1)(i) of this section. The statement must be filed in the manner 
prescribed in publications, forms, instructions, or other guidance. The 
attachment of an unsigned copy of the election statement to the timely-
filed return for the relevant taxable year satisfies the signature 
requirement of this paragraph (b)(2)(iii) if the person making the 
election retains the original signed election statement in the manner 
specified by Sec. 1.6001-1(e).
    (3) Acceleration of payment--(i) Acceleration. Notwithstanding 
paragraph (b)(1)(i) of this section, if a person makes a section 965(h) 
election and an

[[Page 553]]

acceleration event described in paragraph (b)(3)(ii) of this section 
subsequently occurs, then, except as provided in paragraph (b)(3)(iii) 
of this section, the unpaid portion of the remaining installments will 
be due on the date of the acceleration event (or in the case of a title 
11 or similar case, the day before the petition is filed).
    (ii) Acceleration events. The following events are acceleration 
events for purposes of paragraph (b)(3)(i) of this section with respect 
to a person that has made a section 965(h) election--
    (A) An addition to tax is assessed for the failure to timely pay an 
installment described in paragraph (b)(1)(i) of this section;
    (B) A liquidation, sale, exchange, or other disposition of 
substantially all of the assets of the person (including in a title 11 
or similar case, or, in the case of an individual, by reason of death);
    (C) In the case of a person that is not an individual, a cessation 
of business by the person;
    (D) Any event that results in the person no longer being a United 
States person, including a resident alien (as defined in section 
7701(b)(1)(A)) becoming a nonresident alien (as defined in section 
7701(b)(1)(B));
    (E) In the case of a person that was not a member of any 
consolidated group, the person becoming a member of a consolidated 
group;
    (F) In the case of a consolidated group, the group ceasing to exist 
(including by reason of the acquisition of a consolidated group within 
the meaning of Sec. 1.1502-13(j)(5)) or the group otherwise 
discontinuing in the filing of a consolidated return; or
    (G) A determination by the Commissioner described in the second 
sentence of paragraph (b)(3)(iii)(C)(2) of this section.
    (iii) Eligible section 965(h) transferee exception--(A) In general. 
Paragraph (b)(3)(i) of this section does not apply (such that the unpaid 
portion of all remaining installments will not be due as of the date of 
the acceleration event) to a person with respect to which an 
acceleration event occurs if the requirements described in paragraphs 
(b)(3)(iii)(A)(1) and (2) of this section are satisfied. A person with 
respect to which an acceleration event described in this paragraph 
(b)(3)(iii)(A) occurs is referred to as an eligible section 965(h) 
transferor.
    (1) Requirement to have a covered acceleration event. The 
acceleration event satisfies the requirements of this paragraph 
(b)(3)(iii)(A)(1) if it is described in--
    (i) Paragraph (b)(3)(ii)(B) of this section, and the acceleration 
event is a qualifying consolidated group member transaction within the 
meaning of paragraph (b)(3)(iii)(E) of this section;
    (ii) Paragraph (b)(3)(ii)(B) of this section (other than, in the 
case of an individual, an acceleration event caused by reason of death) 
in a transaction that is not a qualifying consolidated group member 
transaction;
    (iii) Paragraph (b)(3)(ii)(E) of this section;
    (iv) Paragraph (b)(3)(ii)(F) of this section, and the acceleration 
event results from the acquisition of a consolidated group within the 
meaning of Sec. 1.1502-13(j)(5), and the acquired consolidated group 
members join a different consolidated group as of the day following the 
acquisition;
    (v) Paragraph (b)(3)(ii)(F) of this section, and the group ceases to 
exist as a result of the transfer of all of the assets of one or more 
members of the consolidated group to other members with only one entity 
remaining (the successor entity); or
    (vi) Paragraph (b)(3)(ii)(F) of this section, and the group ceases 
to exist as a result of the termination of the subchapter S election 
pursuant to section 1362(d) of a shareholder of the common parent of the 
consolidated group and, for the shareholder's taxable year immediately 
following the termination, the shareholder joins in the filing of a 
consolidated return as a consolidated group that includes all of the 
former members of the former consolidated group.
    (2) Requirement to enter into a transfer agreement. An eligible 
section 965(h) transferor and an eligible section 965(h) transferee (as 
defined in paragraph (b)(3)(iii)(B)(1) of this section) must enter into 
an agreement with the Commissioner that satisfies the requirements of 
paragraph (b)(3)(iii)(B) of this section.

[[Page 554]]

    (B) Transfer agreement--(1) Eligibility. A transfer agreement that 
satisfies the requirements of this paragraph (b)(3)(iii)(B) must be 
entered into by an eligible section 965(h) transferor and an eligible 
section 965(h) transferee. For this purpose, the term eligible section 
965(h) transferee refers to a single United States person that is not a 
domestic pass-through entity and that--
    (i) With respect to an acceleration event described in paragraph 
(b)(3)(iii)(A)(1)(i) of this section, is a departing member (as defined 
in paragraph (b)(3)(iii)(E)(1)(i) of this section) or its qualified 
successor (as defined in paragraph (b)(3)(iii)(E)(2) of this section);
    (ii) With respect to an acceleration event described in paragraph 
(b)(3)(iii)(A)(1)(ii) of this section, acquires substantially all of the 
assets of an eligible section 965(h) transferor;
    (iii) With respect to an acceleration event described in paragraph 
(b)(3)(iii)(A)(1)(iii) of this section, is the agent (within the meaning 
of Sec. 1.1502-77) of the consolidated group that the eligible section 
965(h) transferor joins;
    (iv) With respect to an acceleration event described in paragraph 
(b)(3)(iii)(A)(1)(iv) of this section, is the agent (within the meaning 
of Sec. 1.1502-77) of the surviving consolidated group;
    (v) With respect to an acceleration event described in paragraph 
(b)(3)(iii)(A)(1)(v) of this section, is the successor entity (within 
the meaning of paragraph (b)(3)(iii)(A)(1)(v) of this section); or
    (vi) With respect an acceleration event described in paragraph 
(b)(3)(iii)(A)(1)(vi) of this section, is the agent (within the meaning 
of Sec. 1.1502-77) of the consolidated group that includes the 
shareholder whose subchapter S election was terminated and all of the 
former members of the former consolidated group.
    (2) Filing requirements--(i) In general. A transfer agreement must 
be timely filed. Except as provided in paragraph (b)(3)(iii)(B)(2)(ii) 
of this section, a transfer agreement is considered timely filed only if 
the transfer agreement is filed within 30 days of the date that the 
acceleration event occurs. The transfer agreement must be filed in 
accordance with the rules provided in publications forms, instructions, 
or other guidance. In addition, a duplicate copy of the transfer 
agreement must be attached to the returns of both the eligible section 
965(h) transferee and the eligible section 965(h) transferor for the 
taxable year during which the acceleration event occurs filed by the due 
date for such returns (taking into account extensions, if any). Relief 
is not available under Sec. 301.9100-2 or 301.9100-3 to file a transfer 
agreement late.
    (ii) Transition rule. If an acceleration event occurs on or before 
February 5, 2019, the transfer agreement must be filed by March 7, 2019, 
to be considered timely filed.
    (3) Signature requirement. The transfer agreement that is filed 
within 30 days of the acceleration event or by the due date specified in 
paragraph (b)(3)(iii)(B)(2)(ii) of this section must be signed under 
penalties of perjury by a person who is authorized to sign a return on 
behalf of the eligible section 965(h) transferor and a person who is 
authorized to sign a return on behalf of the eligible section 965(h) 
transferee.
    (4) Terms of agreement. A transfer agreement under this paragraph 
(b)(3)(iii)(B) must be entitled ``Transfer Agreement Under Section 
965(h)(3)'' and must contain the following information and 
representations--
    (i) A statement that the document constitutes an agreement by the 
eligible section 965(h) transferee to assume the liability of the 
eligible section 965(h) transferor for any unpaid installment payments 
of the eligible section 965(h) transferor under section 965(h);
    (ii) A statement that the eligible section 965(h) transferee (and, 
if the eligible section 965(h) transferor continues in existence 
immediately after the acceleration event, the eligible section 965(h) 
transferor) agrees to comply with all of the conditions and requirements 
of section 965(h) and paragraph (b) of this section, as well as any 
other applicable requirements in the section 965 regulations;
    (iii) The name, address, and taxpayer identification number of the 
eligible section 965(h) transferor and the eligible section 965(h) 
transferee;
    (iv) The amount of the eligible section 965(h) transferor's section 
965(h) net tax liability remaining unpaid, as

[[Page 555]]

determined by the eligible section 965(h) transferor, which amount is 
subject to adjustment by the Commissioner;
    (v) A copy of the eligible section 965(h) transferor's most recent 
Form 965-A or Form 965-B, as applicable, if the eligible section 965(h) 
transferor has been required to file a Form 965-A or Form 965-B;
    (vi) A detailed description of the acceleration event that led to 
the transfer agreement;
    (vii) A representation that the eligible section 965(h) transferee 
is able to make the remaining payments required under section 965(h) and 
paragraph (b) of this section with respect to the section 965(h) net tax 
liability being assumed;
    (viii) If the eligible section 965(h) transferor continues to exist 
immediately after the acceleration event, an acknowledgement that the 
eligible section 965(h) transferor and any successor to the eligible 
section 965(h) transferor will remain jointly and severally liable for 
any unpaid installment payments of the eligible section 965(h) 
transferor under section 965(h), including, if applicable, under Sec. 
1.1502-6;
    (ix) A statement as to whether the leverage ratio of the eligible 
section 965(h) transferee and all subsidiary members of its affiliated 
group immediately after the acceleration event exceeds three to one, 
which ratio may be modified as provided in publications, forms, 
instructions, or other guidance;
    (x) A certification by the eligible section 965(h) transferee 
stating that the eligible section 965(h) transferee waives the right to 
a notice of liability and consents to the immediate assessment of the 
portion of the section 965(h) net tax liability remaining unpaid; and
    (xi) Any additional information, representation, or certification 
required by the Commissioner in publications, forms, instructions, or 
other guidance.
    (5) Consolidated groups. For purposes of this paragraph 
(b)(3)(iii)(B), in the case of a consolidated group, the terms 
``eligible section 965(h) transferor'' and ``eligible section 965(h) 
transferee'' each refer to a consolidated group that is a party to a 
covered acceleration event described in paragraph (b)(3)(iii)(A)(1) of 
this section. In such a case, any transfer agreement under this 
paragraph (b)(3)(iii)(B) must be entered into by the agent (as defined 
in Sec. 1.1502-77) of the relevant consolidated group.
    (6) Leverage ratio. For purposes of paragraph (b)(3)(iii)(B)(4)(ix) 
of this section, and except as otherwise provided in publications, 
forms, instructions, or other guidance, the term leverage ratio means 
the ratio that the total indebtedness of the eligible section 965(h) 
transferee bears to the sum of its money and all other assets reduced 
(but not below zero) by such total indebtedness. For this purpose, the 
amount taken into account with respect to any asset is the adjusted 
basis thereof for purposes of determining gain, and the amount taken 
into account with respect to any indebtedness with original issue 
discount is its issue price plus the portion of the original issue 
discount previously accrued as determined under the rules of section 
1272 (determined without regard to subsection (a)(7) or (b)(4) thereof).
    (C) Consent of Commissioner--(1) In general. Except as otherwise 
provided in publications, forms, instructions, or other guidance, if an 
eligible section 965(h) transferor and an eligible section 965(h) 
transferee file a transfer agreement in accordance with the provisions 
of paragraph (b)(3)(iii)(B) of this section, the eligible section 965(h) 
transferor and the eligible section 965(h) transferee will be considered 
to have entered into an agreement described in paragraph 
(b)(3)(iii)(A)(2) of this section with the Commissioner for purposes of 
section 965(h)(3) and paragraph (b)(3)(iii) of this section. If the 
Commissioner determines that additional information is necessary (for 
example, additional information regarding the ability of the eligible 
section 965(h) transferee to fully pay the remaining section 965(h) net 
tax liability), the eligible section 965(h) transferee must provide such 
information upon request.
    (2) Material misrepresentations and omissions. If the Commissioner 
determines that an agreement filed by an eligible section 965(h) 
transferor and an eligible section 965(h) transferee contains a material 
misrepresentation or material omission, or if the eligible

[[Page 556]]

section 965(h) transferee does not provide the additional information 
requested under paragraph (b)(3)(iii)(C)(1) of this section within a 
reasonable timeframe communicated by the Commissioner to the eligible 
section 965(h) transferee, then the Commissioner may reject the transfer 
agreement (effective as of the date of the related acceleration event). 
In the alternative, on the date that the Commissioner determines that 
the transfer agreement includes a material misrepresentation or material 
omission, the Commissioner may determine that an acceleration event has 
occurred with respect to the eligible section 965(h) transferee as of 
the date of the determination, such that any unpaid installment payments 
of the eligible section 965(h) transferor that were assumed by the 
eligible section 965(h) transferee become due on the date of the 
determination.
    (D) Effect of assumption--(1) In general. If the exception in this 
paragraph (b)(3)(iii) applies with respect to an eligible section 965(h) 
transferor and an eligible section 965(h) transferee, the eligible 
section 965(h) transferee assumes all of the outstanding obligations and 
responsibilities of the eligible section 965(h) transferor with respect 
to the section 965(h) net tax liability as though the eligible section 
965(h) transferee had included the section 965(a) inclusion in income. 
Accordingly, the eligible section 965(h) transferee is responsible for 
making payments and reporting with respect to any unpaid installment 
payments. In addition, for example, if an acceleration event described 
in paragraph (b)(3)(ii) of this section occurs with respect to an 
eligible section 965(h) transferee, any unpaid installment payments of 
the eligible section 965(h) transferor that were assumed by the eligible 
section 965(h) transferee will become due on the date of such event, 
subject to any applicable exception in paragraph (b)(3)(iii) of this 
section.
    (2) Eligible section 965(h) transferor liability. An eligible 
section 965(h) transferor (or a successor) remains jointly and severally 
liable for any unpaid installment payments of the eligible section 
965(h) transferor that were assumed by the eligible section 965(h) 
transferee, as well as any penalties, additions to tax, or other 
additional amounts attributable to such net tax liability.
    (E) Qualifying consolidated group member transaction--(1) Definition 
of qualifying consolidated group member transaction. For purposes of 
this paragraph (b)(3), the term qualifying consolidated group member 
transaction means a transaction in which--
    (i) A member of a consolidated group (the departing member) ceases 
to be a member of the consolidated group (including by reason of the 
distribution, sale, or exchange of the departing member's stock);
    (ii) The transaction results in the consolidated group (which is 
treated as a single person for this purpose under Sec. 1.965-8(e)(1)) 
being treated as transferring substantially all of its assets for 
purposes of paragraph (b)(3)(ii)(B) of this section; and
    (iii) The departing member either continues to exist immediately 
after the transaction or has a qualified successor.
    (2) Definition of qualified successor. For purposes of this 
paragraph (b)(3), the term qualified successor means, with respect to a 
departing member described in this paragraph (b)(3)(iii)(E), another 
domestic corporation (or consolidated group) that acquires substantially 
all of the assets of the departing member (including in a transaction 
described in section 381(a)(2)).
    (3) Departure of multiple members of a consolidated group. Multiple 
members that deconsolidate from the same consolidated group as a result 
of a single transaction are treated as a single departing member to the 
extent that, immediately after the transaction, they become members of 
the same (second) consolidated group, which would be treated as a single 
person under Sec. 1.965-8(e)(1).
    (c) Section 965(i) election--(1) In general. Each shareholder of an 
S corporation (including a person listed in Sec. 1.1362-6(b)(2) with 
respect to a trust or estate, but not a domestic pass-through entity 
itself) that is a United States shareholder of a deferred foreign income 
corporation may elect under section 965(i) and this paragraph (c) to 
defer the payment of the shareholder's

[[Page 557]]

section 965(i) net tax liability with respect to the S corporation until 
the shareholder's taxable year that includes a triggering event 
described in paragraph (c)(3) of this section. This election may be 
revoked only by paying the full amount of the unpaid section 965(i) net 
tax liability.
    (2) Manner of making election--(i) Eligibility. Each shareholder 
with a section 965(i) net tax liability with respect to an S corporation 
may make the section 965(i) election with respect to such S corporation, 
provided that, with respect to the shareholder, none of the triggering 
events described in paragraph (c)(3)(ii) of this section have occurred 
before the election is made. Notwithstanding the preceding sentence, a 
shareholder that would be eligible to make the section 965(i) election 
but for the occurrence of an event described in paragraph (c)(3)(ii) of 
this section may make the section 965(i) election if an exception 
described in paragraph (c)(3)(iv) of this section applies.
    (ii) Timing. A section 965(i) election must be made no later than 
the due date (taking into account extensions, if any) for the 
shareholder's return for each taxable year that includes the last day of 
the taxable year of the S corporation in which the S corporation has a 
section 965(a) inclusion to which the shareholder's section 965(i) net 
tax liability is attributable. Relief is not available under Sec. 
301.9100-2 or 301.9100-3 to make a late election.
    (iii) Election statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, to make a section 
965(i) election, a shareholder must attach a statement, signed under 
penalties of perjury consistent with the rules for signatures applicable 
to the person's return, to its return for the taxable year that includes 
the last day of a taxable year of the S corporation in which the S 
corporation has a section 965(a) inclusion to which the shareholder's 
section 965(i) net tax liability is attributable. The statement must 
include the shareholder's name, taxpayer identification number, the name 
and taxpayer identification number of the S corporation with respect to 
which the election is made, the amount described in paragraph 
(g)(10)(i)(A) of this section as modified by paragraph (g)(6) of this 
section for purposes of determining the section 965(i) net tax liability 
with respect to the S corporation, the amount described in paragraph 
(g)(10)(i)(B) of this section, and the section 965(i) net tax liability 
with respect to the S corporation. The statement must be filed in the 
manner prescribed in publications, forms, instructions, or other 
guidance. The attachment of an unsigned copy of the election statement 
to the timely-filed return for the relevant taxable year satisfies the 
signature requirement of this paragraph (c)(2)(iii) if the shareholder 
retains the original signed election statement in the manner specified 
by Sec. 1.6001-1(e).
    (3) Triggering events--(i) In general. If a shareholder makes a 
section 965(i) election with respect to an S corporation, the 
shareholder defers payment of its section 965(i) net tax liability with 
respect to the S corporation until the shareholder's taxable year that 
includes the occurrence of a triggering event described in paragraph 
(c)(3)(ii) of this section with respect to the section 965(i) net tax 
liability with respect to the S corporation. If a triggering event 
described in paragraph (c)(3)(ii) of this section with respect to an S 
corporation occurs, except as provided in paragraph (c)(3)(iv) of this 
section, the shareholder's section 965(i) net tax liability with respect 
to the S corporation will be assessed as an addition to tax for the 
shareholder's taxable year that includes the triggering event.
    (ii) Triggering events. The following events are considered 
triggering events for purposes of paragraph (c)(3)(i) of this section 
with respect to a shareholder's section 965(i) net tax liability with 
respect to an S corporation--
    (A) The corporation ceases to be an S corporation (determined as of 
the first day of the first taxable year that the corporation is not an S 
corporation);
    (B) A liquidation, sale, exchange, or other disposition of 
substantially all of the assets of the S corporation (including in a 
title 11 or similar case), a cessation of business by the S corporation, 
or the S corporation ceasing to exist;
    (C) The transfer of any share of stock of the S corporation by the 
shareholder

[[Page 558]]

(including by reason of death or otherwise) that results in a change of 
ownership for federal income tax purposes; or
    (D) A determination by the Commissioner described in the second 
sentence of paragraph (c)(3)(iv)(C)(2) of this section.
    (iii) Partial transfers. If an S corporation shareholder transfers 
less than all of its shares of stock of the S corporation, the transfer 
will be a triggering event only with respect to the portion of a 
shareholder's section 965(i) net tax liability that is properly 
allocable to the transferred shares.
    (iv) Eligible section 965(i) transferee exception--(A) In general. 
Paragraph (c)(3)(i) of this section will not apply (such that a 
shareholder's section 965(i) net tax liability with respect to an S 
corporation will not be assessed as an addition to tax for the 
shareholder's taxable year that includes the triggering event) if the 
requirements described in paragraphs (c)(3)(iv)(A)(1) and (2) of this 
section are satisfied. A shareholder with respect to which a triggering 
event described in this paragraph (c)(3)(iv)(A) occurs is referred to as 
an eligible section 965(i) transferor.
    (1) Requirement to have a covered triggering event. The triggering 
event satisfies the requirements of this paragraph (c)(3)(iv)(A)(1) if 
it is described in paragraph (c)(3)(ii)(C) of this section.
    (2) Requirement to enter into a transfer agreement. The shareholder 
with respect to which a triggering event occurs and an eligible section 
965(i) transferee (as defined in paragraph (c)(3)(iv)(B)(1) of this 
section) must enter into an agreement with the Commissioner that 
satisfies the requirements of paragraph (c)(3)(iv)(B) of this section.
    (B) Transfer agreement--(1) Eligibility. A transfer agreement that 
satisfies the requirements of this paragraph (c)(3)(iv)(B) may be 
entered into by an eligible section 965(i) transferor and an eligible 
section 965(i) transferee. For this purpose, the term eligible section 
965(i) transferee refers to a single United States person that becomes a 
shareholder of the S corporation (including a person listed in Sec. 
1.1362-6(b)(2) with respect to a trust or estate, but not a domestic 
pass-through entity itself). In the case of a transfer that consists of 
multiple partial transfers (as described in paragraph (c)(3)(iii) of 
this section), a transfer agreement that satisfies the requirements of 
this paragraph (c)(3)(iv)(B) may be entered into by an eligible section 
965(i) transferor and an eligible section 965(i) transferee for each 
partial transfer.
    (2) Filing requirements--(i) In general. A transfer agreement must 
be timely filed. Except as provided in paragraphs (c)(3)(iv)(B)(2)(ii) 
and (iii) of this section, a transfer agreement is considered timely 
filed only if the transfer agreement is filed within 30 days of the date 
that the triggering event occurs. The transfer agreement must be filed 
in accordance with the rules provided in publications, forms, 
instructions, or other guidance. In addition, a duplicate copy of the 
transfer agreement must be attached to the returns of both the eligible 
section 965(i) transferee and the eligible section 965(i) transferor for 
the taxable year during which the triggering event occurs filed by the 
due date (taking into account extensions, if any) for such returns. 
Relief is not available under Sec. 301.9100-2 or 301.9100-3 to file a 
transfer agreement late.
    (ii) Transition rule. If a triggering event occurs on or before 
February 5, 2019, the transfer agreement must be filed by March 7, 2019, 
to be considered timely filed.
    (iii) Death of eligible section 965(i) transferor. If the triggering 
event is the death of the eligible section 965(i) transferor, the 
transfer agreement must be filed by the later of the unextended due date 
for the eligible section 965(i) transferor's final income tax return or 
March 7, 2019.
    (3) Signature requirement. The transfer agreement that is filed 
within 30 days of the triggering event or by the due date specified in 
paragraph (c)(3)(iv)(B)(2)(ii) or (iii) of this section must be signed 
under penalties of perjury by a person who is authorized to sign a 
return on behalf of the eligible section 965(i) transferor and a person 
who is authorized to sign a return on behalf of the eligible section 
965(i) transferee.
    (4) Terms of agreement. A transfer agreement under this paragraph 
(c)(3)(iv)(B) must be entitled ``Transfer Agreement Under Section 
965(i)(2)'' and

[[Page 559]]

must contain the following information and representations:
    (i) A statement that the document constitutes an agreement by the 
eligible section 965(i) transferee to assume the liability of the 
eligible section 965(i) transferor for the unpaid portion of the section 
965(i) net tax liability, or, in the case of a partial transfer, for the 
unpaid portion of the section 965(i) net tax liability attributable to 
the transferred stock;
    (ii) A statement that the eligible section 965(i) transferee agrees 
to comply with all of the conditions and requirements of section 965(i) 
and paragraph (c) of this section, including the annual reporting 
requirement, as well as any other applicable requirements in the section 
965 regulations;
    (iii) The name, address, and taxpayer identification number of the 
eligible section 965(i) transferor and the eligible section 965(i) 
transferee;
    (iv) The amount of the eligible section 965(i) transferor's unpaid 
section 965(i) net tax liability or, in the case of a partial transfer, 
the unpaid portion of the section 965(i) net tax liability attributable 
to the transferred stock, each as determined by the eligible section 
965(i) transferor, which amount is subject to adjustment by the 
Commissioner;
    (v) A copy of the eligible section 965(i) transferor's most recent 
Form 965-A, if the eligible section 965(i) transferor has been required 
to file a Form 965-A;
    (vi) A detailed description of the triggering event that led to the 
transfer agreement, including the name and taxpayer identification 
number of the S corporation with respect to which the section 965(i) 
election was effective;
    (vii) A representation that the eligible section 965(i) transferee 
is able to pay the section 965(i) net tax liability being assumed;
    (viii) An acknowledgement that the eligible section 965(i) 
transferor and any successor to the eligible section 965(i) transferor 
will remain jointly and severally liable for the section 965(i) net tax 
liability being assumed by the eligible section 965(i) transferee;
    (ix) A statement as to whether the leverage ratio of the eligible 
section 965(i) transferee immediately after the triggering event exceeds 
three to one, which ratio may be modified as provided in publications, 
forms, instructions, or other guidance;
    (x) Any additional information, representation, or certification 
required by the Commissioner in publications, forms, instructions, or 
other guidance.
    (5) Special rule in the case of death of eligible section 965(i) 
transferor. Except in the case of transfers to trusts, if the triggering 
event is the death of the eligible section 965(i) transferor, and the 
identity of the beneficiary or beneficiaries (in the case of multiple 
partial transfers) is determined as of the due date for the transfer 
agreement described in paragraph (c)(3)(iv)(B)(2)(iii) of this section, 
then the transfer may be treated as a transfer directly between the 
eligible 965(i) transferor and the beneficiary or beneficiaries. If, 
however, the identity of the beneficiary or beneficiaries is not 
determined as of the due date for the transfer agreement described in 
paragraph (c)(3)(iv)(B)(2)(iii) of this section, then the transfer must 
be treated first as a transfer between the eligible section 965(i) 
transferor and his or her estate at the time of death and second as a 
transfer between the estate and the beneficiary or beneficiaries when 
the shares are actually transferred to the beneficiary or beneficiaries. 
Separate transfer agreements must be filed for each transfer. The 
transfer from the eligible section 965(i) transferor to his or her 
estate is a transfer resulting from a triggering event that is the death 
of the eligible section 965(i) transferor, and the transfer agreement is 
subject to the timing rules in paragraph (c)(3)(iv)(B)(2)(iii) of this 
section. The transfer from the estate to the beneficiary or 
beneficiaries is not a transfer resulting from a triggering event that 
is the death of the eligible section 965(i) transferor, and the transfer 
agreement is subject to the timing rules in paragraph 
(c)(3)(iv)(B)(2)(i) and (ii) of this section.
    (6) Leverage ratio. For purposes of paragraph (c)(3)(iv)(B)(4)(ix) 
of this section, and except as otherwise provided in publications, 
forms, instructions, or other guidance, the term leverage ratio means 
the ratio that the total indebtedness of the eligible section 965(i)

[[Page 560]]

transferee bears to the sum of its money and all other assets reduced 
(but not below zero) by such total indebtedness. For this purpose, the 
amount taken into account with respect to any asset is the adjusted 
basis thereof for purposes of determining gain, and the amount taken 
into account with respect to any indebtedness with original issue 
discount is its issue price plus the portion of the original issue 
discount previously accrued as determined under the rules of section 
1272 (determined without regard to subsection (a)(7) or (b)(4) thereof).
    (C) Consent of Commissioner--(1) In general. Except as otherwise 
provided in publications, forms, instructions, or other guidance, if an 
eligible section 965(i) transferor and an eligible section 965(i) 
transferee file a transfer agreement in accordance with the provisions 
of paragraph (c)(3)(iv)(B) of this section, the eligible section 965(i) 
transferor and the eligible section 965(i) transferee will be considered 
to have entered into an agreement with the Commissioner for purposes of 
section 965(i)(2) and paragraph (c)(3)(iv) of this section. If the 
Commissioner determines that additional information is necessary (for 
example, additional information regarding the ability of the eligible 
section 965(i) transferee to pay the eligible section 965(i) 
transferor's unpaid section 965(i) net tax liability), the eligible 
section 965(i) transferee must provide such information upon request.
    (2) Material misrepresentations and omissions. If the Commissioner 
determines that an agreement filed by an eligible section 965(i) 
transferor and an eligible section 965(i) transferee contains a material 
misrepresentation or material omission, or if the eligible section 
965(i) transferee does not provide the additional information requested 
under paragraph (c)(3)(iv)(C)(1) of this section within a reasonable 
timeframe communicated by the Commissioner to the eligible section 
965(i) transferee, then the Commissioner may reject the transfer 
agreement (effective as of the date of the related triggering event). In 
the alternative, on the date that the Commissioner determines that the 
transfer agreement includes a material misrepresentation or material 
omission, the Commissioner may determine that a triggering event has 
occurred with respect to the eligible section 965(i) transferee as of 
the date of the determination, such that the unpaid section 965(i) net 
tax liability of the eligible section 965(i) transferor that was assumed 
by the eligible section 965(i) transferee becomes due on the date of the 
determination.
    (D) Effect of assumption--(1) In general. When the exception in this 
paragraph (c)(3)(iv) applies with respect to an eligible section 965(i) 
transferor and an eligible section 965(i) transferee, the eligible 
section 965(i) transferee assumes all of the outstanding obligations and 
responsibilities of the eligible section 965(i) transferor with respect 
to the section 965(i) net tax liability with respect to the S 
corporation as though the eligible section 965(i) transferee had 
included the section 965(a) inclusion in income. Accordingly, the 
eligible section 965(i) transferee is responsible for making payments 
and reporting with respect to any unpaid section 965(i) net tax 
liability with respect to the S corporation. In addition, for example, 
if a triggering event described in paragraph (c)(3)(ii) of this section 
occurs with respect to an eligible section 965(i) transferee, any unpaid 
portion of the section 965(i) net tax liability of the eligible section 
965(i) transferor that was assumed by the eligible section 965(i) 
transferee becomes due on the date of such event, subject to any 
applicable exception in paragraph (c)(3)(iv) or (v) of this section.
    (2) Eligible section 965(i) transferor liability. An eligible 
section 965(i) transferor remains jointly and severally liable for any 
unpaid installment payments of the eligible section 965(i) transferor 
that were assumed by the eligible section 965(i) transferee, as well as 
any penalties, additions to tax, or other additional amounts 
attributable to such net tax liability.
    (v) Coordination with section 965(h) election--(A) In general. 
Subject to the limitation described in paragraph (c)(3)(v)(D) of this 
section, a shareholder that has made a section 965(i) election with 
respect to an S corporation, upon the occurrence of a triggering event 
with respect to such S

[[Page 561]]

corporation, may make a section 965(h) election with respect to the 
portion of the shareholder's section 965(i) net tax liability with 
respect to such S corporation that is assessed as an addition to tax for 
the shareholder's taxable year that includes the triggering event 
pursuant to paragraph (c)(3)(i) of this section as if such portion were 
a section 965(h) net tax liability.
    (B) Timing for election. A section 965(h) election made pursuant to 
section 965(i)(4) and paragraph (c)(3)(v)(A) of this section must be 
made no later than the due date (taking into account extensions, if any) 
for the shareholder's return for the taxable year in which the 
triggering event with respect to the S corporation occurs. Relief is not 
available under Sec. 301.9100-2 or Sec. 301.9100-3 to make a late 
election.
    (C) Due date for installment. If a shareholder makes a section 
965(h) election pursuant to section 965(i)(4) and paragraph (c)(3)(v)(A) 
of this section, the payment of the first installment (as described in 
paragraph (b)(1)(i) of this section) must be made no later than the due 
date (without regard to extensions) for the shareholder's return of tax 
for the taxable year in which the triggering event with respect to the S 
corporation occurs.
    (D) Limitation--(1) In general. Notwithstanding paragraph 
(c)(3)(v)(A) of this section, if the triggering event with respect to an 
S corporation is a triggering event described in paragraph (c)(3)(ii)(B) 
of this section, then the section 965(h) election may only be made with 
the consent of the Commissioner.
    (2) Manner of obtaining consent--(i) In general. In order to obtain 
the consent of the Commissioner as required by paragraph (c)(3)(v)(D)(1) 
of this section, the shareholder intending to make the section 965(h) 
election must file the agreement described in paragraph (c)(3)(v)(D)(4) 
of this section within 30 days of the occurrence of the triggering 
event, except as described in paragraph (c)(3)(v)(D)(2)(ii) of this 
section. The agreement must be filed in accordance with the rules 
provided in publications, forms, instructions, or other guidance. In 
addition, a duplicate copy of the agreement must be filed, with the 
shareholder's timely-filed return for the taxable year during which the 
triggering event occurs (taking into account extensions, if any), along 
with the election statement described in paragraph (b)(2)(iii) of this 
section. Relief is not available under Sec. 301.9100-2 or Sec. 
301.9100-3 to file an agreement late.
    (ii) Transition rule. If a triggering event occurs on or before 
February 5, 2019, the agreement must be filed by March 7, 2019, in order 
to be considered timely filed.
    (3) Signature requirement. The agreement that is filed within 30 
days of the triggering event or by the due date specified in paragraph 
(c)(3)(v)(D)(2)(ii) of this section must be signed under penalties of 
perjury by the shareholder.
    (4) Terms of agreement. The agreement under this paragraph 
(c)(3)(v)(D) must be entitled ``Consent Agreement Under Section 
965(i)(4)(D)'' and must contain the following information and 
representations--
    (i) A statement that the shareholder agrees to comply with all of 
the conditions and requirements of section 965(h) and paragraph (b) of 
this section, as well as any other applicable requirements in the 
section 965 regulations;
    (ii) The name, address, and taxpayer identification number of the 
shareholder;
    (iii) The amount of the section 965(i) net tax liability under 
section 965 remaining unpaid with respect to which the section 965(h) 
election is made pursuant to section 965(i)(4)(D) and paragraph 
(c)(3)(v)(A) of this section, as determined by the shareholder, which 
amount is subject to adjustment by the Commissioner; and
    (iv) A representation that the shareholder is able to make the 
payments required under section 965(h) and paragraph (b) of this section 
with respect to the portion of the total net tax liability under section 
965 remaining unpaid described in paragraph (c)(3)(v)(D)(4)(iii) of this 
section.
    (v) A statement as to whether the leverage ratio of the shareholder 
and all subsidiary members of its affiliated group immediately following 
the triggering event exceeds three to one; and
    (vi) Any additional information, representation, or certification 
required by the Commissioner in publications, forms, instructions, or 
other guidance.

[[Page 562]]

    (5) Consent of Commissioner--(i) In general. If a shareholder files 
an agreement in accordance with the provisions of paragraph (c)(3)(v)(D) 
of this section, the shareholder will be considered to have obtained the 
consent of the Commissioner for purposes of section 965(i)(4)(D) and 
paragraph (c)(3)(v)(D)(1) of this section. However, if the Commissioner 
reviews the agreement and determines that additional information is 
necessary, the shareholder must provide such information upon request.
    (ii) Material misrepresentations and omissions. If the Commissioner 
determines that an agreement filed by a shareholder in accordance with 
the provisions of this paragraph (c)(3)(v)(D) contains a material 
misrepresentation or material omission, or if the shareholder does not 
provide the additional information requested under paragraph 
(c)(3)(v)(D)(5)(i) of this section within a reasonable timeframe 
communicated by the Commissioner to the shareholder, then the 
Commissioner may reject the agreement (effective as of the date of the 
related triggering event).
    (6) Leverage ratio. For purposes of paragraph (c)(3)(v)(D)(4)(v) of 
this section, and except as otherwise provided in publications, forms, 
instructions, or other guidance, the term leverage ratio means the ratio 
that the total indebtedness of the shareholder bears to the sum of its 
money and all other assets reduced (but not below zero) by such total 
indebtedness. For this purpose, the amount taken into account with 
respect to any asset is the adjusted basis thereof for purposes of 
determining gain, and the amount taken into account with respect to any 
indebtedness with original issue discount is its issue price plus the 
portion of the original issue discount previously accrued as determined 
under the rules of section 1272 (determined without regard to subsection 
(a)(7) or (b)(4) thereof).
    (4) Joint and several liability. If any shareholder of an S 
corporation makes a section 965(i) election, the S corporation is 
jointly and severally liable for the payment of the shareholder's 
section 965(i) net tax liability with respect to the S corporation, as 
well as any penalties, additions to tax, or other additional amounts 
attributable to such net tax liability.
    (5) Extension of limitation on collection. If an S corporation 
shareholder makes a section 965(i) election with respect to its section 
965(i) net tax liability with respect to an S corporation, any 
limitation on the time period for the collection of the net tax 
liability shall not begin before the date of the triggering event with 
respect to the section 965(i) net tax liability.
    (6) Annual reporting requirement--(i) In general. A shareholder that 
makes a section 965(i) election with respect to its section 965(i) net 
tax liability with respect to an S corporation is required to report the 
amount of its deferred net tax liability on its return of tax for the 
taxable year in which the election is made and on the return of tax for 
each subsequent taxable year until such net tax liability has been fully 
assessed.
    (ii) Failure to report. If a shareholder fails to report the amount 
of its deferred net tax liability as required with respect to any 
taxable year by the due date (taking into account extensions, if any) 
for the return of tax for that taxable year, five percent of such 
deferred net tax liability will be assessed as an addition to tax for 
such taxable year.
    (d) Section 965(m) election and special rule for real estate 
investment trusts--(1) In general. A real estate investment trust may 
elect under section 965(m) and this paragraph (d) to defer the inclusion 
in gross income (for purposes of the computation of real estate 
investment trust taxable income under section 857(b)) of its REIT 
section 965 amounts and include them in income according to the schedule 
described in paragraph (d)(2) of this section. This election is 
revocable only by including in gross income (for purposes of the 
computation of real estate investment trust taxable income under section 
857(b)) the full amount of the REIT section 965 amounts.
    (2) Inclusion schedule for section 965(m) election. If a real estate 
investment trust makes the section 965(m) election, the REIT section 965 
amounts will be included in the real estate investment trust's gross 
income as follows--
    (i) Eight percent of the REIT section 965 amounts in each taxable 
year in the five-taxable year period beginning with

[[Page 563]]

the taxable year the amount would otherwise be included;
    (ii) Fifteen percent of the REIT section 965 amounts in the first 
year following the five year period described in paragraph (d)(2)(i) of 
this section;
    (iii) Twenty percent of the REIT section 965 amounts in the second 
year following the five year period described in paragraph (d)(2)(i) of 
this section; and
    (iv) Twenty-five percent of the REIT section 965 amounts in the 
third year following the five year period described in paragraph 
(d)(2)(i) of this section.
    (3) Manner of making election--(i) Eligibility. A real estate 
investment trust with section 965(a) inclusions may make the section 
965(m) election.
    (ii) Timing. A section 965(m) election must be made no later than 
the due date (taking into account extensions, if any) for the return for 
the first year of the five year period described in paragraph (d)(2)(i) 
of this section. Relief is not available under Sec. 301.9100-2 or Sec. 
301.9100-3 to make a late election.
    (iii) Election statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, to make a section 
965(m) election, a real estate investment trust must attach a statement, 
signed under penalties of perjury consistent with the rules for 
signatures applicable to the person's return, to its return for the 
taxable year in which it would otherwise be required to include the REIT 
section 965 amounts in gross income. The statement must include the real 
estate investment trust's name, taxpayer identification number, REIT 
section 965 amounts, and the anticipated amounts of each portion of the 
REIT section 965 amounts described under paragraph (d)(2) of this 
section, and the statement must be filed in the manner prescribed in 
publications, forms, instructions, or other guidance. The attachment of 
an unsigned copy of the election statement to the timely-filed return 
for the relevant taxable year satisfies the signature requirement of 
this paragraph (d)(3)(iii) if the real estate investment trust retains 
the original signed election statement in the manner specified by Sec. 
1.6001-1(e).
    (4) Coordination with section 965(h). A real estate investment trust 
that makes the section 965(m) election may not also make a section 
965(h) election for any year with respect to which a section 965(m) 
election is in effect.
    (5) Acceleration of inclusion. If a real estate investment trust 
makes a section 965(m) election and subsequently there is a liquidation, 
sale, exchange, or other disposition of substantially all of the assets 
of the real estate investment trust (including in a title 11 or similar 
case), or a cessation of business by the real estate investment trust, 
any amount not yet included in gross income (for purposes of the 
computation of real estate investment trust taxable income under section 
857(b)) as a result of the section 965(m) election will be so included 
as of the day before the date of the event. The unpaid portion of any 
tax liability with respect to such inclusion will be due on the date of 
the event (or in the case of a title 11 or similar case, the day before 
the petition is filed).
    (6) Treatment of section 965(a) inclusions of a real estate 
investment trust. Regardless of whether a real estate investment trust 
has made a section 965(m) election, and regardless of whether it is a 
United States shareholder of a deferred foreign income corporation, any 
section 965(a) inclusions of the real estate investment trust are not 
taken into account as gross income of the real estate investment trust 
for purposes of applying paragraphs (2) and (3) of section 856(c) for 
any taxable year for which the real estate investment trust takes into 
account a section 965(a) inclusion, including pursuant to paragraph 
(d)(2) of this section.
    (e) Section 965(n) election--(1) In general--(i) General rule. A 
person may elect to not take into account the amount described in 
paragraph (e)(1)(ii) of this section in determining its net operating 
loss under section 172 for the taxable year or in determining the amount 
of taxable income for such taxable year (computed without regard to the 
deduction allowable under section 172) that may be reduced by net 
operating loss carryovers or carrybacks to such taxable year under 
section 172. Except as provided in paragraph (e)(2)(ii)(B) of this 
section, the election for each taxable year is irrevocable. If the 
section 965(n) election creates or

[[Page 564]]

increases a net operating loss under section 172 for the taxable year, 
then the taxable income of the person for the taxable year cannot be 
less than the amount described in paragraph (e)(1)(ii) of this section. 
The amount of deductions equal to the amount by which a net operating 
loss is created or increased for the taxable year by reason of the 
section 965(n) election (the deferred amount) is not taken into account 
in computing taxable income or the separate foreign tax credit 
limitations under section 904 for that year. The source and separate 
category (as defined in Sec. 1.904-5(a)(4)(v)) components of the 
deferred amount are determined in accordance with paragraph (e)(1)(iv) 
of this section.
    (ii) Applicable amount for section 965(n) election. If a person 
makes a section 965(n) election, the amount referred to in paragraph 
(e)(1)(i) of this section is the sum of--
    (A) The person's section 965(a) inclusions for the taxable year 
reduced by the person's section 965(c) deductions for the taxable year, 
and
    (B) In the case of a domestic corporation, the taxes deemed paid 
under section 960(a)(1) for the taxable year with respect to the 
person's section 965(a) inclusions that are treated as dividends under 
section 78.
    (iii) Scope of section 965(n) election. If a person makes a section 
965(n) election, the election applies to both net operating losses for 
the taxable year for which the election is made and the net operating 
loss carryovers or carrybacks to such taxable year, each in their 
entirety. Any section 965(n) election made by the agent (within the 
meaning of Sec. 1.1502-77) of a consolidated group applies to all net 
operating losses available to the consolidated group, including all 
components of the consolidated net operating loss deduction (as defined 
in Sec. 1.1502-21(a)).
    (iv) Effect of section 965(n) election--(A) In general. The section 
965(n) election for a taxable year applies solely for purposes of 
determining the amount of net operating loss under section 172 for the 
taxable year and determining the amount of taxable income for the 
taxable year (computed without regard to the deduction allowable under 
section 172) that may be reduced by net operating loss carryovers or 
carrybacks to such taxable year under section 172. Paragraph 
(e)(1)(iv)(B) of this section provides a rule for coordinating the 
section 965(n) election's effect on section 172 with the computation of 
the separate foreign tax credit limitations under section 904.
    (B) Ordering rule for allocation and apportionment of deductions for 
purposes of the section 904 limitation. The effect of a section 965(n) 
election with respect to a taxable year on the computation of the 
separate foreign tax credit limitations under section 904 is computed as 
follows and in the following order.
    (1) Deductions, including those that create or increase a net 
operating loss for the taxable year by reason of the section 965(n) 
election, are allocated and apportioned under Sec. Sec. 1.861-8 through 
1.861-17 to the relevant statutory and residual groupings, taking into 
account the amount described in paragraph (e)(1)(ii) of this section. 
The source and separate category of the net operating loss carryover or 
carryback to the taxable year, if any, is determined under the rules of 
Sec. 1.904(g)-3(b), taking into account the amount described in 
paragraph (e)(1)(ii) of this section. Therefore, if the amount of the 
net operating loss carryover or carryback to the taxable year (as 
reduced by reason of the section 965(n) election) exceeds the U.S. 
source loss component of the net operating loss that is carried over 
under Sec. 1.904(g)-3(b)(3)(i), but such excess is less than the 
potential carryovers (or carrybacks) of the separate limitation losses 
that are part of the net operating loss, the potential carryovers (or 
carrybacks) are proportionately reduced as provided in Sec. 1.904(g)-
3(b)(3)(ii) or (iii), as applicable.
    (2) If a net operating loss is created or increased for the taxable 
year by reason of the section 965(n) election, the deferred amount (as 
defined in paragraph (e)(1)(i) of this section) is not allowed as a 
deduction for the taxable year. See paragraph (e)(1)(i) of this section. 
The deferred amount (which is the corresponding addition to the net 
operating loss for the taxable year) comprises a ratable portion of the 
deductions (including the deduction allowed under section 965(c)) 
allocated

[[Page 565]]

and apportioned to each statutory and residual grouping under paragraph 
(e)(1)(iv)(B)(1) of this section. Such ratable portion equals the 
deferred amount multiplied by a fraction, the numerator of which is the 
deductions allocated and apportioned to the statutory or residual 
grouping under paragraph (e)(1)(iv)(B)(1) of this section and the 
denominator of which is the total deductions described in paragraph 
(e)(1)(iv)(B)(1) of this section. Accordingly, the fraction described in 
the previous sentence takes into account the deferred amount.
    (3) Taxable income and the separate foreign tax credit limitations 
under section 904 for the taxable year are computed without taking into 
account any deferred amount. Deductions allocated and apportioned to the 
statutory and residual groupings under paragraph (e)(1)(iv)(B)(1) of 
this section, to the extent deducted in the taxable year rather than 
deferred to create or increase a net operating loss, are combined with 
income in the statutory and residual groupings to which those deductions 
are assigned in order to compute the amount of separate limitation 
income or loss in each separate category and U.S. source income or loss 
for the taxable year. Section 904(b), (f), and (g) are then applied to 
determine the applicable foreign tax credit limitations for the taxable 
year.
    (2) Manner of making election--(i) Eligibility. A person with a 
section 965(a) inclusion may make the section 965(n) election.
    (ii) Timing--(A) In general. A section 965(n) election must be made 
no later than the due date (taking into account extensions, if any) for 
the person's return for the taxable year to which the election applies. 
Relief is not available under Sec. 301.9100-2 or Sec. 301.9100-3 of 
this chapter to make a late election.
    (B) Transition rule. In the case of a section 965(n) election made 
before June 21, 2019, the election may be revoked by attaching a 
statement, signed under penalties of perjury, to an amended return for 
the taxable year to which the election applies (the election year). The 
statement must include the person's name, taxpayer identification 
number, and a statement that the person revokes the section 965(n) 
election. The amended return to which the statement is attached must be 
filed by--
    (1) In the case of a revocation with respect to an election due 
before February 5, 2019, the due date (taking into account extensions, 
if any, or any additional time that would have been granted if the 
person had made an extension request) for the return for the taxable 
year following the election year; or
    (2) In the case of a revocation with respect to an election due on 
or after February 5, 2019, the due date (taking into account extensions, 
if any, or any additional time that would have been granted if the 
person had made an extension request) for the return for the election 
year.
    (iii) Election statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, to make a section 
965(n) election, a person must attach a statement, signed under 
penalties of perjury consistent with the rules for signatures applicable 
to the person's return, to its return for the taxable year to which the 
election applies. The statement must include the person's name, taxpayer 
identification number, the amounts described in section 965(n)(2)(A) and 
paragraph (e)(1)(ii)(A) of this section and section 965(n)(2)(B) and 
paragraph (e)(1)(ii)(B) of this section, and the sum thereof, and the 
statement must be filed in the manner prescribed in publications, forms, 
instructions, or other guidance. The attachment of an unsigned copy of 
the election statement to the timely-filed return for the relevant 
taxable year satisfies the signature requirement of this paragraph 
(e)(2)(iii) if the person making the election retains the original 
signed election statement in the manner specified by Sec. 1.6001-1(e).
    (3) Examples. The following examples illustrate the application of 
paragraph (e)(1)(iv) of this section.
    (i) Example 1: Net operating loss in inclusion year--(A) Facts. USP, 
a domestic corporation, has a section 965(a) inclusion of $100x and has 
a section 965(c) deduction of $70x for its taxable year ending December 
31, 2017. USP also includes in gross income the amount treated as 
dividends under section 78 of $50x (the foreign taxes deemed paid

[[Page 566]]

under section 960(a) for the taxable year with respect to USP's section 
965(a) inclusion). The section 965(a) inclusion and the section 78 
dividends are foreign source general category income. During the 2017 
taxable year, USP also has U.S. source gross income of $150x and other 
deductions of $210x, comprising $60x of interest expense and $150x of 
other deductible expenses that are not definitely related to any gross 
income. USP's total tax book value of its assets, as determined under 
Sec. Sec. 1.861-9(g)(2) and 1.861-9T(g)(3), is divided equally between 
assets that generate foreign source general category income and assets 
that generate U.S. source income. USP elects under paragraph (e)(1)(i) 
of this section to not take into account the amount described in 
paragraph (e)(1)(ii) of this section in determining its net operating 
loss under section 172 for the taxable year. Before taking into account 
the section 965(n) election, USP's total deductions are $280x ($210x + 
$70x) and USP's taxable income is $20x ($100x + $50x + $150x-$70x-
$210x).
    (B) Analysis. (1) The amount described in paragraph (e)(1)(ii) of 
this section is $80x ($100x section 965(a) inclusion-$70x section 965(c) 
deduction + $50x section 78 dividends). Not taking into account the $80x 
creates a net operating loss under section 172 of $60x ($20x taxable 
income without regard to the section 965(n) election-$80x) for the 
taxable year (the ``deferred amount''). Under paragraph (e)(1)(i) of 
this section, the deferred amount of $60x constitutes a net operating 
loss and is not allowed as a deduction for the taxable year. USP's 
taxable income for the year is $80x ($100x + $50x + $150x-($280x-$60x)).
    (2) Under paragraph (e)(1)(iv)(B)(1) of this section, deductions are 
allocated and apportioned under Sec. Sec. 1.861-8 through 1.861-17 to 
the relevant statutory and residual groupings, taking into account the 
amount described in paragraph (e)(1)(ii) of this section. Under Sec. 
1.861-8(b), USP's section 965(c) deduction is definitely related to the 
section 965(a) inclusion, and, therefore, is allocated solely to foreign 
source general category income. Under Sec. 1.861-9T, based on USP's 
asset values, the interest expense of $60x is ratably apportioned $30x 
to foreign source general category income and $30x to U.S. source 
income. Under Sec. 1.861-8(c)(3), based on $150x of gross U.S. source 
income and $150x of gross foreign source general category income, the 
other expenses of $150x are ratably apportioned $75x to foreign source 
general category income and $75x to U.S. source income. Therefore, USP's 
deductions allocated and apportioned to foreign source general category 
income are $175x ($70x + $30x + $75x) and its deductions allocated and 
apportioned to U.S. source income are $105x ($30x + $75x).
    (3) Under paragraph (e)(1)(iv)(B)(2) of this section, the deferred 
amount of $60x comprises a ratable portion of the allocated and 
apportioned deductions. Therefore, $37.5x ($60x x $175x/$280x) of the 
deferred amount comprises deductions allocated and apportioned to 
foreign source general category income, and $22.5x ($60x x $105x/$280x) 
comprises deductions allocated and apportioned to U.S. source income.
    (4) Under paragraph (e)(1)(iv)(B)(3) of this section, for purposes 
of the separate foreign tax credit limitation under section 904, foreign 
source general category income for the taxable year is computed without 
taking into account the $37.5x of the deferred amount that is 
attributable to the deductions allocated and apportioned to the foreign 
source general category. Therefore, for the 2017 taxable year, foreign 
source general category income is $12.5x ($100x section 965(a) inclusion 
+ $50x section 78 dividends-($175x deductions-$37.5x deferred amount). 
The remaining taxable income of $67.5x is U.S. source income.
    (ii) Example 2: Net operating loss carryover to the inclusion year--
(A) Facts. USP, a domestic corporation, has a section 965(a) inclusion 
of $100x and has a section 965(c) deduction of $60x for its taxable year 
ending December 31, 2017. USP also includes in gross income the amount 
treated as dividends under section 78 of $40x (the foreign taxes deemed 
paid under section 960(a) for the taxable year with respect to USP's 
section 965(a) inclusion). The section 965(a) inclusion and the section 
78 dividends are foreign source general category income. USP also has 
U.S. source gross income of $200x, foreign source

[[Page 567]]

passive category gross income of $100x, and other deductions of $140x. 
Under Sec. 1.861-8(b), USP's $60x section 965(c) deduction is 
definitely related to the section 965(a) inclusion, and, therefore, is 
allocated solely to foreign source general category income. Under 
Sec. Sec. 1.861-8 through 1.861-17, USP allocates and apportions the 
other $140x of deductions as follows: $40x to foreign source general 
category income, $40x to foreign source passive category income, and 
$60x to U.S. source income. USP has a net operating loss of $260x for 
the 2016 taxable year consisting of a $120x U.S. source loss, a $75x 
general category separate limitation loss, and a $65x passive category 
separate limitation loss. Under paragraph (e)(1)(i) of this section, USP 
elects to not take into account the amount described in paragraph 
(e)(1)(ii) of this section in determining the amount of taxable income 
that may be reduced by net operating loss carryovers and carrybacks to 
the taxable year under section 172. USP's taxable income before taking 
into account the section 965(n) election and any net operating loss 
carryover deduction is $240x:

                                       Table 1 to Paragraph (e)(3)(ii)(A)
----------------------------------------------------------------------------------------------------------------
                                                      General         Passive          U.S.            Total
----------------------------------------------------------------------------------------------------------------
Section 965(a) inclusion........................           $100x  ..............  ..............           $100x
Section 78 dividend.............................             40x  ..............  ..............             40x
Other gross income..............................  ..............            100x            200x            300x
Section 965(c) deduction........................           (60x)  ..............  ..............           (60x)
Other deductions................................           (40x)           (40x)           (60x)          (140x)
                                                 ---------------------------------------------------------------
    Net Income..................................             40x             60x            140x            240x
----------------------------------------------------------------------------------------------------------------

    (B) Analysis--(1) The amount described in paragraph (e)(1)(ii) of 
this section is $80x ($100x section 965(a) inclusion-$60x section 965(c) 
deduction + $40x section 78 dividends). As a result of the section 
965(n) election, the net operating loss deduction allowed in the 2017 
taxable year is reduced from $240x to $160x (the amount of USP's taxable 
income reduced by the amount described in paragraph (e)(1)(ii) of this 
section).
    (2) Under paragraph (e)(1)(iv)(B)(1) of this section, the source and 
separate category of the net operating loss deduction allowed in the 
2017 taxable year is determined under the rules of Sec. 1.904(g)-3(b), 
taking into account the amount described in paragraph (e)(1)(ii) of this 
section. Under Sec. 1.904(g)-3(b)(3)(i), first the $120x U.S. source 
component of the net operating loss is allocated to U.S. source income 
for the 2017 taxable year. Because the total tentative carryover under 
Sec. 1.904(g)-3(b)(3)(ii) of $100x ($40x in the general category and 
$60x in the passive category) exceeds the remaining net operating loss 
deduction of $40x ($160x-$120x), the tentative carryover amount from 
each separate category is reduced proportionately, to $16x ($40x x $40x/
$100x) for the general category and $24x ($40x x $60x/$100x) for the 
passive category. Accordingly, $16x of the general category component of 
the net operating loss is carried forward, and $24x of the passive 
category component of the net operating loss is carried forward and 
combined with income in the same respective categories for the 2017 
taxable year. After allocation of the net operating loss carryover from 
2016, USP's taxable income for the 2017 taxable year is as follows:

                                      Table 1 to Paragraph (e)(3)(ii)(B)(2)
----------------------------------------------------------------------------------------------------------------
                                                      General         Passive          U.S.            Total
----------------------------------------------------------------------------------------------------------------
Net income before NOL deduction.................            $40x            $60x           $140x           $240x
NOL deduction...................................           (16x)           (24x)          (120x)          (160x)
    Net income after NOL deduction..............             24x             36x             20x             80x
----------------------------------------------------------------------------------------------------------------


[[Page 568]]

    (f) Election to use alternative method for calculating post-1986 
earnings and profits--(1) Effect of election for specified foreign 
corporations that do not have a 52-53-week taxable year. If an election 
is made under this paragraph (f) with respect to a specified foreign 
corporation that does not have a 52-53-week taxable year, the amount of 
the post-1986 earnings and profits (including a deficit) as of the E&P 
measurement date on November 2, 2017, is determined under paragraph 
(f)(3) of this section. The election described in this paragraph (f) is 
irrevocable. A specified foreign corporation that does not have a 52-53-
week taxable year may not use the alternative method of determination in 
paragraph (f)(3) of this section for purposes of determining its post-
1986 earnings and profits on the E&P measurement date on December 31, 
2017.
    (2) Effect of election for specified foreign corporations that have 
a 52-53-week taxable year. If an election is made under this paragraph 
(f) with respect to a specified foreign corporation that has a 52-53-
week taxable year, the amount of the post-1986 earnings and profits 
(including a deficit) as of both E&P measurement dates is determined 
under paragraph (f)(3) of this section. The election described in this 
paragraph (f) is irrevocable.
    (3) Computation of post-1986 earnings and profits using alternative 
method. With respect to an E&P measurement date, the post-1986 earnings 
and profits of a specified foreign corporation for which an election is 
properly made equals the sum of--
    (i) The specified foreign corporation's post-1986 earnings and 
profits (including a deficit) determined as of the notional measurement 
date, as if it were an E&P measurement date, plus
    (ii) The specified foreign corporation's annualized earnings and 
profits amount with respect to the notional measurement date.
    (4) Definitions--(i) 52-53-week taxable year. The term 52-53-week 
taxable year means a taxable year described in Sec. 1.441-2(a)(1).
    (ii) Annualized earnings and profits amount. The term annualized 
earnings and profits amount means, with respect to a specified foreign 
corporation, an E&P measurement date, and a notional measurement date, 
the amount equal to the product of the number of days between the 
notional measurement date and the E&P measurement date (not including 
the former, but including the latter) multiplied by the daily earnings 
amount of the specified foreign corporation. The annualized earnings and 
profits amount is expressed as a negative number if the E&P measurement 
date precedes the notional measurement date.
    (iii) Daily earnings amount. The term daily earnings amount means, 
with respect to a specified foreign corporation and a notional 
measurement date, the post-1986 earnings and profits (including a 
deficit) of the specified foreign corporation determined as of the close 
of the notional measurement date that were earned (or incurred) during 
the specified foreign corporation's taxable year that includes the 
notional measurement date, divided by the number of days that have 
elapsed in such taxable year as of the close of the notional measurement 
date.
    (iv) Notional measurement date. The term notional measurement date 
means--
    (A) With respect to an E&P measurement date of a specified foreign 
corporation with a 52-53-week taxable year, the closest end of a fiscal 
month to such E&P measurement date, and
    (B) With respect to the E&P measurement date on November 2, 2017, of 
all specified foreign corporations not described in paragraph 
(f)(4)(iv)(A) of this section, October 31, 2017.
    (5) Manner of making election--(i) Eligibility. An election with 
respect to a specified foreign corporation to use the alternative method 
of calculating post-1986 earnings and profits as of an E&P measurement 
date pursuant to this paragraph (f) must be made on behalf of the 
specified foreign corporation by a controlling domestic shareholder (as 
defined in Sec. 1.964-1(c)(5)) pursuant to the rules of Sec. 1.964-
1(c)(3), except that the controlling domestic shareholder is not 
required to file the statement described in Sec. 1.964-1(c)(3)(ii).
    (ii) Timing. An election under this paragraph (f) must be made no 
later than the due date (taking into account extensions, if any) for the 
person's return for the first taxable year in which

[[Page 569]]

the person has a section 965(a) inclusion amount with respect to the 
specified foreign corporation or in which the person takes into account 
a specified E&P deficit with respect to the specified corporation for 
purposes of computing a section 965(a) inclusion amount with respect to 
another specified foreign corporation. Relief is not available under 
Sec. 301.9100-2 or Sec. 301.9100-3 to make a late election.
    (iii) Election statement. Except as otherwise provided in 
publications, forms, instructions, or other guidance, to make an 
election under this paragraph (f), a person must attach a statement, 
signed under penalties of perjury consistent with the rules for 
signatures applicable to the person's return, to the person's return for 
the taxable year described in paragraph (f)(5)(ii) of this section. The 
statement must include the person's name, taxpayer identification 
number, and the name and taxpayer identification number, if any, of each 
of the specified foreign corporations with respect to which the election 
is made, and the statement must be filed in the manner prescribed in 
instructions or other guidance. The attachment of an unsigned copy of 
the election statement to the timely-filed return for the relevant 
taxable year satisfies the signature requirement of this paragraph 
(f)(5)(iii) if the person making the election retains the original 
signed election statement in the manner specified by Sec. 1.6001-1(e).
    (6) Examples. The following examples illustrate the application of 
this paragraph (f).

    Example 1. (i)(A) Facts. FS, a foreign corporation, has a calendar 
year taxable year, and as of October 31, 2017, FS has post-1986 earnings 
and profits of 10,000u, 3,040u of which were earned during the taxable 
year that includes October 31, 2017. An election is properly made under 
paragraph (f)(5) of this section with respect to FS, allowing FS to 
determine its post-1986 earnings and profits under the alternative 
method with respect to its E&P measurement date on November 2, 2017.
    (B) Analysis. As of the close of October 31, 2017, the notional 
measurement date with respect to the E&P measurement date on November 2, 
2017, 304 days have elapsed in the taxable year of FS that includes 
October 31, 2017. Therefore, FS's daily earnings amount is 10u (3,040u 
divided by 304), and FS's annualized earnings and profits amount is 20u 
(10u multiplied by 2 (the number of days between the notional 
measurement date on October 31, 2017, and the E&P measurement date on 
November 2, 2017)). Accordingly, FS's post-1986 earnings and profits as 
of November 2, 2017, are 10,020u (its post-1986 earnings and profits as 
of October 31, 2017 (10,000u), plus its annualized earnings and profits 
amount (20u)).
    Example 2. (ii)(A) Facts. The facts are the same as in paragraph 
(f)(6)(i)(A) of this section (the facts in Example 1), except that a 
deficit of 3,040u was incurred during the taxable year that includes 
October 31, 2017.
    (B) Analysis. The analysis is the same as in paragraph (f)(6)(i)(B) 
of this section (the analysis in Example 1), except that FS's daily 
earnings amount is (10u) ((3,040u) divided by 304), and FS's annualized 
earnings and profits amount is (20u) ((10u) multiplied by 2 (the number 
of days between the notional measurement date on October 31, 2017, and 
the E&P measurement date on November 2, 2017)). Accordingly, FS's post-
1986 earnings and profits as of November 2, 2017, are 9,980u (its post-
1986 earnings and profits as of October 31, 2017 (10,000u), plus its 
annualized earnings and profits amount ((20u))).

    (g) Definitions. This paragraph (g) provides definitions that apply 
for purposes of this section.
    (1) Deferred net tax liability. The term deferred net tax liability 
means, with respect to any taxable year of a person, the amount of the 
section 965(i) net tax liability the payment of which has been deferred 
under section 965(i) and paragraph (c) of this section.
    (2) REIT section 965 amounts. The term REIT section 965 amounts 
means, with respect to a real estate investment trust and a taxable year 
of the real estate investment trust, the aggregate amount of section 
965(a) inclusions and section 965(c) deductions that would (but for 
section 965(m)(1)(B) and paragraph (d) of this section) be taken into 
account in determining the real estate investment trust's income for the 
taxable year.
    (3) Section 965(h) election. The term section 965(h) election means 
the election described in section 965(h)(1) and paragraph (b)(1) of this 
section.
    (4) Section 965(h) net tax liability. The term section 965(h) net 
tax liability means, with respect to a person that has made a section 
965(h) election, the total net tax liability under section 965 reduced 
by the aggregate amount of

[[Page 570]]

the person's section 965(i) net tax liabilities, if any, with respect to 
which section 965(i) elections are effective.
    (5) Section 965(i) election. The term section 965(i) election means 
the election described in section 965(i)(1) and paragraph (c)(1) of this 
section.
    (6) Section 965(i) net tax liability. The term section 965(i) net 
tax liability means, with respect to an S corporation and a shareholder 
of the S corporation, in the case in which a section 965(i) election is 
made, the amount determined pursuant to paragraph (g)(10)(i) of this 
section by adding before the word ``over'' in (g)(10)(i)(A) of this 
section ``determined as if the only section 965(a) inclusions included 
in income by the person are domestic pass-through entity shares of 
section 965(a) inclusions by the S corporation with respect to deferred 
foreign income corporations of which the S corporation is a United 
States shareholder.''
    (7) Section 965(m) election. The term section 965(m) election means 
the election described in section 965(m)(1)(B) and paragraph (d)(1) of 
this section.
    (8) Section 965(n) election. The term section 965(n) election means 
the election described in section 965(n)(1) and paragraph (e)(1)(i) of 
this section.
    (9) Specified individual. The term specified individual means, with 
respect to a taxable year, a person described in Sec. 1.6081-5(a)(5) or 
(6) who receives an extension of time to file and pay under Sec. 
1.6081-5(a) for the taxable year.
    (10) Total net tax liability under section 965--(i) General rule. 
The term total net tax liability under section 965 means, with respect 
to a person, the excess (if any) of--
    (A) The person's net income tax for the taxable year in which the 
person includes a section 965(a) inclusion in income, over--
    (B) The person's net income tax for the taxable year determined--
    (1) Without regard to section 965, and
    (2) Without regard to any income, deduction, or credit properly 
attributable to a dividend received (directly or through a chain of 
ownership described in section 958(a)) by the person (or, in the case of 
a domestic pass-through owner, by the person's domestic pass-through 
entity) from, or an inclusion under sections 951(a)(1)(B) and 956 with 
respect to, a deferred foreign income corporation and paid during, or 
included with respect to, the deferred foreign income corporation's 
inclusion year.
    (ii) Net income tax. For purposes of this paragraph (g)(10), the 
term net income tax means the regular tax liability (as defined in 
section 26(b)) reduced by the credits allowed under subparts A, B, and D 
of part IV of subchapter A of chapter 1 of subtitle A of the Internal 
Revenue Code.
    (iii) Foreign tax credits. The foreign tax credit disregarded in 
determining net income tax determined under paragraph (g)(10)(i)(B) of 
this section includes the credit for foreign income taxes deemed paid 
with respect to section 965(a) inclusions or foreign income taxes deemed 
paid with respect to a dividend, including a distribution that would 
have been treated as a dividend in the absence of section 965. The 
foreign tax credit disregarded under paragraph (g)(10)(i)(B) of this 
section also includes the credit for foreign income taxes imposed on 
distributions of section 965(a) previously taxed earnings and profits or 
965(b) previously taxed earnings and profits made in the taxable year in 
which the person includes a section 965(a) inclusion in income.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9846, 84 FR 
14261, Apr. 10, 2019; T.D. 9866, 84 FR 29365, June 21, 2019; T.D. 9882, 
84 FR 69120, Dec. 17, 2019]



Sec. 1.965-8  Affiliated groups (including consolidated groups).

    (a) Scope. This section provides rules for applying section 965 and 
the section 965 regulations to members of an affiliated group (as 
defined in section 1504(a)), including members of a consolidated group 
(as defined in Sec. 1.1502-1(h)). Paragraph (b) of this section 
provides guidance regarding the application of section 965(b)(5) to 
determine the section 965(a) inclusion amounts of a member of an 
affiliated group. Paragraph (c) of this section provides guidance for 
designating the source of aggregate unused E&P deficits. Paragraph (d) 
provides rules regarding earning and profits and stock basis 
adjustments. Paragraph (e) of this section provides rules that treat 
members of a consolidated group as a single person

[[Page 571]]

for certain purposes. Paragraph (f) of this section provides definitions 
that apply for purposes of this section. Paragraph (g) of this section 
provides examples illustrating the application of this section.
    (b) Reduction of E&P net surplus shareholder's pro rata share of the 
section 965(a) earnings amount of a deferred foreign income corporation 
by the allocable share of the applicable share of the aggregate unused 
E&P deficit--(1) In general. This paragraph (b) applies after the 
application of Sec. 1.965-1(b)(2) for purposes of determining the 
section 965(a) inclusion amount with respect to a deferred foreign 
income corporation of a section 958(a) U.S. shareholder that is both an 
E&P net surplus shareholder and a member of an affiliated group in which 
not all members are members of the same consolidated group. If this 
paragraph (b) applies, the U.S. dollar amount of the section 958(a) U.S. 
shareholder's pro rata share of the section 965(a) earnings amount of 
the deferred foreign income corporation is further reduced (but not 
below zero) by the deferred foreign income corporation's allocable share 
of the section 958(a) U.S. shareholder's applicable share of the 
affiliated group's aggregate unused E&P deficit.
    (2) Consolidated group as part of an affiliated group. If some, but 
not all, members of an affiliated group are members of a consolidated 
group, then the consolidated group is treated as a single member of the 
affiliated group for purposes of Sec. 1.965-1(b)(2) and paragraph 
(b)(1) of this section.
    (c) Designation of portion of excess aggregate foreign E&P deficit 
taken into account--(1) In general. This paragraph (c) provides rules 
for designating the source of an aggregate unused E&P deficit of an 
affiliated group that is not also a consolidated group taken into 
account under section 965(b)(5) and paragraph (b) of this section if the 
amount described in paragraph (f)(1)(i)(A) of this section with respect 
to the affiliated group exceeds the amount described in paragraph 
(f)(1)(i)(B) of this section with respect to the affiliated group. If 
this paragraph (c)(1) applies, each member of the affiliated group that 
is an E&P net deficit shareholder must designate by maintaining in its 
books and records a statement (identical to the statement maintained by 
all other such members) setting forth the portion of the excess 
aggregate foreign E&P deficit of the E&P net deficit shareholder taken 
into account under section 965(b)(5) and paragraph (b) of this section. 
See Sec. 1.965-2(d)(2)(ii)(B) for a rule for designating the portion of 
a section 958(a) U.S. shareholder's pro rata share of a specified E&P 
deficit of an E&P deficit foreign corporation taken into account under 
section 965(b), Sec. 1.965-1(b)(2), and paragraph (b) of this section, 
as applicable.
    (2) Consolidated group as part of an affiliated group. If some, but 
not all, members of an affiliated group are properly treated as members 
of a consolidated group, then the consolidated group is treated as a 
single member of the affiliated group for purposes of applying paragraph 
(c)(1) of this section.
    (d) Adjustments to earning and profits and stock basis.
    (1) [Reserved]
    (2) Consolidated groups. See Sec. 1.1502-33(d)(1) for adjustments 
to members' earnings and profits and Sec. 1.1502-32(b)(3) for 
adjustments to members' basis.
    (e) Treatment of a consolidated group or other affiliated group as a 
single section 958(a) U.S. shareholder or a single person--(1) In 
general. All members of a consolidated group that are section 958(a) 
U.S. shareholders of a specified foreign corporation are treated as a 
single section 958(a) U.S. shareholder for purposes of section 965(b), 
Sec. 1.965-1(b)(2), and Sec. 1.965-3. Furthermore, all members of a 
consolidated group are treated as a single person for purposes of 
paragraphs (h), (k), and (n) of section 965 and Sec. 1.965-7. In 
addition, all members of an affiliated group that are section 958(a) 
U.S. shareholders of a specified foreign corporation are treated as a 
single section 958(a) U.S. shareholder for purposes of Sec. 1.965-2(f). 
Thus, for example, any election governed by section 965(h) and Sec. 
1.965-7(b) must be made by the agent (within the meaning of Sec. 
1.1502-77) of the group as a single election on behalf of all members of 
the consolidated group. Similarly, the determination of whether the 
transfer of assets by one member to a non-member of the consolidated 
group would

[[Page 572]]

constitute an acceleration event under Sec. 1.965-7(b)(3)(ii)(B) takes 
into account all of the assets of the consolidated group, which for 
purposes of this determination, includes all of the assets of each 
consolidated group member. In analyzing issues relating to the transfer 
of assets of a consolidated group, appropriate adjustments are made to 
prevent the duplication of assets or asset value.
    (2) Limitation. Paragraph (e)(1) of this section does not apply to 
treat all members of a consolidated group as a single section 958(a) 
U.S. shareholder or a single person, as applicable, for purposes of 
determining the amount of any member's inclusion under section 951 
(including a section 965(a) inclusion), the foreign income taxes deemed 
paid with respect to a section 965(a) inclusion (see sections 960 and 
902), or any purpose other than those specifically listed in paragraph 
(e)(1) of this section or another provision of the section 965 
regulations.
    (3) Determination of section 965(c) deduction amount. For purposes 
of determining the section 965(c) deduction amount of any section 958(a) 
U.S. shareholder that is a member of a consolidated group, the aggregate 
foreign cash position of the section 958(a) U.S. shareholder is equal to 
the aggregate section 965(a) inclusion amount of the section 958(a) U.S. 
shareholder multiplied by the group cash ratio of the consolidated 
group.
    (f) Definitions. This paragraph (f) provides definitions that apply 
for purposes of applying the section 965 regulations to members of an 
affiliated group, including members of a consolidated group.
    (1) Aggregate unused E&P deficit--(i) General rule. The term 
aggregate unused E&P deficit means, with respect to an affiliated group, 
the lesser of--
    (A) The sum of the excess aggregate foreign E&P deficit with respect 
to each E&P net deficit shareholder that is a member of the affiliated 
group, or
    (B) The amount determined under paragraph (f)(3)(ii) of this 
section.
    (ii) Reduction with respect to E&P net deficit shareholders that are 
not wholly owned by the affiliated group. If the group ownership 
percentage of an E&P net deficit shareholder is less than 100 percent, 
the amount of the excess aggregate foreign E&P deficit with respect to 
the E&P net deficit shareholder that is taken into account under 
paragraph (f)(1)(i) of this section is the product of the group 
ownership percentage multiplied by the excess aggregate foreign E&P 
deficit.
    (2) Allocable share. The term allocable share means, with respect to 
a deferred foreign income corporation and an E&P net surplus 
shareholder's applicable share of an aggregate unused E&P deficit of an 
affiliated group, the product of the E&P net surplus shareholder's 
applicable share of the affiliated group's aggregate unused E&P deficit 
and the ratio described in Sec. 1.965-1(f)(11) with respect to the 
deferred foreign income corporation.
    (3) Applicable share. The term applicable share means, with respect 
to an E&P net surplus shareholder and an aggregate unused E&P deficit of 
an affiliated group, the amount that bears the same proportion to the 
affiliated group's aggregate unused E&P deficit as--
    (i) The product of--
    (A) The E&P net surplus shareholder's group ownership percentage, 
multiplied by
    (B) The amount that would (but for section 965(b)(5) and paragraph 
(b) of this section) constitute the E&P net surplus shareholder's 
aggregate section 965(a) inclusion amount, bears to
    (ii) The aggregate amount determined under paragraph (f)(3)(i) of 
this section with respect to all E&P net surplus shareholders that are 
members of the group.
    (4) Consolidated group aggregate foreign cash position. The term 
consolidated group aggregate foreign cash position means, with respect 
to a consolidated group, the aggregate foreign cash position (as defined 
in Sec. 1.965-1(f)(8)(i)) determined by treating each member of the 
consolidated group that is a section 958(a) U.S. shareholder as a single 
section 958(a) U.S. shareholder pursuant to paragraph (e)(1) of this 
section.
    (5) E&P net deficit shareholder. The term E&P net deficit 
shareholder means a section 958(a) U.S. shareholder that has an excess 
aggregate foreign E&P deficit.

[[Page 573]]

    (6) E&P net surplus shareholder. The term E&P net surplus 
shareholder means a section 958(a) U.S. shareholder that would (but for 
section 965(b)(5) and paragraph (b) of this section) have an aggregate 
section 965(a) inclusion amount greater than zero.
    (7) Excess aggregate foreign E&P deficit. The term excess aggregate 
foreign E&P deficit means, with respect to a section 958(a) U.S. 
shareholder, the amount, if any, by which the amount described in Sec. 
1.965-1(f)(9)(i) with respect to the section 958(a) U.S. shareholder 
exceeds the amount described in Sec. 1.965-1(f)(9)(ii) with respect to 
the section 958(a) U.S. shareholder.
    (8) Group cash ratio. The term group cash ratio means, with respect 
to a consolidated group, the ratio of--
    (i) The consolidated group aggregate foreign cash position, to
    (ii) The sum of the aggregate section 965(a) inclusion amounts of 
all members of the consolidated group.
    (9) Group ownership percentage. The term group ownership percentage 
means, with respect to a section 958(a) U.S. shareholder that is a 
member of an affiliated group, the percentage of the value of the stock 
of the United States shareholder which is held by other includible 
corporations in the affiliated group. Notwithstanding the preceding 
sentence, the group ownership percentage of the common parent of the 
affiliated group is 100 percent. Any term used in this paragraph (f)(9) 
that is also used in section 1504 has the same meaning as when used in 
such section. Additionally, if the term is used in the context of a rule 
for which all members of a consolidated group are treated as a single 
section 958(a) U.S. shareholder under paragraph (e)(1) of this section, 
then the group ownership percentage is determined solely with respect to 
the value of the stock of the common parent of the consolidated group 
held by other includible corporations that are not members of the 
consolidated group.
    (g) Examples. The following examples illustrate the application of 
this section.

    Example 1. (1) Application of affiliated group rule--(i) Facts--(A) 
In general. USP owns all of the stock of USS1, USS2, and USS3. Each of 
USP, USS1, USS2, and USS3 is a domestic corporation and is a member of 
an affiliated group of which USP is the common parent (the ``USP 
Group''). The USP Group has not elected to file a consolidated federal 
income tax return. USS1 owns all of the stock of CFC1 and CFC2, USS2 
owns all of the stock of CFC3, and USS3 owns all of the stock of CFC4. 
Each of CFC1, CFC2, CFC3, and CFC4 is a controlled foreign corporation 
within the meaning of section 957(a), and, therefore, each is a 
specified foreign corporation under section 965(e) and Sec. 1.965-
1(f)(45). Each of USP, USS1, USS2, USS3, CFC1, CFC2, CFC3, and CFC4 has 
the calendar year as its taxable year.
    (B) Facts relating to section 965. CFC1 and CFC3 are deferred 
foreign income corporations with section 965(a) earnings amounts of 
$600x and $300x, respectively. CFC1 and CFC3 have cash positions of $0x 
and $50x, respectively, on each of their cash measurement dates. CFC2 
and CFC4 are E&P deficit foreign corporations with specified E&P 
deficits of $400x and $100x, respectively. CFC2 and CFC4 have cash 
positions of $100x and $50x, respectively, on each of their cash 
measurement dates. The cash positions all consist solely of cash. CFC1, 
CFC2, CFC3, and CFC4 all use the U.S. dollar as their functional 
currency.
    (ii) Analysis--(A) Section 965(a) inclusion amounts before 
application of section 965(b)(5). USS1 is a section 958(a) U.S. 
shareholder with respect to CFC1 and CFC2; USS2 is a section 958(a) U.S. 
shareholder with respect to CFC3; and USS3 is a section 958(a) U.S. 
shareholder with respect to CFC4. USS1's pro rata share of CFC1's 
section 965(a) earnings amount is $600x. Under section 965(b)(3)(A) and 
Sec. 1.965-1(f)(9), USS1's aggregate foreign E&P deficit is $400x, the 
lesser of the aggregate of USS1's pro rata share of the specified E&P 
deficit of each E&P deficit foreign corporation ($400x) and the amount 
described in Sec. 1.965-1(f)(9)(ii) with respect to USS1 ($600x). Under 
section 965(b) and Sec. 1.965-1(b)(2), in determining its section 
965(a) inclusion amount with respect to CFC1, USS1 reduces its pro rata 
share of the U.S. dollar amount of section 965(a) earnings amount of 
CFC1 by CFC1's allocable share of USS1's aggregate foreign E&P deficit. 
CFC1's allocable share of USS1's aggregate foreign E&P deficit is $400x, 
which is the product of USS1's aggregate foreign E&P deficit ($400x) and 
1, which is the ratio determined by dividing USS1's pro rata share of 
the section 965(a) earnings amount of CFC1 ($600x), by the amount 
described in Sec. 1.965-1(f)(9)(ii) with respect to USS1 ($600x). 
Accordingly, under section 965(b) and Sec. 1.965-1(b)(2) (before 
applying section 965(b)(5) and paragraph (b) of this section), USS1's 
section 965(a) inclusion amount with respect to CFC1 would be $200x 
(USS1's pro rata share of the section 965(a) earnings amount of CFC1 of 
$600x reduced by CFC1's allocable share of USS1's aggregate foreign E&P 
deficit of $400x). Under section 965(b)

[[Page 574]]

and Sec. 1.965-1(b)(2) (before applying section 965(b)(5) and paragraph 
(b) of this section), USS2's section 965(a) inclusion amount with 
respect to CFC3 would be $300x (USS2's pro rata share of the section 
965(a) earnings amount of CFC3).
    (B) Application of section 965(b)(5)--(1) Determination of E&P net 
surplus shareholders and E&P net deficit shareholders. USS1 is an E&P 
net surplus shareholder because it would have an aggregate section 
965(a) inclusion amount of $200x but for the application of section 
965(b)(5) and paragraph (b) of this section. USS2 is also an E&P net 
surplus shareholder because it would have an aggregate section 965(a) 
inclusion amount of $300x but for the application of section 965(b)(5) 
and paragraph (b) of this section. USS3 is an E&P net deficit 
shareholder because it has an excess aggregate foreign E&P deficit of 
$100x.
    (2) Determining section 965(a) inclusion amounts under section 
965(b)(5). Under section 965(b) and paragraph (b) of this section, for 
purposes of determining the section 965(a) inclusion amount of a section 
958(a) U.S. shareholder with respect to a deferred foreign income 
corporation, if, after applying Sec. 1.965-1(b)(2), the section 958(a) 
U.S. shareholder is an E&P net surplus shareholder, then the U.S. dollar 
amount of the section 958(a) U.S. shareholder's pro rata share of the 
section 965(a) earnings amount of the deferred foreign income 
corporation is further reduced (but not below zero) by the deferred 
foreign income corporation's allocable share of the section 958(a) U.S. 
shareholder's applicable share of the affiliated group's aggregate 
unused E&P deficit. USS3 is the only E&P net deficit shareholder in the 
USP Group, and, therefore, the aggregate unused E&P deficit of the USP 
Group is equal to USS3's excess aggregate foreign E&P deficit ($100x). 
The applicable share of the USP Group's aggregate unused E&P deficit of 
each of USS1 and USS2, respectively, is an amount that bears the same 
proportion to the USP Group's aggregate unused E&P deficit as the 
product of the group ownership percentage of USS1 and USS2, 
respectively, multiplied by the amount that would (but for section 
965(b)(5) and paragraph (b) of this section) constitute the aggregate 
section 965(a) inclusion amount of USS1 and USS2, respectively, bears to 
the aggregate of such amounts with respect to both USS1 and USS2. 
Therefore, USS1's applicable share of the USP Group's aggregate unused 
E&P deficit is $40 ($100x x ($200x/($200x + $300x))) and USS2's 
applicable share of the USP Group's aggregate unused E&P deficit is $60x 
($100x x ($300x/($200x + $300x))). Because USS1 is a section 958(a) U.S. 
shareholder with respect to only one deferred foreign income 
corporation, the entire $40x of USS1's applicable share of the USP 
Group's aggregate unused E&P deficit is treated as CFC1's allocable 
share of USS1's applicable share of the USP Group's aggregate unused E&P 
deficit, and thus USS1's section 965(a) inclusion amount with respect to 
CFC1 is reduced to $160x ($200x-$40x). Because USS2 is a section 958(a) 
U.S. shareholder with respect to only one deferred foreign income 
corporation, the entire $60x of USS2's applicable share of the USP 
Group's aggregate unused E&P deficit is treated as CFC3's allocable 
share of USS2's applicable share of the USP Group's aggregate unused E&P 
deficit, and thus USS2's section 965(a) inclusion amount with respect to 
CFC3 is reduced to $240x ($300x-$60x).
    (C) Aggregate foreign cash position. Under section 965(c) and Sec. 
1.965-1(c), a section 958(a) U.S. shareholder that includes a section 
965(a) inclusion amount in income is allowed a deduction equal to the 
section 965(c) deduction amount. The section 965(c) deduction amount is 
computed by taking into account the aggregate foreign cash position of 
the section 958(a) U.S. shareholder. Under Sec. 1.965-1(f)(8)(i), the 
aggregate foreign cash position of USS1 is $100x, and the aggregate 
foreign cash position of USS2 is $50x.
    (D) Section 965(c) deduction amount. The section 965(c) deduction 
amount of USS1 is $102x, which is equal to (i) USS1's 8 percent rate 
equivalent percentage (77.1428571%) of its 8 percent rate amount for 
USS1's 2017 year ($60x ($160x-$100x)), plus USS1's 15.5 percent rate 
equivalent percentage (55.7142857%) of its 15.5 percent rate amount for 
USS1's 2017 year ($100x). The section 965(c) deduction amount of USS2 is 
$174.43x, which is equal to (i) USS2's 8 percent rate equivalent 
percentage (77.1428571%) of its 8 percent rate amount for USS2's 2017 
year ($190x ($240x-$50x)), plus USS2's 15.5 percent rate equivalent 
percentage (55.7142857%) of its 15.5 percent rate amount for USS2's 2017 
year ($50x). Because USS3 has no section 965(a) inclusion amount, it has 
no section 965(c) deduction amount and therefore is not allowed a 
section 965(c) deduction.
    Example 2--(2) Application to members of a consolidated group--(i) 
Facts. The facts are the same as in paragraph (g)(1)(i) of this section 
(the facts in Example 1), except that the USP Group has elected to file 
a consolidated return.
    (ii) Analysis--(A) Section 965(a) inclusion amount--(1) Single 
section 958(a) U.S. shareholder treatment. Because each of USS1, USS2, 
and USS3 is a section 958(a) U.S. shareholder of a specified foreign 
corporation and is a member of a consolidated group, paragraph (e)(1) of 
this section applies to treat USS1, USS2, and USS3 as a single section 
958(a) U.S. shareholder for purposes of section 965(b) and Sec. 1.965-
1(b)(2).
    (2) Determination of inclusion amount. The single section 958(a) 
U.S. shareholder composed of USS1, USS2, and USS3 is a section 958(a) 
U.S. shareholder with respect to CFC1, CFC2, CFC3, and CFC4. Under Sec. 
1.965-1(b)(2),

[[Page 575]]

in determining USS1's section 965(a) inclusion amount, the single 
section 958(a) U.S. shareholder decreases its pro rata share of the U.S. 
dollar amount of the section 965(a) earnings amount of CFC1 by CFC1's 
allocable share of the aggregate foreign E&P deficit of the single 
section 958(a) U.S. shareholder. CFC1's allocable share of the aggregate 
foreign E&P deficit is $333.33x, which is the product of the aggregate 
foreign E&P deficit of the single section 958(a) U.S. shareholder ($500x 
($400x + $100x)) and .67, which is the ratio determined by dividing its 
pro rata share of the section 965(a) earnings amount of CFC1 ($600x) by 
the amount described in Sec. 1.965-1(f)(9)(ii) with respect to the 
single section 958(a) U.S. shareholder ($900x ($600x + $300x)). 
Therefore, USS1's section 965(a) inclusion amount with respect to CFC1 
is $266.67 (its pro rata share of the section 965(a) earnings amount of 
CFC1 ($600) less CFC1's allocable share of the aggregate foreign E&P 
deficit of the single section 958(a) U.S. shareholder ($333.33x)). 
Similarly, under Sec. 1.965-1(b)(2), in determining the section 965(a) 
inclusion amount of USS2, the single section 958(a) U.S. shareholder 
decreases its pro rata share of the U.S. dollar amount of the section 
965(a) earnings amount of CFC3 by CFC3's allocable share of the 
aggregate foreign E&P deficit of the single section 958(a) U.S. 
shareholder. CFC3's allocable share of the aggregate foreign E&P deficit 
is $166.67x, which is the product of the aggregate foreign E&P deficit 
of the single section 958(a) U.S. shareholder ($500x) and .33, which is 
the ratio determined by dividing its pro rata share of the section 
965(a) earnings amount of CFC3 ($300x) by the amount described in Sec. 
1.965-1(f)(9)(ii) with respect to the single section 958(a) U.S. 
shareholder ($900x ($600x + $300x)). Therefore, USS2's section 965(a) 
inclusion amount with respect to CFC3 is $133.33x (its pro rata share of 
the section 965(a) earnings amount of CFC3 ($300x) less CFC3's allocable 
share of the aggregate foreign E&P deficit of the single section 958(a) 
U.S. shareholder ($166.67x)).
    (B) Consolidated group aggregate foreign cash position. Because USS1 
and USS2 are members of a consolidated group, the aggregate foreign cash 
position of each of USS1 and USS2 is determined under paragraph (e)(3) 
of this section. Under paragraph (e)(3) of this section, the aggregate 
foreign cash position of each of USS1 and USS2 is equal to the aggregate 
section 965(a) inclusion amount of USS1 and USS2, respectively, 
multiplied by the group cash ratio of the USP Group, as determined 
pursuant to paragraph (f)(8) of this section. The group cash ratio of 
the USP Group is .50, which is the ratio of the USP Group's consolidated 
group aggregate foreign cash position ($200x ($50x + $100x + $50x)) and 
the sum of the aggregate section 965(a) inclusion amounts of all members 
of the USP Group ($400x ($266.67x + $133.33x)). Therefore, under 
paragraph (e)(3) of this section, the aggregate foreign cash positions 
of USS1 and USS2 are, respectively, $133.34x ($266.67x x ($200x/$400x)) 
and $66.67 ($133.33x x ($200x/400x)).
    (C) Section 965(c) deduction amount. The section 965(c) deduction 
amount of USS1 is $177.14x, which is equal to (i) USS1's 8 percent rate 
equivalent percentage (77.1428571%) of its 8 percent rate amount for 
USS1's 2017 year ($133.33x ($266.67x-$133.34x)), plus USS1's 15.5 
percent rate equivalent percentage (55.7142857%) of its 15.5 percent 
rate amount for USS1's 2017 year ($133.34x). The section 965(c) 
deduction amount of USS2 is $88.56x, which is equal to (i) USS2's 8 
percent rate equivalent percentage (77.1428571%) of its 8 percent rate 
amount for USS2's 2017 year ($66.66x ($133.33x-$66.67x)), plus USS2's 
15.5 percent rate equivalent percentage (55.7142857%) of its 15.5 
percent rate amount for USS2's 2017 year ($66.67x). Because USS3 has no 
section 965(a) inclusion amount, it has no section 965(c) deduction 
amount and therefore is not allowed a section 965(c) deduction.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9846, 84 FR 
14261, Apr. 10, 2019]



Sec. 1.965-9  Applicability dates.

    (a) In general. Except as otherwise provided in this section, 
Sec. Sec. 1.965-1 through 1.965-8 apply beginning the last taxable year 
of a foreign corporation that begins before January 1, 2018, and with 
respect to a United States person, beginning the taxable year in which 
or with which such taxable year of the foreign corporation ends.
    (b) Applicability dates for rules disregarding certain transactions. 
Section 1.965-4 applies regardless of whether, with respect to a foreign 
corporation, the transaction, effective date of a change in method of 
accounting, effective date of an entity classification election, or 
specified payment described in Sec. 1.965-4 occurred before the first 
day of the foreign corporation's last taxable year that begins before 
January 1, 2018, or, with respect to a United States person, the 
transaction, effective date of a change in method of accounting, 
effective date of an entity classification election, or specified 
payment described in Sec. 1.965-4 occurred before the first day of the 
taxable year of the United States person in which or with which the 
taxable year of the foreign corporation ends.
    (c) Applicability date for certain portions of Sec. 1.965-5. 
Paragraph (c)(1)(iii) of

[[Page 576]]

Sec. 1.965-5 applies to taxable years of foreign corporations that both 
begin after December 31, 2017, and end on or after December 4, 2018, and 
with respect to a United States person, to the taxable years in which or 
with which such taxable years of the foreign corporations end. Section 
1.965-5(b)(2) applies to taxable years of foreign corporations that end 
on or after December 16, 2019, and with respect to a United States 
person, to the taxable years in which or with which such taxable years 
of the foreign corporations end.

[T.D. 9846, 84 FR 1875, Feb. 5, 2019, as amended by T.D. 9882, 84 FR 
69120, Dec. 17, 2019; T.D. 9922, 85 FR 72072, Nov. 12, 2020]

                        export trade corporations



Sec. 1.970-1  Export trade corporations.

    (a) In general. Sections 970 through 972 provide in general that if 
a controlled foreign corporation is an export trade corporation for any 
taxable year, the subpart F income of such corporation shall, subject to 
limitations provided by section 970(a) and paragraph (b) of this 
section, be reduced by so much of such corporation's export trade income 
as constitutes foreign base company income. To the extent subpart F 
income of an export trade corporation is reduced under section 970 and 
this section, an amount is required by section 970(b) and paragraph (c) 
of this section to be included in gross income of United States 
shareholders of the corporation if there is a subsequent decrease in 
such corporation's investments in export trade assets. See section 
971(a) and paragraph (a) of Sec. 1.971-1 for definition of the term 
``export trade corporation'', section 971(b) and paragraph (b) of Sec. 
1.971-1 for definition of the term ``export trade income'', and section 
971(c) and paragraph (c) of Sec. 1.971-1 for definition of the term 
``export trade assets''.
    (b) Amount by which export trade income shall reduce subpart F 
income--(1) Deductible amount. The subpart F income, determined as 
provided in section 952 and the regulations thereunder but without 
regard to section 970 and this paragraph, of a controlled foreign 
corporation which is an export trade corporation for its taxable year 
shall be reduced by an amount equal to so much of its export trade 
income as constitutes foreign base company income for such taxable year, 
but only to the extent that such amount of export trade income does not 
exceed the limitation determined under subparagraph (2) of this 
paragraph for such taxable year. See section 972 and Sec. 1.972-1 for 
rules relating to the consolidation of export trade corporations for 
purposes of determining the limitations described in subparagraph (2) of 
this paragraph.
    (2) Limitation on the amount of export trade income deductible from 
subpart F income. The amount by which subpart F income of an export 
trade corporation may be reduced for any taxable year under subparagraph 
(1) of this paragraph may not exceed whichever of the following 
limitations is the smallest:
    (i) The amount which is equal to 150 percent of the export promotion 
expenses, as defined in section 971(d) and paragraph (d) of Sec. 1.971-
1, of the export trade corporation paid or incurred during the taxable 
year which are properly allocable to the receipt or the production of so 
much of its export trade income as constitutes foreign base company 
income for such taxable year;
    (ii) The amount which is equal to 10 percent of the gross receipts 
(other than from commissions, fees, or other compensation for services), 
plus 10 percent of the gross amount upon the basis of which are computed 
commissions, fees, or other compensation for services included in gross 
receipts, of the export trade corporation received or accrued during the 
taxable year from, or in connection with, the sale, installation, 
operation, maintenance, or use of property in respect of which such 
corporation derives export trade income which constitutes foreign base 
company income for such taxable year; or
    (iii) The amount which bears the same ratio to the increase in 
investments in export trade assets, as defined in section 970(c)(2) and 
paragraph (d)(2) of this section, of the export trade corporation for 
its taxable year as the export trade income which constitutes foreign 
base company income of such corporation for such taxable year bears to 
the entire export trade income of the corporation for such year.


[[Page 577]]



Under subdivision (ii) of this subparagraph, in the case of minimum or 
maximum fee arrangements, the determination shall be made on the basis 
of the actual gross amounts with respect to which such fees are paid, 
rather than on the basis of the amounts upon which such minimum or 
maximum fees are computed. All determinations of limitations under this 
subparagraph shall be made on an aggregate basis and not with respect to 
separate items or categories of income described in paragraph (b)(1) of 
Sec. 1.971-1.
    (3) Determination of export promotion expense limitation. For 
purposes of determining the limitation contained in subparagraph (2)(i) 
of this paragraph for any taxable year of the export trade corporation, 
there shall be taken into account with respect to those items or 
categories of export trade income which constitute foreign base company 
income the entire amount of those export promotion expenses which are 
directly related to such items or categories of income and a ratable 
part of any other export promotion expenses which are indirectly related 
to such items or categories of income, except that no export promotion 
expense shall be allocated to an item or category of income to which it 
clearly does not apply and no deduction allowable to such corporation 
under section 882(c) and the regulations thereunder shall be taken into 
account.
    (4) Application of section 482. The limitations provided in section 
970(a) and subparagraph (2) of this paragraph shall not affect the 
authority of the district director to apply the provisions of section 
482 and the regulations thereunder, relating to allocation of income and 
deductions among taxpayers.
    (5) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation A is a wholly owned subsidiary of 
domestic corporation M. Both corporations use the calendar year as the 
taxable year. For 1963, A Corporation's subpart F income determined 
under section 952 and the regulations thereunder is $35, the total of 
its gross receipts and gross amounts referred to in subparagraph (2)(ii) 
of this paragraph is $310, its export promotion expenses properly 
allocable to its export trade income which constitutes foreign base 
company income are $18, its increase in investments in export trade 
assets is $32, and its export trade income is $40, of which $30 
constitutes foreign base company income and $10 does not constitute 
foreign base company income. The subpart F income of A Corporation for 
1963 as reduced under section 970(a) is $11, determined as follows:

(i) Subpart F income....................................  ......     $35
(ii) Less: $30 export trade income which constitutes
 foreign base company income, but deduction not to
 exceed the smallest of the following limitations
 (smallest of (a), (b), or (c)):
    (a) 150 percent of allocable export promotion            $27
     expenses referred to in subparagraph (2)(i) of this
     paragraph (150% of $18)............................
    (b) 10 percent of gross receipts and gross amounts       $31
     referred to in subparagraph (2)(ii) of this
     paragraph (10% of $310)............................
    (c) Amount which bears to the increase in                $24     $24
     investments in export trade assets ($32) the same
     ratio as the export trade income which constitutes
     foreign base company income ($30) bears to total
     export trade income ($40) (75% [$30/$40] of $32)...
                                                                 =======
(iii) Subpart F income as reduced under section 970(a)..  ......      11
 

    Example 2. The facts are the same as in example 1, except that A 
Corporation's export promotion expenses properly allocable to export 
trade income which constitutes foreign base company income are $14 
instead of $18. The applicable limitation on the amount deductible from 
A Corporation's subpart F income for 1963 is $21 (150% of $14) instead 
of $24. The subpart F income as reduced under section 970(a) is $14 ($35 
less $21).
    Example 3. The facts are the same as in example 1, except that the 
total amount of A Corporation's gross receipts and gross amounts 
referred to in subparagraph (2)(ii) of this paragraph is $200 instead of 
$310. The applicable limitation on the amount deductible from A 
Corporation's subpart F income for 1963 is $20 (10 percent of $200) 
instead of $24. The subpart F income as reduced under section 970(a) is 
$15 ($35 less $20).
    Example 4. The facts are the same as in example 1, except that A 
Corporation derives its export trade income which constitutes foreign 
base company income of $30 in a service arrangement with M Corporation 
under which it receives as a fee 5 percent of the gross receipts from M 
Corporation's sales or a minimum fee of $30. Such gross receipts are 
$220. The gross amounts taken into account in determining the limitation 
under subparagraph (2)(ii) of this paragraph are $220. The applicable 
limitation on the amount deductible from A Corporation's subpart F 
income for 1963 is $22 (10 percent of $220) instead of $24. The subpart 
F income as reduced under section 970(a) is $13 ($35 minus $22).

[[Page 578]]

    Example 5. The facts are the same as in example 1, except that A 
Corporation derives its export trade income which constitutes foreign 
base company income of $30 in a service arrangement with M Corporation 
under which it receives as a fee 9 percent of the gross receipts from M 
Corporation's sales or a maximum fee of $30. Such gross receipts are 
$400. In such instance, the limitation under (ii)(b) of example 1 is $40 
(10 percent of $400) instead of $31. The applicable limitation on the 
amount deductible from A Corporation's subpart F income for 1963 is $24, 
the smallest of the three limitations. The subpart F income as reduced 
under section 970(a) is $11 ($35 less $24).

    (c) Withdrawal of previously excluded export trade income--(1) 
Inclusion of withdrawal in income of United States shareholders. If--
    (i) A controlled foreign corporation was an export trade corporation 
for any taxable year,
    (ii) Such corporation in any such taxable year derived subpart F 
income which, under the provisions of section 970(a) and paragraph (b) 
of this section, was reduced, and
    (iii) Such corporation has in a subsequent taxable year a decrease 
in investments in export trade assets,


every person who is a United States shareholder, as defined in section 
951(b), of such corporation on the last day of such subsequent taxable 
year on which such corporation is a controlled foreign corporation shall 
include in his gross income, under section 951(a)(1)(A)(ii) and the 
regulations thereunder as an amount to which section 955 (as in effect 
before the enactment of the Tax Reduction Act of 1975) applies, his pro 
rata share of the amount of such decrease in investments but only to the 
extent that such pro rata share does not exceed the limitations 
determined under subparagraph (2) of this paragraph. A United States 
shareholder's pro rata share of a controlled foreign corporation's 
decrease for any taxable year in investments in export trade assets 
shall be his pro rata share of such corporation's decrease for such year 
determined under section 970(c)(3) and paragraph (d)(3) of this section.
    (2) Limitations applicable in determining amount includible in 
income--(i) General. A United States shareholder's pro rata share of a 
controlled foreign corporation's decrease in investments in export trade 
assets for any taxable year of such corporation shall, for purposes of 
determining an amount to be included in the gross income for any taxable 
year of such shareholder, not exceed the lesser of the limitations 
determined under (a) and (b) of this subdivision:
    (a) Such shareholder's pro rata share of the sum of the controlled 
foreign corporation's earnings and profits (or deficit in earnings and 
profits) for the taxable year, computed as of the close of the taxable 
year without diminution by reason of any distributions made during the 
taxable year, plus his pro rata share of the sum of its earnings and 
profits (or deficits in earnings and profits) accumulated for prior 
taxable years beginning after December 31, 1962, or
    (b)(1) Such shareholder's pro rata share of the sum of the amounts 
by which the subpart F income of such controlled foreign corporation for 
prior taxable years was reduced under section 970(a) and paragraph (b) 
of this section, plus
    (2) Such shareholder's pro rata share of the sum of the amounts 
which were not included in the subpart F income of such controlled 
foreign corporation for such prior taxable years by reason of the 
application of section 972 and Sec. 1.972-1, minus
    (3) Such shareholder's pro rata share of the sum of the amounts 
which were previously included in his gross income for prior taxable 
years under section 951(a)(1)(A)(ii) by reason of the application of 
section 970(b) and this paragraph with respect to such controlled 
foreign corporation.


The net amount determined under (b) of this subdivision with respect to 
any stock owned by the United States shareholder shall be determined 
without taking into account any amount attributable to a period prior to 
the date on which such shareholder acquired such stock. See section 1248 
and the regulations thereunder for rules governing the treatment of gain 
from sales or exchanges of stock in certain foreign corporations.
    (ii) Treatment of earnings and profits. For purposes of determining 
earnings

[[Page 579]]

and profits of a controlled foreign corporation under subdivision (i) 
(a) of this subparagraph, such earnings and profits shall be considered 
not to include any amounts which are attributable to--
    (a) Amounts which are, or have been, included in the gross income of 
a United States shareholder of such controlled foreign corporation under 
section 951(a) (other than an amount included in the gross income of a 
United States shareholder under section 951(a)(1)(A)(ii) or section 
951(a)(1)(B) for the taxable year) and have not been distributed, or
    (b)(1) Amounts which for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) or would be so included under 
such section but for the fact that such amounts were distributed to such 
shareholder during the taxable year, or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subdivision apply only in determining the limitation 
on a United States shareholder's pro rata share of a controlled foreign 
corporation's decrease in investments in export trade assets. See 
section 959 and the regulations thereunder for limitations on the 
exclusion of previously taxed earnings and profits.
    (iii) Rules of application. The determinations made under 
subdivision (i) of this subparagraph for purposes of determining the 
United States shareholder's pro rata share of a controlled foreign 
corporation's decrease in investments in export trade assets for any 
taxable year shall be made on the basis of the stock such shareholder 
owns, within the meaning of section 958(a) and the regulations 
thereunder, in the controlled foreign corporation on the last day in the 
taxable year on which such corporation is a controlled foreign 
corporation even though such shareholder owned more or less stock in 
such corporation prior to that date. See section 972 and paragraph 
(b)(3) of Sec. 1.972-1 for rules relating to the allocation of a 
decrease in investments in export trade assets of export trade 
corporations in a consolidated chain of such corporations. See section 
951(a)(3) and the regulations thereunder for an additional limitation 
upon the amount of a United States shareholder's pro rata share 
determined under this paragraph.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation A, which has one class of stock 
outstanding, is a wholly owned subsidiary of domestic corporation M 
throughout 1963 and 1964. Both corporations use the calendar year as the 
taxable year. For 1963, A Corporation qualifies as an export trade 
corporation and its subpart F income, determined in accordance with the 
provisions of section 952 and the regulations thereunder, is reduced by 
$20 under the provisions of section 970(a) and paragraph (b) of this 
section. Section 972 is assumed not to apply to A Corporation. For 1964, 
A Corporation has a decrease of $8 in investments in export trade 
assets. For 1963 and 1964, A Corporation has earnings and profits of $30 
(determined under the provisions of subparagraph (2) of this paragraph). 
Corporation M's pro rata share of A Corporation's decrease in 
investments in export trade assets for 1964 which is includible in M 
Corporation's gross income for 1964 under section 951(a)(1)(A)(ii) by 
reason of the application of section 970(b) is $8, determined as 
follows:

(i) Corporation M's pro rata share of A              .....  .....     $8
 Corporation's decrease in investments in export
 trade assets for 1964 (100% of $8)................
(ii) Limitation on amount includible in gross
 income of M Corporation for 1964 (smaller of (a)
 or (b)):
  (a) Corporation M's pro rata share of A            .....    $30
   Corporation's earnings and profits for 1963 and
   1964 determined under subparagraph (2) of this
   paragraph (100% of $30).........................
  (b) Corporation M's pro rata share of amounts by     $20
   which the subpart F income of A Corporation for
   1963 was reduced under section 970(a) (100% of
   $20)............................................
  Plus: Corporation M's pro rata share of amounts        0
   which were not included in subpart F income of A
   Corporation for 1963 by reason of the
   application of section 972......................
                                                    -------
      Total........................................     20

[[Page 580]]

 
  Less: Corporation M's pro rata share of the sum        0     20
   of amounts which were previously included in
   gross income of M Corporation under section
   951(a)(1)(A)(ii) by reason of the application of
   section 970(b) with respect to A Corporation....
                                                    --------------
(iii) Corporation M's pro rata share includible in   .....  .....      8
 gross income for 1964 under section
 951(a)(1)(A)(ii) by reason of the application of
 section 970(b) (smaller of (i) or (ii))...........
 

    Example 2. Assume the same facts as in example 1, except that on 
February 14, 1965, M Corporation sells 25 percent of its stock in A 
Corporation to N Corporation. Corporation N is a domestic corporation 
which also uses the calendar year as a taxable year. For 1965, A 
Corporation has a decrease of $16 in investments in export trade assets. 
Corporation A's earnings and profits for 1963 and 1964 (determined under 
the provisions of subparagraph (2) of this paragraph) are $22 ($30 minus 
$8). Corporation A's earnings and profits for 1965 are $6 (determined 
under the provisions of subparagraph (2) of this paragraph). For 1965, M 
Corporation's pro rata share of A Corporation's decrease in investments 
in export trade assets which is includible in M Corporation's gross 
income under section 951(a)(1)(A)(ii) is $9, and N Corporation's pro 
rata share includible in gross income under such section is $0, 
determined as follows:

                              M Corporation
(i) Corporation M's pro rata share of A              .....  .....    $12
 Corporation's decrease in investments in export
 trade assets for 1965 (75% of $16)................
(ii) Limitation on amount includible in gross
 income of M Corporation for 1965 (smaller of (a)
 or (b)):
  (a) Corporation M's pro rata share of A            .....    $21
   Corporation's earnings and profits for 1963,
   1964, and 1965 determined under subparagraph (2)
   of this paragraph (75% of $28)..................
  (b) Corporation M's pro rata share of amounts by     $15
   which the subpart F income of A Corporation for
   1963 was reduced under section 970(a) (75% of
   $20)............................................
    Plus: Corporation M's pro rata share of amounts      0
     which were not included in subpart F income of
     A Corporation for 1963 and 1964 by reason of
     the application of section 972................
                                                    -------
      Total........................................    $15
  Less: Corporation M's pro rata share of the sum        6      9
   of amounts which were previously included in
   gross income of M Corporation under section
   951(a)(1)(A)(ii) by reason of the application of
   section 970(b) with respect to A Corporation
   (75% of $8).....................................
                                                    -------
(iii) Corporation M's pro rata share includible in   .....  .....      9
 gross income for 1965 under section
 951(a)(1)(A)(ii) by reason of the application of
 section 970(b) (smaller of (i) or (ii))...........
 
                              N Corporation
 
(i) Corporation N's pro rata share of A              .....  .....      0
 Corporation's decrease in investments in export
 trade assets for 1965 (25% of $16)................
(ii) Limitation on amount includible in gross
 income of N Corporation for 1965 (smaller of (a)
 or (b)):
  (a) Corporation N's pro rata share of A            .....     07
   Corporation's earnings and profits for 1963,
   1964, and 1965 determined under subparagraph (2)
   of this paragraph (25% of $28)..................
  (b) Corporation N's pro rata share of amounts by       0
   which the subpart F income of A Corporation for
   1963 was reduced under section 970(a) (amounts
   prior to 2/14/65 not being taken into account)..
    Plus: Corporation N's pro rata share of amounts      0
     which were not included in subpart F income of
     A Corporation for 1963 and 1964 by reason of
     the application of section 972 (amounts prior
     to 2/14/65 not being taken into account)......
                                                    -------
      Total........................................      0
  Less: Corporation N's pro rata share of the sum        0      0
   of amounts which were previously included in
   gross income of N Corporation under section
   951(a)(1)(A)(ii) by reason of the application of
   section 970(b) with respect to A Corporation
   (amounts prior to 2/14/65 not being taken into
   account)........................................
(iii) Corporation N's pro rata share includible in   .....  .....      0
 gross income for 1965 under section
 951(a)(1)(A)(ii) by reason of the application of
 section 970(b) (smaller of (i) or (ii))...........
 

    (d) Investments in export trade assets--(1) Amount of investments. 
For purposes of sections 970 through 972 and Sec. Sec. 1.970-1 to 
1.972-1, inclusive, export trade assets shall be taken into account on 
the following bases:
    (i) Working capital. Working capital to which section 971(c)(1) 
applies shall be taken into account at the adjusted basis of current 
assets, determined as of the applicable determination date,

[[Page 581]]

less any current liabilities (except as provided in subdivision (iii) of 
this subparagraph).
    (ii) Other export trade assets. Inventory to which section 971(c)(2) 
applies, facilities to which section 971(c)(3) applies, and evidences of 
indebtedness to which section 971(c)(4) applies, shall be taken into 
account at their adjusted bases as of the applicable determination date, 
reduced by any liabilities (except as provided in subdivision (iii) of 
this subparagraph) to which such property is subject on such date. To be 
taken into account under this subparagraph, a liability must constitute 
a specific charge against the property involved. Thus, a liability 
evidenced by an open account or a liability secured only by the general 
credit of the controlled foreign corporation will not be taken into 
account. On the other hand, if a liability constitutes a specific charge 
against several items of property and cannot definitely be allocated to 
any single item of property, the liability shall be apportioned against 
each of such items of property in that ratio which the adjusted basis of 
such item on the applicable determination date bears to the adjusted 
basis of all such items on such date. A liability in excess of the 
adjusted basis of the property which is subject to such liability will 
not be taken into account for the purpose of reducing the adjusted basis 
of other property which is not subject to such liability. See paragraph 
(c)(6) of Sec. 1.971-1 for treatment of export trade assets which 
constitute working capital to which section 971(c)(1) applies and which 
also constitute inventory to which section 971(c)(2) applies or 
evidences of indebtedness to which section 971(c)(4) applies.
    (iii) Treatment of certain liabilities. For purposes of subdivisions 
(i) and (ii) of this subparagraph, a current liability, or a specific 
charge created with respect to any item of property, principally for the 
purpose of artificially increasing or decreasing the amount of a 
controlled foreign corporation's investments in export trade assets 
shall be taken into account in such a manner as to properly reflect the 
controlled foreign corporation's investments in export trade assets; 
whether a specific charge or current liability is created principally 
for such purpose will depend upon all the facts and circumstances of 
each case. One of the factors that will be considered in making such a 
determination with respect to a loan is whether the loan is from a 
related person, as defined in section 954(d)(3) and paragraph (e) of 
Sec. 1.954-1.
    (iv) Statement required. If for purposes of this section a United 
States shareholder of a controlled foreign corporation reduces the 
adjusted basis of property which constitutes an export trade asset on 
the ground that such property is subject to a liability, he shall attach 
to his return a statement setting forth the adjusted basis of the 
property before the reduction and the amount and nature of the 
reduction.
    (2) Increase in investments in export trade assets. For purposes of 
section 970(a) and paragraph (b) of this section, the amount of increase 
in investments in export trade assets of a controlled foreign 
corporation for a taxable year shall be, except as provided in Sec. 
1.970-2, the amount by which--
    (i) The amount of its investments in export trade assets at the 
close of such taxable year, exceeds
    (ii) The amount of its investments in export trade assets at the 
close of the preceding taxable year.
    (3) Decrease in investments in export trade assets. For purposes of 
section 970(b) and paragraph (c) of this section, the amount of the 
decrease in investments in export trade assets of a controlled foreign 
corporation for a taxable year shall be, except as provided in Sec. 
1.970-2, the amount by which--
    (i) The amount of its investments in export trade assets at the 
close of the preceding taxable year, minus
    (ii) An amount equal to the excess of recognized losses over 
recognized gains on sales, exchanges, involuntary conversions, assets or 
other dispositions, of export trade during the taxable year, exceeds
    (iii) The amount of its investments in export trade assets at the 
close of the taxable year.


For purposes of subdivision (ii) of this subparagraph, recognized losses 
include a write-down of inventory to lower of cost or market in 
accordance with a method of inventory valuation established or adopted 
by or on behalf of

[[Page 582]]

such foreign corporation under paragraph (c) of Sec. 1.964-1.

[T.D. 6755, 29 FR 12704, Sept. 9, 1964, as amended by T.D. 6795, 30 FR 
947, Jan. 29, 1965; T.D. 6892, 31 FR 11144, Aug. 23, 1966; T.D. 7293, 38 
FR 32802, Nov. 28, 1973; T.D. 7893, 48 FR 22511, May 19, 1983]



Sec. 1.970-2  Elections as to date of determining investments 
in export trade assets.

    (a) Nature of elections--(1) In general. In lieu of determining the 
increase under the provisions of paragraph (d)(2) of Sec. 1.970-1, or 
the decrease under the provisions of paragraph (d)(3) of Sec. 1.970-1, 
in a controlled foreign corporation's investments in export trade assets 
for a taxable year in the manner provided in such provisions, a United 
States shareholder of such corporation may elect, under the provisions 
of section 970(c)(4) and this section, to determine such increase or 
decrease in accordance with the provisions of subparagraph (2) of this 
paragraph or, in the case of export trade assets which are facilities 
described in section 971(c)(3), in accordance with the provisions of 
subparagraph (3) of this paragraph. Separate elections may be made under 
subparagraph (2) and/or (3) of this paragraph with respect to each 
controlled foreign corporation with respect to which a person is a 
United States shareholder, within the meaning of section 951(b).
    (2) Election of 75-day rule. A United States shareholder of a 
controlled foreign corporation may elect with respect to a taxable year 
of such corporation to make the determinations under subparagraphs 
(2)(i) and (3)(iii) of paragraph (d) of Sec. 1.970-1 of the amount of 
such corporation's investments in export trade assets as of the 75th day 
after the close of the taxable year referred to in such subparagraphs of 
paragraph (d) of Sec. 1.970-1. The election provided by this 
subparagraph may be made with respect to export trade assets other than 
facilities described in section 971(c)(3) or with respect to export 
trade assets which are facilities or with respect to both types of 
export trade assets (but the election under this paragraph with respect 
to export trade assets which are facilities or with respect to both 
types of export trade assets may be made only if the election provided 
by subparagraph (3) of this paragraph is not made). If the election 
provided by this subparagraph is made, the amount of export trade assets 
with respect to which such election is made at the close of the 
preceding taxable year which is described in subparagraphs (2)(ii) and 
(3)(i) of paragraph (d) of Sec. 1.970-1 shall be the amount of export 
trade assets which was considered by application of the 75-day rule to 
be the amount of export trade assets at the close of such preceding 
taxable year; except that for the first taxable year of the controlled 
foreign corporation for which the 75-day rule is elected the amount of 
investments in export trade assets with respect to which such election 
is made at the close of such preceding year described in subparagraphs 
(2)(ii) and (3)(i) of paragraph (d) of Sec. 1.970-1 shall be the amount 
of investments in export trade assets at the actual close of such 
preceding year. In the case of a taxable year of such corporation 
beginning after December 31, 1962, and before December 31, 1963, the 
amount of investments in export trade assets with respect to which such 
election is made alternatively may be determined by the United States 
shareholder as of the 75th day after the close of the preceding taxable 
year referred to in subparagraphs (2)(ii) and (3)(i) of paragraph (d) of 
Sec. 1.970-1 rather than as of the close of such preceding taxable 
year.
    (3) Election for export trade assets which are facilities. A United 
States shareholder of a controlled foreign corporation may elect with 
respect to a taxable year of such corporation to make the determinations 
under subparagraphs (2)(i) and (3)(iii) of paragraph (d) of Sec. 1.970-
1 of the amount of such corporation's investments in export trade assets 
which are facilities described in section 971(c)(3) as of the close of 
such corporation's taxable year following the taxable year referred to 
in such subparagraphs of paragraph (d) of Sec. 1.970-1. The election 
provided by this subparagraph may be made only if the United States 
shareholder does not elect the 75-day rule of subparagraph (2) of this 
paragraph with respect to export trade assets which are facilities. If

[[Page 583]]

the election provided by this subparagraph is made, the amount of 
investments in export trade assets which are facilities at the close of 
the preceding taxable year which is described in subparagraphs (2)(ii) 
and (3)(i) of paragraph (d) of Sec. 1.970-1 shall be the amount of 
export trade assets which are facilities which was considered, by reason 
of the application of the following-year rule provided in this 
subparagraph with respect to such preceding taxable year, to be the 
amount of export trade assets which are facilities at the close of such 
preceding taxable year; except that for the first taxable year of the 
controlled foreign corporation for which such following-year rule is 
elected the amount of investments in export trade assets which are 
facilities at the close of the preceding taxable year described in 
subparagraphs (2)(ii) and (3)(i) of paragraph (d) of Sec. 1.970-1 shall 
be the amount of investments in export trade assets which are facilities 
at the actual close of such preceding taxable year.
    (b) Time and manner of making elections--(1) Without consent. A 
United States shareholder may, with respect to any controlled foreign 
corporation, make one or both of the elections described in paragraph 
(a)(2) or (3) of this section without the consent of the Commissioner by 
filing a statement to such effect with his return for his taxable year 
in which or with which ends the first taxable year of such corporation 
in which--
    (i) Such shareholder owns, within the meaning of section 958(a), or 
is considered as owning, by applying the rules of section 958(b), 10 
percent or more of the total combined voting power of all classes of 
stock entitled to vote of such corporation, and
    (ii) Such corporation realizes subpart F income which is reduced 
under section 970(a) and paragraph (b) of Sec. 1.970-1.


The statement shall contain the name and address of the controlled 
foreign corporation, identification of such first taxable year of such 
corporation, and an indication as to which election or elections 
described in paragraph (a) of this section the United States shareholder 
is making. If such return has been filed on or before the 90th day after 
the date these regulations are published in the Federal Register, such 
United States shareholder shall file such statement with the district 
director with which the return was filed on or before such 90th day.
    (2) With consent. A United States shareholder may make one or both 
of the elections described in paragraph (a)(2) or (3) of this section 
with respect to any controlled foreign corporation at any time with the 
consent of the Commissioner. Consent will not be granted unless the 
shareholder and the Commissioner agree to the terms, conditions, and 
adjustments under which the election will be effected. The application 
for consent to elect shall be made by the shareholder's mailing a letter 
for such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to determine an exclusion under section 970(a) 
in accordance with one or both of the elections provided in paragraph 
(a) of this section. The application shall include the following 
information:
    (i) The name, address, and taxable year of the United States 
shareholder;
    (ii) The name, address, and taxable year of the controlled foreign 
corporation;
    (iii) A statement indicating which of the elections the shareholder 
desires to make;
    (iv) The amount of the foreign corporation's investments in export 
trade assets (by a category which includes export trade assets other 
than facilities and a category which includes only export trade assets 
which are facilities) at the close of its preceding taxable year;
    (v) The shareholder's pro rata share of the sum of the amounts by 
which the subpart F income of the foreign corporation, for all prior 
taxable years during which such shareholder was a United States 
shareholder of such corporation, was reduced under section 970(a) and 
paragraph (b) of Sec. 1.970-1;
    (vi) The shareholder's pro rata share of the sum of the amounts 
which were not included in the subpart F income of the foreign 
corporation, for all prior

[[Page 584]]

taxable years during which such shareholder was a United States 
shareholder of such corporation, by reason of the application of section 
972 and Sec. 1.972-1; and
    (vii) The shareholder's pro rata share of the sum of the amounts 
which were previously included in his gross income, for all prior 
taxable years during which such shareholder was a United States 
shareholder of such corporation, under section 951(a)(1)(A)(ii) by 
reason of the application of section 970(b) and paragraph (b) of Sec. 
1.970-1 to the foreign corporation.
    (c) Effect of elections--(1) In general. Except as provided in 
subparagraphs (3) and (4) of this paragraph, an election made under 
paragraph (a) of this section with respect to a controlled foreign 
corporation shall be binding on the United States shareholder and--
    (i) In the case of the election described in paragraph (a)(2) of 
this section, shall apply to all investments in export trade assets with 
respect to which such election is made acquired, or disposed of, by such 
corporation during the 75-day period following its taxable year for 
which subpart F income is first computed under the election and during 
all succeeding corresponding 75-day periods of such corporation, or
    (ii) In the case of the election described in paragraph (a)(3) of 
this section, shall apply to all investments in export trade assets 
which are facilities acquired, or disposed of, by such corporation 
during the taxable year following its taxable year for which subpart F 
income is first computed under the election and during all succeeding 
corresponding taxable years of such corporation.
    (2) Returns. Any return of a United States shareholder required to 
be filed before the completion of a period with respect to which 
determinations are to be made as to a controlled foreign corporation's 
investments in export trade assets for purposes of computing such 
shareholder's taxable income shall be filed on the basis of an estimate 
of the amount of such corporation's investments in export trade assets 
at the close of the period. If the actual amount of such investments is 
not the same as the amount of the estimate, the shareholder shall 
immediately notify the Commissioner. The Commissioner will thereupon 
redetermine the amount of such shareholder's tax for the year or years 
with respect to which the incorrect amount was taken into account. The 
amount of tax, if any, due upon such redetermination shall be paid by 
the shareholder upon notice and demand by the district director. The 
amount of tax, if any, shown by such redetermination to have been 
overpaid shall be credited or refunded to the shareholder in accordance 
with the provisions of sections 6402 and 6511 and the regulations 
thereunder.
    (3) Revocation--(i) In general--(a) Consent required. Upon 
application by the United States shareholder, an election made under 
paragraph (a) of this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless the 
shareholder and the Commissioner agree to the terms, conditions, and 
adjustments under which the revocation will be effected.
    (b) Revocation of 75-day rule. In the case of the revocation of an 
election described in paragraph (a)(2) of this section, the change in 
the controlled foreign corporation's investments in export trade assets 
with respect to which such election was made for its first taxable year 
for which subpart F income or a decrease in investments in export trade 
assets is computed without regard to the election previously made shall, 
unless the agreement with the Commissioner provides otherwise, be 
considered to be the amount by which--
    (1) Such corporation's investments in export trade assets with 
respect to which such election was made at the close of such taxable 
year exceeds or, if applicable, is exceeded by
    (2) Such corporation's investments in export trade assets with 
respect to which such election was made at the close of the 75th day 
after the close of the preceding taxable year of such corporation.
    (c) Revocation of following-year rule. In the case of the revocation 
of an election described in paragraph (a)(3) of this section, the change 
in the controlled foreign corporation's investments in export trade 
assets which are facilities for its first taxable year for

[[Page 585]]

which subpart F income or a decrease in investments in export trade 
assets is computed without regard to the election previously made shall, 
unless the agreement with the Commissioner provides otherwise, be 
considered to be zero.
    (ii) Time and manner of applying for consent to revocation--(a) 
Application to Commissioner. The application for consent to revocation 
of an election shall be made by the United States shareholder's mailing 
a letter for such purpose to the Commissioner of Internal Revenue, 
Washington, DC, 20224. The application shall be mailed before the close 
of the first taxable year of the controlled foreign corporation with 
respect to which the shareholder desires to determine an exclusion under 
section 970(a) or an inclusion under section 970(b) without regard to 
such election.
    (b) Information required. The application shall include the 
following information:
    (1) The name, address, and taxable year of the United States 
shareholder;
    (2) The name, address, and taxable year of the controlled foreign 
corporation;
    (3) A statement indicating the election the shareholder desires to 
revoke under this subparagraph;
    (4) The information required under subdivisions (iv) through (vii) 
of paragraph (b)(2) of this section;
    (5) In the case of an application for consent to revocation of an 
election made under paragraph (a)(2) of this section, the amount of the 
foreign corporation's investments in export trade assets with respect to 
which such election was made at the close of the 75th day after the 
close of such corporation's taxable year immediately preceding the 
taxable year of such corporation; and
    (6) The reasons for the request for consent to revocation.
    (4) Transfer of stock--(i) Election of 75-day rule in force. (a) If 
during any taxable year of a controlled foreign corporation--
    (1) A United States shareholder who has made the election described 
in paragraph (a)(2) of this section with respect to such corporation 
sells, exchanges, or otherwise disposes of all or part of his stock in 
such corporation, and
    (2) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange, or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
successor in interest shall consider the controlled foreign 
corporation's change during the first 75 days of such taxable year in 
investments in export trade assets with respect to which such election 
is made to be zero.
    (b) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(2) of this section in order to determine 
an exclusion under section 970(a) for the taxable year of such 
corporation in which the acquires such stock, the amount of the 
controlled foreign corporation's investments in export trade assets with 
respect to which such election is made at the close of its preceding 
taxable year shall be considered, with respect to the stock so acquired, 
to be the amount of such corporation's investments in export trade 
assets with respect to which such election is made at the close of the 
75th day after the close of such preceding taxable year.
    (c) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(2) of this section in order to determine 
an exclusion under section 970(a) for a taxable year of such corporation 
subsequent to the taxable year in which he acquired the stock, the 
amount of the controlled foreign corporation's investments in export 
trade assets with respect to which such election is made at the close of 
its taxable year immediately preceding such subsequent taxable year 
shall, with respect to the stock so acquired, be the amount of such 
corporation's investments in such assets at the actual close of such 
preceding taxable year.
    (ii) Election in force with respect to export trade assets which are 
facilities--(a) If during any taxable year of a controlled foreign 
corporation--
    (1) A United States shareholder who has made the election described 
in paragraph (a)(3) of this section with respect to such corporation 
sells, exchanges, or otherwise disposes of all or

[[Page 586]]

part of his stock in such corporation, and
    (2) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
successor in interest shall consider the controlled foreign 
corporation's change for such taxable year in investments in export 
trade assets which are facilities to be zero.
    (b) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(3) of this section in order to determine 
an exclusion under section 970(a) for the taxable year of such 
corporation in which he acquires such stock, the amount of the 
controlled foreign corporation's investments in export trade assets 
which are facilities at the close of its preceding taxable year shall be 
considered, with respect to the stock so acquired, to be the amount of 
such corporation's investments in export trade assets which are 
facilities at the close of the taxable year in which such stock is 
acquired.
    (c) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(3) of this section in order to determine 
an exclusion under section 970(a) for a taxable year of such corporation 
subsequent to the taxable year in which he acquired the stock, the 
amount of the controlled foreign corporation's investments in export 
trade assets which are facilities at the close of its taxable year 
immediately preceding such subsequent taxable year shall, with respect 
to the stock so acquired, be the amount of such corporation's 
investments in such assets at the actual close of such preceding taxable 
year.
    (d) Illustrations. The principles contained in this section are 
illustrated by the examples set forth in paragraph (d) of Sec. 1.955.3.

[T.D. 6755, 29 FR 12707, Sept. 9, 1964]



Sec. 1.970-3  Effective date of subpart G.

    Sections 970 through 972 and Sec. Sec. 1.970-1 through 1.972-1 
shall apply with respect to taxable years of foreign corporations 
beginning after December 31, 1962, and to taxable years of United States 
shareholders within which or with which such taxable years of such 
corporations end.

[T.D. 6755, 29 FR 12709, Sept. 9, 1964]



Sec. 1.971-1  Definitions with respect to export trade corporations.

    (a) Export trade corporations--(1) In general. For purposes of 
sections 970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, 
the term ``export trade corporation'' means a controlled foreign 
corporation which for the period specified in subparagraph (2) of this 
paragraph satisfies the conditions specified in subparagraph (3) of this 
paragraph. However, no controlled foreign corporation may qualify as an 
export trade corporation for any taxable year beginning after October 
31, 1971, unless it qualified as an export trade corporation for any 
taxable year beginning before such date. In addition, if a corporation 
fails to qualify as an export trade corporation for a period of any 3 
consecutive taxable years beginning after October 31, 1971, then for any 
taxable year beginning after such 3-year period, such corporation shall 
not be included within the term ``export trade corporation''.
    (2) Three-year period. The period referred to in subparagraph (1) of 
this paragraph is the 3-year period ending with the close of the 
controlled foreign corporation's current taxable year, or such part of 
such 3-year period as occurs on and after the beginning of the 
corporation's first taxable year beginning after December 31, 1962, 
whichever period is shorter.
    (3) Gross income requirements. The conditions referred to in 
subparagraph (1) of this paragraph are that the controlled foreign 
corporation derives--
    (i) 90 percent or more of its gross income from sources without the 
United States, and
    (ii)(a) 75 percent of more of its gross income from transactions, 
activities, or interest described in section 971(b) and paragraph (b) of 
this section, or
    (b) 50 percent or more of its gross income from transactions, 
activities, or interest described in section 971(b) and paragraph (b) of 
this section in respect of agricultural products grown in the United 
States.

[[Page 587]]

    (4) Determination of sources of gross income. The sources of gross 
income of a controlled foreign corporation shall be determined for 
purposes of subparagraph (3)(i) of this paragraph in accordance with the 
rules for determining sources of gross income set forth in sections 861 
through 864 and the regulations thereunder.
    (b) Export trade income--(1) General rule. For purposes of sections 
970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term 
``export trade income'' means the gross export trade income of a 
controlled foreign corporation derived from transactions, activities, or 
interest described in subdivisions (i) through (vii) of this 
subparagraph, less deductions allowed under subdivision (viii) of this 
subparagraph.
    (i) Sale of export property. Gross export trade income of a 
controlled foreign corporation includes gross income it derives from the 
sale of export property (as defined in paragraph (e) of this section) 
which it purchases, if the sale is made to an unrelated person for use, 
consumption, or disposition outside the United States. See section 
971(b)(1). As a general rule, property will be presumed to have been 
sold for use, consumption, or disposition in the country of destination 
of the sale. However, if at the time of the sale the controlled foreign 
corporation knows, or should have known from the facts and circumstances 
surrounding the sales transaction, that the property will probably be 
used, consumed, or disposed of in the United States, such property will 
be presumed to have been sold for use, consumption, or disposition in 
the United States unless the controlled foreign corporation establishes 
that such property was used, consumed, or disposed of outside the United 
States. For purposes of this subdivision, export property must be sold 
by a controlled foreign corporation in essentially the same form in 
which such property is purchased. Whether export property sold is in 
essentially the same form in which such property is purchased shall be 
determined on the basis of all the facts and circumstances in each case. 
Storage, handling, transportation, packaging, or servicing of property 
will be considered not to alter the form in which property is purchased. 
However, manufacture or production, within the meaning of paragraph 
(a)(4) of Sec. 1.954-3, will be considered to alter the form in which 
property is purchased and no part of the gross income from the sale of 
such property will be treated as export trade income. The application of 
this subdivision may be illustrated by the following example:

    Example. Controlled foreign corporation A, incorporated under the 
laws of foreign country Y, purchases articles manufactured in the United 
States from domestic corporation M and sells them in the form in which 
purchased to foreign corporation B, unrelated to A Corporation, for use 
in foreign countries, X, Y, and Z. The gross income of A Corporation 
from the purchase and sale of the articles constitutes gross export 
trade income.

    (ii) Commissions and other income derived in connection with the 
sale of export property. Gross export trade income of a controlled 
foreign corporation includes gross commissions, fees, compensation, or 
other income derived by such corporation from the performance for any 
person of commercial, industrial, financial, technical, scientific, 
managerial, engineering, architectural, skilled, or other services in 
respect of a sale by such corporation in a transaction described in 
subdivision (i) of this subparagraph or in respect of the sale by any 
other person of export property to a person unrelated to the controlled 
foreign corporation for use, consumption, or disposition outside the 
United States. Such gross export trade income includes payments received 
for surveys made prior to, and in connection with, the sale of such 
export property (whether or not such sales are ultimately consummated). 
See section 971(b)(1). The term ``any person'' or ``any other person'' 
as used in this subdivision includes a related person as defined in 
section 954(d)(3) and paragraph (e) of Sec. 1.954-1. The application of 
this subdivision may be illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, receives from M Corporation a commission 
equal to 6 percent of the gross selling price of all personal property 
shipped by M Corporation as a result of services performed by A 
Corporation in soliciting orders in foreign countries X, Y, and Z. In 
fulfillment of such orders, M Corporation ships

[[Page 588]]

products manufactured by it in the United States. Corporation A does not 
assume title to the property sold. Gross commissions received by A 
Corporation from M Corporation in connection with the sale of such 
property to persons unrelated to A Corporation for use, consumption, or 
disposition outside the United States constitute gross export trade 
income.
    Example 2. Foreign corporation B, incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
N. Corporation N, is engaged in the business of manufacturing heavy duty 
electrical equipment in the United States. By contract, N Corporation 
engages B Corporation for the purpose of conducting engineering, 
technical, and financial studies required by N Corporation in the 
preparation of bids to supply foreign country Y with electrical 
equipment for a construction project to be undertaken by such country. 
Corporation N pays B Corporation a fee for the services, all of which 
are performed in country Y, which is based upon the number of hours of 
work performed without regard to whether a sale is ultimately 
consummated. Corporation N does not receive a contract from country Y on 
its bid to supply equipment. Income derived by B Corporation from 
performance of the service contract constitutes gross export trade 
income.

    (iii) Commissions and other income derived in connection with the 
installation or maintenance of export property. Gross export trade 
income of a controlled foreign corporation includes gross commissions, 
fees, compensation, or other income derived by such corporation from the 
performance for any person of commercial, industrial, financial, 
technical, scientific, managerial, engineering, architectural, skilled, 
or other services in respect of the installation or maintenance of 
export property which has been sold by such corporation in a transaction 
described in subdivision (i) of this subparagraph or by any other person 
to a person unrelated to the controlled foreign corporation for use, 
consumption, or disposition outside the United States. See section 
971(b)(1). The term ``any person'' or ``any other person'' as used in 
this subdivision includes a related person as defined in section 
954(d)(3) and paragraph (e) of Sec. 1.954-1.
    (iv) Commissions and other income derived in connection with the use 
of patents, copyrights, and other like property. Gross export trade 
income of a controlled foreign corporation includes gross commissions, 
fees, compensation, or other income derived by such corporation from the 
performance for any person of commercial, industrial, financial, 
technical, scientific, managerial, engineering, architectural, skilled, 
or other services in connection with the use outside of the United 
States by an unrelated person of patents, copyrights, secret processes 
and formulas, goodwill, trademarks, trade brands, franchises, and other 
like property, including gross income derived from obtaining licensees 
for patents, but only if the patent, copyright, or other like property 
is acquired, or developed, and owned by the manufacturer, producer, 
grower, or extractor of any export property, in respect of which the 
controlled foreign corporation also derives gross export trade income 
within the meaning of subdivision (i), (ii), or (iii) of this 
subparagraph. See section 971(b)(2). The application of this subdivision 
may be illustrated by the following example:

    Example. Foreign corporation A incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
M. Corporation M, the owner of a patent registered in foreign country X, 
grants B Corporation, a corporation unrelated to A Corporation, the 
right to use such patent in foreign country Y in exchange for payment of 
a royalty. By a separate contract with B Corporation, A Corporation 
agrees for a gross fee of $100,000 to furnish, by maintaining a staff of 
technical representatives at the offices of B Corporation, technical 
services to B Corporation in connection with B Corporation's use of the 
patent. Corporation A also derives export trade income from the sale of 
export property which it purchases from M Corporation, the manufacturer 
of such property, and sells to C Corporation, an unrelated person, for 
use in country Y by C Corporation. The gross fee of $100,000 received by 
A Corporation for the furnishing of technical services in connection 
with B Corporation's use of M Corporation's patent constitutes gross 
export trade income since the service for which the fee is paid is 
performed in connection with the use outside the United States by an 
unrelated person (B Corporation) of a patent owned by a manufacturer (M 
Corporation) of export property in respect of which the controlled 
foreign corporation (A Corporation) derives gross export trade income 
from the sale to an unrelated person (C Corporation) for use outside the 
United States of export property purchased by it from the manufacturer 
(M Corporation).


[[Page 589]]


    (v) Income attributable to use of export property by an unrelated 
person. Gross export trade income of a controlled foreign corporation 
includes gross commissions, fees, rents, compensation, or other income 
which is received by such corporation from an unrelated person and is 
attributable to the use of export property by such unrelated person. See 
section 971(b)(3). The application of this subdivision may be 
illustrated by the following example:

    Example. Foreign corporation A, incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
M. Corporation A acquires by purchase bottling machines manufactured in 
the United States and leases the machines to B Corporation, a 
corporation unrelated to A Corporation, for use by B Corporation in 
foreign country Y. Gross rental income of A Corporation from the lease 
of the machines to B Corporation constitutes gross export trade income.

    (vi) Income attributable to the use of export property in the 
rendition of technical, scientific, or engineering services--(a) 
General. Gross export trade income of a controlled foreign corporation 
includes gross commissions, fees, compensation, or other income which is 
received by such corporation from an unrelated person and is 
attributable to the use of export property in the performance of 
technical, scientific, or engineering services to such unrelated person. 
See section 971(b)(3).
    (b) Rule of apportionment. If a commission, fee, or other income 
received by a controlled foreign corporation from an unrelated person 
under a contract or arrangement for the performance of technical, 
scientific, or engineering services is not solely attributable to the 
use of export property in the performance of such services and the 
amount of the gross income attributable to such use of export property 
cannot be established by reference to transactions between other 
unrelated persons, such gross income shall be an amount which bears the 
same ratio to total gross income from the contract or arrangement as the 
cost of the export property consumed in the performance of such 
services, including a reasonable allowance for depreciation with respect 
to the export property so used, bears to the total costs and expenses 
attributable to the production of income under the contract or 
arrangement.
    (c) Illustration. The application of this subdivision may be 
illustrated by the following example:

    Example. Foreign corporation A, incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
M. Corporation A is engaged in the seismograph service business in 
foreign country X. In an effort to establish the probable existence of 
oil in a concession area it owns in foreign country Y, B Corporation 
which is unrelated to A Corporation enters into a contract with A 
Corporation whereby A Corporation is required to make seismographic 
tests of the area in country Y for a fixed fee of $100,000. In 
performance of the contract, A Corporation hires a skilled crew to carry 
out the contract and utilizes equipment and supplies (for example, 
trucks, seismographic equipment, etc.) which constitute export property. 
Corporation A cannot establish by reference to transactions between 
other unrelated persons, the income attributable to the use of the 
export property in the performance of the contract. Corporation A's 
total costs and expenses (for example, salaries of the crew, 
administrative expenses, all supplies, total depreciation on property 
used in performance of the contract, etc.) incurred in performance of 
the contract are $80,000. The cost of export property consumed in 
performance of the contract (for example, dynamite, motor oil, and other 
supplies which were produced in the United States, reasonable 
depreciation on trucks and seismographic equipment manufactured in the 
United States and used in performance of the contract, etc.) is $30,000. 
Corporation A's gross export trade income from the contract is $37,500, 
that is, the amount which bears the same ratio to total gross income 
from the contract ($100,000) as the cost of the export property consumed 
in the rendition of the services ($30,000) bears to total costs and 
expenses attributable to the contract ($80,000).

    (vii) Interest from export trade assets. Gross export trade income 
of a controlled foreign corporation includes interest derived by it from 
export trade assets described in section 971(c)(4) and paragraph (c)(5) 
of this section. See section 971(b)(4).
    (viii) Deductions to be taken into account. Export trade income of a 
controlled foreign corporation for any taxable year shall be the amount 
determined by deducting from the items or categories of gross income 
described in subdivisions (i) through (vii) of this subparagraph the 
entire amount of

[[Page 590]]

those expenses, taxes, and other deductions properly allocable to such 
items or categories of income. For purposes of this section, expenses, 
taxes, and other deductions shall first be allocated to items or 
categories of gross income to which they directly relate; then, 
expenses, taxes, and other deductions which cannot definitely be 
allocated to some item or category of gross income shall be ratably 
apportioned among all items or categories of gross income, except that 
no expense, tax, or other deduction shall be allocated to an item or 
category of income to which it clearly does not apply and no deduction 
allowable to such controlled foreign corporation under section 882(c) 
and the regulations thereunder shall be taken into account.
    (2) Cross reference. For rules governing the determination of gross 
income and taxable income of a foreign corporation, see Sec. 1.952-2.
    (c) Export trade assets--(1) In general. For purposes of sections 
970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term 
``export trade assets'' means--
    (i) Working capital reasonably necessary for the production of 
export trade income,
    (ii) Inventory of export property held for use, consumption, or 
disposition outside the United States,
    (iii) Facilities located outside the United States for the storage, 
handling, transportation, packaging, servicing, sale, or distribution of 
export property, and
    (iv) Evidences of indebtedness executed by unrelated persons in 
connection with payment for purchases of export property for use, 
consumption, or disposition outside the United States, or in connection 
with the payment for services described in section 971(b)(2) or (3) and 
paragraph (b)(1)(iv), (v), or (vi) of this section.
    (2) Working capital. For purposes of subparagraph (1)(i) of this 
paragraph, working capital of a controlled foreign corporation is the 
excess of its current assets over its current liabilities. Liabilities 
maturing in one year or less shall be considered current liabilities. A 
determination of the amount of working capital of a controlled foreign 
corporation which is reasonably necessary for the production of export 
trade income will depend upon the nature and volume of the activities of 
the controlled foreign corporation which produce export trade income as 
they exist on the applicable determination date. In determining working 
capital which is reasonably necessary for the production of export trade 
income, the anticipated future needs of the business will be taken into 
account to the extent that such needs relate to the year of the 
controlled foreign corporation following the applicable determination 
date; anticipated future needs relating to a later period will not be 
taken into account unless it is clearly established that such needs are 
reasonably related to the production of export trade income as of the 
applicable determination date.
    (3) Inventory of export property. For purposes of subparagraph 
(1)(ii) of this paragraph, the inclusion of items in inventory shall be 
determined in accordance with rules applicable to domestic corporations. 
See Sec. Sec. 1.471-1 through 1.471-9. Inventory of export property of 
a controlled foreign corporation includes export property held for use, 
consumption, or disposition outside the United States regardless of 
where it is located on the applicable determination date. Thus, such 
property may be physically located in the United States on such date. 
However, for property physically located in the United States to 
constitute export property, it must have been acquired by the controlled 
foreign corporation with a clear intent that it would dispose of the 
property for use, consumption, or disposition outside the United States. 
As a general rule, if during the year following the applicable 
determination date export property which was physically located in the 
United States on such date is actually exported for use, consumption, or 
disposition outside the United States, such property will be deemed held 
for such purpose on the applicable determination date. On the other 
hand, the indefinite warehousing of export property in the United States 
by the controlled foreign corporation, or the subsequent sale of export 
property by such corporation for use, consumption, or disposition in the 
United States, will evidence a lack of intent by such

[[Page 591]]

corporation on the applicable determination date to hold such property 
for use, consumption, or disposition outside the United States.
    (4) Facilities located outside the United States--(i) In general. 
For purposes of subparagraph (1)(iii) of this paragraph, a facility, as 
defined in subdivision (ii)(a) of this subparagraph, will be considered 
an export trade asset only--
    (a) If such facility is located outside the United States, and
    (b) To the extent that such facility is used, within the meaning of 
subdivision (ii)(c) of this subparagraph, by the controlled foreign 
corporation for the storage, handling, transportation, packaging, 
servicing, sale, or distribution of export property in essentially the 
same form in which such property is acquired by such corporation.


Thus, a facility in which property is manufactured or produced, even 
though export property is used or consumed in the production or becomes 
a component part of the manufactured article, will not qualify as an 
export trade asset.
    (ii) Special rules--(a) Facility defined. For purposes of 
subdivision (i) of this subparagraph, the term ``facility'' includes any 
asset or group of assets used for the storage, handling, transportation, 
packaging, servicing, sale, or distribution of export property. Thus, 
such term includes warehouse, storage, or sales facilities (for example, 
sales office equipment), transportation equipment (for example, motor 
trucks, vessels, etc.), and machinery and equipment (for example, 
packaging equipment, servicing equipment, cranes, forklift trucks used 
in warehouses, etc.).
    (b) Determination of location of transportation facilities. A 
transportation facility shall be considered to be located outside the 
United States for purposes of subdivision (i)(a) of this subparagraph if 
such property is predominantly located outside the United States. As a 
general rule, on an applicable determination date a transportation 
facility will be considered to be predominantly located outside the 
United States if 70 percent or more of the miles traversed (during the 
12-month period immediately preceding such determination date or for 
such part of such period as such facility is owned by the controlled 
foreign corporation) in the use of such facility are traversed outside 
the United States or if such facility is located outside the United 
States at least 70 percent of the time during such period or such part 
thereof.
    (c) Determination of use. For purposes of subdivision (i)(b) of this 
subparagraph, the extent to which a facility is used in carrying on the 
activities described in such subdivision depends on the use made of the 
facility for the 12-month period immediately preceding the applicable 
determination date or for such part of such period as such facility is 
owned by the controlled foreign corporation. The method of measuring 
such use will depend upon the facts and circumstances in each case. 
However, such determinations of use will generally be made for a 
facility as a whole and not on the basis of individual items used in the 
operation of a facility. Thus, a determination as to the use of a 
warehouse facility will generally be made with respect to the entire 
facility and not separately for the items used in such warehouse, such 
as forklift trucks, storage bins, etc.
    (5) Evidences of indebtedness. For purposes of subparagraph (1)(iv) 
of this paragraph, the term ``evidence of indebtedness'' shall mean a 
note, installment sales contract, a time bill of exchange evidencing a 
sale on credit, or similar written instrument executed by an unrelated 
person which evidences the obligation of an unrelated person to pay for 
export property which an unrelated person purchases for use, 
consumption, or disposition outside the United States or to pay for 
services described in section 971(b)(2) or (3) and paragraph (b)(1)(iv), 
(v), or (vi) of this section which are performed for an unrelated 
person. Receivables which arise out of the delivery of export property, 
or the performance of services, which are evidenced by invoices, bills 
of lading, bills of exchange which do not evidence a sale on credit, 
sales slips, and similar documents created by the unilateral act of a 
creditor shall not be considered evidences of indebtedness for purposes 
of section 971(c)(4).

[[Page 592]]

    (6) Duplication of treatment and priority of application. No asset 
which constitutes an export trade asset shall be taken into account more 
than once in determining the investments in export trade assets of a 
controlled foreign corporation. Assets which constitute working capital 
and also constitute inventory to which section 971(c)(2) applies or 
evidences of indebtedness to which section 971(c)(4) applies shall be 
taken into account in determining whether the amount of working capital 
of the controlled foreign corporation is reasonably necessary for the 
production of export trade income. However, to the extent that the 
amount of inventory to which section 971(c)(2) applies or evidences of 
indebtedness to which section 971(c)(4) applies is not included in 
working capital to which section 971(c)(1) applies on the ground that 
such amount is not reasonably necessary for the production of export 
trade income, the amount shall be included under section 971(c)(2) or 
971(c)(4), as the case may be, in a controlled foreign corporation's 
investments in export trade assets.
    (d) Export promotion expenses--(1) In general. For purposes of 
sections 970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, 
the term ``export promotion expenses'' means, subject to the provisions 
of subparagraph (2) of this paragraph, all the ordinary and necessary 
expenses paid or incurred during the taxable year by the controlled 
foreign corporation which are reasonably allocable to the receipt or 
production of export trade income including--
    (i) A reasonable allowance for salaries or other compensation for 
personal services actually rendered for such purpose,
    (ii) Rentals or other payments for the use of property actually used 
for such purpose, and
    (iii) A reasonable allowance for the exhaustion, wear and tear, or 
obsolescence of property actually used for such purpose.


In determining for purposes of this subparagraph whether expenses are 
reasonably allocable to the receipt or production of export trade 
income, consideration shall be given to the facts and circumstances of 
each case. As a general rule, if export trade income results from the 
sale of export property, export promotion expenses allocable to such 
income shall include warehousing, advertising, selling, billing, 
collection, other administrative, and similar costs properly allocable 
to the marketing activity, but shall not include cost of goods sold, 
income or similar tax, any expense which does not advance the 
distribution or sale of export property for use, consumption, or 
disposition outside the United States, or any expense for which the 
controlled foreign corporation is reimbursed. If export trade income 
results from the rental of export property, export promotion expenses 
allocable to such income shall include a reasonable allowance for 
depreciation and servicing of such property, and the administrative and 
similar costs properly allocable to the rental activity. If export trade 
income results from the performance of services, export promotion 
expenses shall include a reasonable allowance for compensation of the 
persons performing services for the controlled foreign corporation in 
the execution of the service contract or arrangement and administrative 
expenses reasonably allocable to the service activity. In no case shall 
income taxes be included in export promotion expenses.
    (2) Expenses incurred within the United States. No expense incurred 
within the United States shall be treated as an export promotion expense 
for purposes of section 971(d) and subparagraph (1) of this paragraph 
unless at least--
    (i) 90 percent of all salaries and other personal service 
compensation incurred in the receipt or the production of export trade 
income,
    (ii) 90 percent of rents and other payments for the use of property 
used in the receipt or the production of export trade income,
    (iii) 90 percent of the allowances for the exhaustion, wear and 
tear, or obsolescence of property used in the receipt or the production 
of export trade income, and
    (iv) 90 percent of all other ordinary and necessary expenses 
reasonably allocable to the receipt or the production of export trade 
income,


is incurred outside the United States. For this purpose, personal 
service compensation will be considered incurred

[[Page 593]]

at the place where the service is performed (for example, salaries will 
be considered incurred at the place where the employee works; payments 
for art work will be considered incurred at the place where the art work 
is prepared, etc.); rent, depreciation, and other expenses related to 
real or personal property will be considered incurred at the place where 
the property is located; and expenses for media advertising will be 
considered incurred at the place where the advertising is consumed. For 
such purpose, newspaper or periodical advertising will be considered 
consumed where the newspaper or periodical is principally distributed, 
and television and radio advertising will be considered consumed at the 
place where the audience is primarily located. Technicalities of 
contract or payment, for example, the place where a contract is executed 
or the location of a bank account from which payment is made, shall not 
be determinative of the place where an expense is incurred.
    (e) Export property. For purposes of sections 970 through 972 and 
Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term ``export property'' 
means property, or any interest in property, which is manufactured, 
produced, grown, or extracted in the United States. Whether property 
will be considered manufactured or produced in the United States will 
depend on the facts and circumstances of each case. As a general rule, 
if--
    (1) The property sold, serviced, used, or rented by the controlled 
foreign corporation is substantially transformed in the United States 
prior to its export from the United States, or
    (2) The operations conducted in the United States with respect to 
the property sold, serviced, used, or rented by the controlled foreign 
corporation, whether performed in the United States by one person or a 
series of persons in a chain of distribution, are substantial in nature 
and are generally considered to constitute the manufacture or production 
of property,


then the property sold, serviced, used, or rented will be considered to 
have been manufactured or produced in the United States. The rules under 
paragraph (a)(4)(ii) of Sec. 1.954-3, relating to the substantial 
transformation of property, and paragraph (a)(4)(iii) of such section, 
dealing with a substantive test for determining whether property will be 
treated as having been manufactured or produced, shall apply for 
purposes of making determinations under this paragraph.
    (f) Unrelated person. For purposes of sections 970 through 972 and 
Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term ``unrelated person'' 
means a person other than a related person as defined in section 
954(d)(3) and paragraph (e) of Sec. 1.954-1.

[T.D. 6755, 29 FR 12710, Sept. 9, 1964, as amended by T.D. 7293, 38 FR 
32802, Nov. 28, 1973; T.D. 7533, 43 FR 6603, Feb. 15, 1978]



Sec. 1.972-1  Consolidation of group of export trade corporations.

    (a) Election to consolidate--(1) In general. One or more United 
States shareholders (as defined in section 951(b)) owning (within the 
meaning of section 958(a)) or who are considered as owning by applying 
the rules of ownership of section 958(b) more than 50 percent of the 
total combined voting power of all classes of stock entitled to vote of 
an export trade corporation, which is the top-tier corporation in a 
chain (within the meaning of subparagraph (2) of this paragraph) of 
export trade corporations, may, subject to the provisions of this 
section, elect to consolidate such chain for purposes of determining--
    (i) The limitations, described in section 970(a) and paragraph 
(b)(2) of Sec. 1.970-1, on the amount by which subpart F income of an 
export trade corporation in such chain shall be reduced as provided in 
section 970(a) and paragraph (b)(1) of Sec. 1.970-1, and
    (ii) The amount includible in gross income of such shareholders 
under section 951(a)(1)(A)(ii) with respect to such a corporation's 
decrease in investments in export trade assets to which section 970(b) 
applies as described in paragraph (c) of Sec. 1.970-1.
    (2) ``Chain'' defined. A chain of export trade corporations shall 
include--
    (i) The top-tier export trade corporation referred to in 
subparagraph (1) of this paragraph which is the first export trade 
corporation in a chain of ownership described in section 958(a);
    (ii) All export trade corporations 80 percent or more of the total 
combined

[[Page 594]]

voting power of all classes of stock entitled to vote of which is owned 
directly by such top-tier export trade corporation on the last day of 
its taxable year; and
    (iii) All export trade corporations 80 percent or more of the total 
combined voting power of all classes of stock entitled to vote of which 
is owned directly by the export trade corporations described in 
subdivision (ii) of this subparagraph on the last day of the taxable 
year of the export trade corporation described in subdivision (i) of 
this subparagraph.


For purposes of this section, a reference to a top-tier corporation 
shall mean an export trade corporation described in subdivision (i) of 
this subparagraph, a reference to a second-tier corporation shall mean 
an export trade corporation described in subdivision (ii) of this 
subparagraph, and a reference to a third-tier corporation shall mean an 
export trade corporation described in subdivision (iii) of this 
subparagraph.
    (3) Inclusion requirement. If an election is made by a United States 
shareholder under this paragraph with respect to a chain of export trade 
corporations (as defined in subparagraph (2) of this paragraph), all 
export trade corporations which are included in the chain must be 
included in the consolidation. If such an election is made, the 
determinations under section 970 shall be made on a consolidated basis 
with respect to the entire interest which the electing United States 
shareholder owns in each of the export trade corporations in the chain, 
including any minority interests owned directly or indirectly by such 
shareholder in second-tier and third-tier corporations in the chain. A 
United States shareholder may elect to consolidate his interest in 
export trade corporations in one chain of such corporations without 
electing to consolidate his interest in export trade corporations in 
other chains.
    (4) Conditions for making initial election--(i) Without consent. The 
initial election to consolidate a chain of export trade corporations may 
be made without the consent of the Commissioner only if, immediately 
before the election to consolidate, each of the export trade 
corporations to be included in the consolidation is using the same 
taxable year and has the same elections under section 970(c)(4) and 
Sec. 1.970-2 in force, or not in force, as the case may be. The 
election shall be made by the electing shareholder or shareholders with 
respect to the taxable year in which or with which ends the first 
taxable year of the top-tier corporation to which the election to 
consolidate applies and at the time of filing such shareholders' returns 
for such taxable year or within 90 days after final regulations under 
this section are published in the Federal Register, whichever date 
occurs later. Each United States shareholder making such an election 
shall attach to his return a statement showing:
    (a) The name, address, and taxable year of each export trade 
corporation in the chain of such corporations for which an election is 
made,
    (b) The amount and percentage of each class of stock owned by such 
shareholder (within the meaning of section 958), corporation by 
corporation, in each of such export trade corporations, and
    (c) A list of the names and addresses, and a description of the 
ownership interests, of all other United States shareholders, if any, 
who are making the same election to consolidate and a statement that 
such shareholders are also making the election.
    (ii) With consent. If, immediately before the election to 
consolidate, each of the export trade corporations in a chain of such 
corporations does not use the same taxable year or does not have the 
same elections under section 970(c)(4) and Sec. 1.970-2 in force, or 
not in force, as the case may be, the initial election to consolidate 
such chain may be exercised by the electing shareholder or shareholders 
only with the consent of the Commissioner. Consent will not be granted 
unless each electing United States shareholder and the Commissioner 
agree to the terms, conditions, and adjustments under which such 
consolidation is to be effected and unless, subject to such terms, 
conditions, and adjustments as the Commissioner may prescribe, each of 
the export trade corporations in the chain adopts a common taxable year 
and has the same elections under section

[[Page 595]]

970(c)(4) and Sec. 1.970-2 in force, or not in force, as the case may 
be. The application for consent to consolidate shall be made by mailing 
a letter, signed by each of the electing United States shareholders, to 
the Commissioner of Internal Revenue, Washington, DC 20224. The 
application shall be mailed before the close of the first taxable year 
of the top-tier corporation with respect to which the electing 
shareholder or shareholders desire to make a consolidation or before the 
close of the 90th day after final regulations under this section are 
published in the Federal Register, whichever date occurs later, and 
shall include the statement described in subdivision (i) of this 
subparagraph.
    (5) Effect of election. If an election to consolidate a chain of 
export trade corporations is made for a taxable year of a United States 
shareholder, such election shall, except as provided in subparagraph (6) 
of this paragraph, be binding on such shareholder for such taxable year 
and for all succeeding taxable years. If, in a subsequent taxable year 
of the United States shareholder, an export trade corporation for the 
first time qualifies as a second-tier or third-tier corporation in such 
chain on the last day of the taxable year of the top-tier corporation 
which ends in or with the subsequent taxable year of such shareholder, 
the shareholder's interest in such export trade corporation shall be 
included in the consolidation to which the election applies, but only if 
such export trade corporation as of such last day uses the same taxable 
year and has the same elections under section 970(c)(4) and Sec. 1.970-
2 in force, or not in force, as the case may be, as such top-tier 
corporation. The United States shareholder shall, with respect to such 
additional export trade corporation, submit with his return for such 
subsequent taxable year the statement described in subparagraph (4)(i) 
of this paragraph.
    (6) Termination of election. An election under this paragraph to 
consolidate a chain of export trade corporations shall terminate for the 
first taxable year of the foreign corporation which during the period of 
consolidation is a top-tier corporation--
    (i) At the close of which any foreign corporation which was included 
in such consolidation for the preceding taxable year ceases to qualify 
as an export trade corporation or to be eligible under this paragraph 
for inclusion in such chain,
    (ii) At the close of which an export trade corporation for the first 
time qualifies as a second-tier or third-tier corporation in such chain 
but does not as of such close of the year use the same taxable year or 
have the same elections under section 970(c)(4) and Sec. 1.970-2 in 
force, or not in force, as the case may be, as such top-tier 
corporation, or
    (iii)(a) In respect of which the Commissioner, upon application made 
by a United States shareholder who made the election to consolidate, or 
his successor in interest, consents to a termination of the election. 
Approval will not be granted unless the United States shareholder and 
the Commissioner agree to the terms, conditions, and adjustments under 
which the termination will be effected.
    (b) The application for consent to termination shall be made by the 
United States shareholder's mailing a letter for such purpose to the 
Commissioner of Internal Revenue, Washington, DC 20224. The application 
shall be mailed before the close of the taxable year of the foreign 
corporations with respect to which the shareholder desires to terminate 
the consolidation and shall include the following information:
    (1) The name, address, and taxable year of each export trade 
corporation in the chain of such corporations for which the election was 
made,
    (2) The amount and percentage of each class of stock owned by such 
shareholder (within the meaning of section 958), corporation by 
corporation, in each of such export trade corporations, and
    (3) A list of the names and addresses, and a description of the 
ownership interests, of all other United States shareholders, if any, 
who participated in making the election with such United States 
shareholder, or their successors in interest, and a statement whether 
such other persons are or are not terminating the election.

[[Page 596]]

    (7) Election subsequent to initial election. If a United States 
shareholder elects under subparagraph (4) of this paragraph to 
consolidate his interest in a chain of export trade corporations and the 
election to consolidate such corporations terminates under the 
provisions of subparagraph (6) of this paragraph, such shareholder may 
not thereafter elect under this section to consolidate his interest in 
any corporation which was in that chain of export trade corporations 
unless he receives the consent of the Commissioner to do so. Application 
to obtain such consent of the Commissioner shall be made by a letter 
mailed to the Commissioner of Internal Revenue, Washington, DC, 20224, 
before the close of the first taxable year of the top-tier corporation 
of the chain of export trade corporations in which the election to 
include such interest is to apply. Such application for consent shall 
include a statement showing:
    (i) With respect to such chain, the information required to be shown 
in the statement described in subparagraph (4)(i) of this paragraph, and
    (ii) The United States shareholder's interest in such chain which 
was previously included in a consolidation, the taxable years of such 
previous consolidation, and the manner in which such previous 
consolidation was terminated.
    (8) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. Domestic corporation M owns 60 percent of the only class of 
stock of foreign corporation A, and 100 percent of the only class of 
stock of foreign corporation F, respectively. Corporation A owns 80 
percent of the only class of stock of foreign corporations B and C, 
respectively. Corporation M also owns 20 percent of the stock of B 
Corporation. Corporation B owns 80 percent of the only class of stock of 
foreign corporation D. Corporations B and C each own 50 percent of the 
only class of stock of foreign corporation E. Corporation F owns 100 
percent of the only class of stock of foreign corporation G, which owns 
100 percent of the only class of stock of foreign corporation H. 
Corporation F also owns 20 percent of the stock of C Corporation. 
Domestic corporations N and R own 30 percent and 10 percent, 
respectively, of the stock of A Corporation. All corporations use the 
calendar year as a taxable year, and all foreign corporations qualify as 
export trade corporations for 1963. Corporation M may elect for 1963 to 
consolidate its interest in the chain (the ``A'' chain) of export trade 
corporations which includes corporations A, B, C, D, and E; and 
Corporation M need not, but may, elect to consolidate its interest in 
the chain (the ``F'' chain) of export trade corporations which includes 
corporations F, G, and H. Consolidation of M Corporation's interest in 
the ``A'' chain with its interest in the ``F'' chain is not permitted. 
If M Corporation elects to consolidate the ``A'' chain, M Corporation 
must include in the consolidation its 20 percent directly owned interest 
in B Corporation and its 20 percent indirectly owned (through F 
Corporation) interest in C Corporation. Either N Corporation or R 
Corporation, or both, may join M Corporation in electing to consolidate 
their interests in the ``A'' chain. However, neither N Corporation nor R 
Corporation may elect to consolidate the ``A'' chain unless M 
Corporation also agrees to so elect, because corporations N and R, 
neither jointly nor separately, own more than 50 percent of the total 
combined voting power of all classes of stock entitled to vote of A 
Corporation. If corporations M, N, and R elect to consolidate the ``A'' 
chain, the determinations specified in subparagraph (1) of this 
paragraph will be made on a consolidated basis with respect to such 
corporations' respective interest in the chain as shown in the following 
tabulation:

------------------------------------------------------------------------
                                               A %  B %  C %   D %   E %
------------------------------------------------------------------------
M Corporation's interest:
  Direct interest............................   60
  (60% x 80%) + 20% direct interest..........  ...   68
  (60% x 80%) + 20% indirect interest........  ...  ...   68
  (68% x 80%)................................  ...  ...  ...   54.4
  (68% x 50%) + (68% x 50%)..................  ...  ...  ...  .....   68
N Corporation's interest:
  Direct interest............................   30
  (30% x 80%)................................  ...   24
  (30% x 80%)................................  ...  ...   24
  (24% x 80%)................................  ...  ...  ...   19.2
  (24% x 50%) + (24% x 50%)..................  ...  ...  ...  .....   24
R Corporation's interest:
  Direct interest............................   10
  (10% x 80%)................................  ...    8
  (10% x 80%)................................  ...  ...    8
  (8% x 80%).................................  ...  ...  ...    6.4
  (8% x 50%) + (8% x 50%)....................  ...  ...  ...  .....    8
                                              --------------------------
    Total interests to which consolidation     100  100  100     80  100
     applies.................................
------------------------------------------------------------------------

    (b) Effect of consolidation--(1) Determination of subpart F income, 
export trade income, etc. An election under paragraph (a) of this 
section to consolidate export trade corporations in a chain of such 
corporations shall have no effect on the determination of the

[[Page 597]]

character of income as subpart F income or on the determination of 
export trade income, export trade income which constitutes foreign base 
company income, or earnings and profits of the individual export trade 
corporations in the chain. Thus, the consolidation of export trade 
corporations under this section shall not have the effect of reducing 
earnings and profits of such corporations or of changing the 
characterization of income from that which is, for example, foreign base 
company income to that which is not. The application of this paragraph 
may be illustrated by the following example:

    Example. Corporation A, incorporated under the laws of foreign 
country X, and corporation B, incorporated under the laws of foreign 
country Y, are both wholly owned subsidiaries of domestic corporation M. 
Corporations A and B both qualify under section 971(a) as export trade 
corporations. Corporation A purchases personal property produced in the 
United States from an unrelated person and sells the property to B 
Corporation for use outside of country X. Corporation B resells the 
property to an unrelated person for use in foreign country Z. 
Corporations A and B each derive foreign base company sales income 
described in Sec. 1.954-3 from the purchase and sale transactions. 
Consolidation of Corporations A and B under this section does not result 
in the two transactions being treated as one transaction which is a 
purchase of property from an unrelated person and a sale of property to 
an unrelated person or the nonrecognition of gain on the sale of export 
property by A Corporation to B Corporation.

    (2) Determination of amount by which consolidated subpart F income 
is reduced--(i) In general. In determining the amount by which the 
subpart F income of each export trade corporation includible in a 
consolidation of export trade corporations shall be reduced as provided 
in section 970(a) and paragraph (b)(1) of Sec. 1.970-1 for any taxable 
year of consolidation, the limitations provided by section 970(a) and 
paragraph (b)(2) of Sec. 1.970-1 on such amount for each such export 
trade corporation shall be determined on the basis of such corporation's 
separate share of--
    (a) Amounts included in the total export promotion expense,
    (b) The total gross receipts from the sale, installation, operation, 
maintenance, or use of property in respect of which each such 
corporation derives such export trade income as is properly allocable to 
the export trade income which constitutes foreign base company income, 
and
    (c) The total increase in investments in export trade assets,


of all export trade corporations to which the consolidation applies for 
the taxable year.
    (ii) Limitations not effective. If for any taxable year each of the 
limitations under paragraph (b)(2) of Sec. 1.970-1, determined on a 
consolidated basis, equals or exceeds the total export trade income 
which constitutes foreign base company income of all corporations 
includible in the consolidation of export trade corporations, the 
subpart F income of each includible corporation shall be reduced under 
section 970(a) for such year by its separate export trade income which 
constitutes foreign base company income.
    (iii) Limitation effective. If for any taxable year one of the 
limitations under paragraph (b)(2) of Sec. 1.970-1, determined on a 
consolidated basis, is less than the total export trade income which 
constitutes foreign base company income of all corporations includible 
in the consolidation of export trade corporations, the amount by which 
the subpart F income of each includible corporation shall be reduced 
under section 970(a) for such year shall be an amount which bears the 
same ratio to the amount by which the subpart F income may be reduced on 
a consolidated basis as the export trade income which constitutes 
foreign base company income of each includible corporation bears to the 
total export trade income which constitutes foreign base company income 
of all export trade corporations includible in the consolidation of 
export trade corporations.
    (iv) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Domestic corporation M owns 100 percent of the only 
class of stock of controlled foreign corporation A, which, in turn, owns 
100 percent of the only class of stock of controlled foreign corporation 
B. All corporations use the calendar year as the taxable year, and 
corporations A and B are export trade corporations throughout the period 
here involved. Corporation M elects

[[Page 598]]

under this section to consolidate corporations A and B for the entire 
period here involved. Corporation M elects under paragraph (a)(2) of 
Sec. 1.970-2 for 1963 to determine both A Corporation's and B 
Corporation's investments in export trade assets as of the close of the 
75th day after the close of such corporations' taxable year.
    (b) The following amounts are applicable to corporations A and B for 
1964:

------------------------------------------------------------------------
                                                Corporation  Corporation
                                                     A            B
------------------------------------------------------------------------
Subpart F income..............................      $100         $200
Export trade income which constitutes foreign         25           75
 base company income..........................
Other export trade income.....................        10           15
Export promotion expenses allocable to export         10           80
 trade income which constitutes foreign base
 company income...............................
Gross receipts from the sale of property in          400          600
 respect of which export trade income which
 constitutes foreign base company income is
 derived......................................
Increase in investments in export trade assets        35          120
 for period beginning with March 16, 1964, and
 ending with March 16, 1965...................
------------------------------------------------------------------------

    (c) The amount by which subpart F income of corporations A and B is 
reduced for 1964 on a separate-company basis without regard to section 
972 may be determined as set forth in items (i) through (vii) below, and 
the results of the consolidation of corporations A and B for 1964 are 
set forth in items (viii) through (x). Assuming an alternative case in 
which for 1964 the facts are the same as set forth in paragraphs (a) and 
(b) of this example except that B Corporation incurs export promotion 
expenses of $50 (rather than $80) which are allocable to the export 
trade income which constitutes foreign base company income, the results 
of the consolidation of corporations A and B for such year (a case where 
one of the limitations under paragraph (b)(2) of Sec. 1.970-1 is 
effective) are set forth in items (xi) through (xiii):

------------------------------------------------------------------------
                                            A            B
                                       Corporation  Corporation   Total
                                           (1)          (2)        (3)
------------------------------------------------------------------------
(i) Subpart F income.................       $100         $200       $300
                                      ==================================
(ii) Export trade income which                25           75        100
 constitutes foreign base company
 income..............................
(iii) Other export trade income......         10           15         25
                                      ----------------------------------
(iv) Total export trade income.......         35           90        125
                                      ==================================
(v) Limitations under Sec. 1.970-
 1(b)(2):
  (a) Increase in export trade assets
   limitation:
    ($35 x $25/$35)..................         25
    ($120 x $75/$90).................  ...........        100
    ([$35 + $120] x $100/ $125)......  ...........  ...........      124
  (b) Gross receipts limitation:
    (10% of $400)....................         40
    (10% of $600)....................  ...........         60
    (10% of $1,000)..................  ...........  ...........      100
  (c) Export promotion expenses
   limitation:
    (150% of $10)....................         15
    (150% of $80)....................  ...........        120
    (150% of $90)....................  ...........  ...........      135
  (d) Export promotion expenses
   limitation (alternative case):
    (150% of $10)....................         15
    (150% of $50)....................  ...........         75
    (150% of $60)....................  ...........  ...........       90
                                      ----------------------------------
(vi) Reduction in subpart F income on         15           60         75
 a separate company basis determined
 without regard to section 972 (item
 (ii), but not to exceed smallest of
 items (v) (a), (b), and (c), in
 columns (1) and (2))................
                                      ----------------------------------
(vii) Subpart F income as reduced on          85          140        225
 a separate company basis (item (i)
 minus item (vi))....................
                                      ==================================
(viii) Reduction in subpart F income   ...........  ...........      100
 on a consolidated basis determined
 under section 972 (item (ii), but
 not to exceed smallest of items (v)
 (a), (b), and (c), in column (3))...
                                      ----------------------------------
(ix) Apportionment of reduction in            25           75        100
 subpart F income (item (ii))........
(x) Subpart F income as reduced on a          75          125        200
 consolidated basis (item (i) minus
 item (ix))..........................
                                      ==================================
 
                            Alternative Case
 
(xi) Reduction in subpart F income on  ...........  ...........        9
 a consolidated basis determined
 under section 972 (item (ii) but not
 to exceed smallest of items (v) (a),
 (b), and (d), in column (3))........
                                                                --------
(xii) Apportionment of reduction in       $22.50
 subpart F income (item (xi) times
 [item (ii) of column (1) over item
 (ii) of column (3)] and item (xi)
 times [item (ii) of column (2) over
 item (ii) of column (3)]); ($90 x
 $25/$100)...........................
  ($90 x $75/$100)...................  ...........     $67.50         90
                                                   ---------------------
(xiii) Subpart F income as reduced on      77.50       132.50        210
 a consolidated basis (item (i) minus
 item (xii)).........................
------------------------------------------------------------------------

    (3) Determination of pro rata share of consolidated withdrawal of 
previously excluded export trade income--(i) In general. If, for any 
taxable year, there is a

[[Page 599]]

decrease in investments in export trade assets under section 970(b) and 
paragraph (c)(1) of Sec. 1.970-1, determined on a consolidated basis, 
of export trade corporations includible in a consolidated chain of such 
corporations, each United States shareholder who has elected under 
paragraph (a) of this section to consolidate his interest in such chain 
of corporations shall include in his gross income, under section 
951(a)(1)(A)(ii) and the regulations thereunder as an amount to which 
section 955 (as in effect before the enactment of the Tax Reduction Act 
of 1975) applies, his pro rata share of the amount of such consolidated 
decrease in investments but only to the extent such pro rata share does 
not exceed the lesser of the limitations provided by section 970(b) and 
paragraph (c)(2) of Sec. 1.970-1 with respect to such shareholder 
determined on a consolidated basis. The consolidated decrease in 
investments and the consolidated limitations shall be determined by 
aggregating the applicable amounts determined under paragraph (c) of 
Sec. 1.970-1 with respect to such shareholder's interest in each 
corporation includible in the consolidation.
    (ii) Allocation of pro rata share of consolidated decrease in 
investments in export trade assets. For purposes of determining the 
amount referred to in paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 for a 
subsequent taxable year, a United States shareholder's pro rata share of 
a consolidated decrease in investments determined under subdivision (i) 
of this subparagraph for the current taxable year shall be allocated to 
such shareholder's interest in each of the export trade corporations 
includible in the consolidation in that ratio which--
    (a) The net amount determined under paragraph (c)(2)(i)(b) of Sec. 
1.970-1 with respect to such shareholder's interest in such corporation 
for all prior taxable years (whether or not a taxable year occurring 
during the period of consolidation) bears to
    (b) The total of the net amounts determined under paragraph 
(c)(2)(i) (b) of Sec. 1.970-1 with respect to such shareholder's 
interests in all export trade corporations includible in such 
consolidation for all prior taxable years (whether or not a taxable year 
occurring during the period of consolidation).
    (iii) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Domestic corporation M owns 60 percent of the only 
class of stock of controlled foreign corporation A, which, in turn, owns 
100 percent of the only class of stock of controlled foreign corporation 
B. All corporations use the calendar year as a taxable year, and 
corporations A and B are export trade corporations throughout the period 
here involved. Corporation M elects to consolidate corporations A and B 
for the entire period here involved.
    (b) The following amounts are applicable to corporations A and B for 
1964:

------------------------------------------------------------------------
                                                            Consolidated
                                              A (1)  B (2)       (3)
------------------------------------------------------------------------
(i) Consolidated decrease in investments in   .....  .....       $100
 export trade assets (determined before
 application of Sec. 1.970-1(c)(2)).......
(ii) M Corporation's pro rata share of        .....  .....         60
 consolidated decrease (60%)................
(iii) M Corporation's pro rata share of        $120    $90        210
 earnings and profits for 1963 and 1964
 (Sec. 1.970-1(c) (2)(i)(a)...............
(iv) M Corporation's pro rata share of net      180     60        240
 amount determined under Sec. 1.970-
 1(c)(2)(i)(b) for 1963.....................
(v) Amount includible in M Corporation's      .....  .....         60
 gross income for 1964 (smallest of items
 (ii), (iii), and (iv) in column (3)).......
------------------------------------------------------------------------


Corporation M must include $60 in its gross income for 1964 under 
section 951(a)(1)(A)(ii) by reason of the application of section 970(b) 
as its pro rata share of the consolidated decrease in investments in 
export trade assets; and, for purposes of determining the amount under 
paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 with respect to M 
Corporation's interest in each of corporations A and B for a subsequent 
taxable year, such consolidated decrease for 1964 is allocated as 
follows: to M Corporation's interest in A Corporation, $45 ($60 times 
$180/$240); and to its interest in B Corporation, $15 ($60 times $60/
$240).
    (c) The following amounts are applicable to corporations A and B for 
1965:

------------------------------------------------------------------------
                                                            Consolidated
                                         A(1)       B(2)         (3)
------------------------------------------------------------------------
(i) Consolidated decrease in          .........  .........         $150
 investments in export trade assets
 (determined before application of
 Sec. 1.970-1(c)(2))..............

[[Page 600]]

 
(ii) M Corporation's pro rata share   .........  .........           90
 of consolidated decrease (60%).....
(iii) M Corporation's pro rata share       $100      ($20)           80
 of earnings and profits (and
 deficits in earnings and profits)
 for 1963, 1964, and 1965 (Sec.
 1.970-1(c)(2)(i)(a))...............
(iv) M Corporation's pro rata share
 of the net amount determined under
 Sec. 1.970-1(c)(2)(i)(b) for 1963
 and 1964...........................
  ($180-$45)........................        135
  ($60-$15).........................  .........         45
    Total...........................  .........  .........          180
(v) Amount includible in M            .........  .........           80
 Corporation's gross income for 1965
 (smallest of items (ii), (iii), and
 (iv) in column (3))................
------------------------------------------------------------------------

Corporation M must include $80 in its gross income for 1965 under 
section 951(a)(1)(A)(ii) by reason of the application of section 970(b) 
as its pro rata share of the consolidated decrease in investments in 
export trade assets; and, for purposes of determining the amount under 
paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 with respect to M 
Corporation's interest in each of corporations A and B for a subsequent 
taxable year, such consolidated decrease for 1965 is allocated as 
follows: to M Corporation's interest in A Corporation, $60 ($80 times 
$135/$180); and to its interest in B Corporation, $20 ($80 times $45/
$180).
    (d) The following amounts are applicable to corporations A and B for 
1966:

------------------------------------------------------------------------
                                                            Consolidated
                                               A(1)   B(2)       (3)
------------------------------------------------------------------------
(i) Consolidated decrease in investments in   .....  .....       $200
 export trade assets (determined before
 application of Sec. 1.970-1(c)(2)).......
(ii) M Corporation's pro rata share of        .....  .....        120
 consolidated decrease (60%)................
(iii) M Corporation's pro rata share of        $120    $50        170
 earnings and profits (and deficits in
 earnings and profits) for 1963, 1964, 1965,
 and 1966 (Sec. 1.970-1(c)(2)(i)(a))......
(iv) M Corporation's pro rata share of the
 net amount determined under Sec. 1.970-
 1(c)(2)(i)(b) for 1963, 1964, and 1965.....
  ($180 minus [$45 + $60])..................     75
  ($60-[$15 + $20]).........................  .....     25
    Total...................................  .....  .....        100
(v) Amount includible in M Corporation's      .....  .....        100
 gross income for 1966 (smallest of items
 (ii), (iii), and (iv) in column (3)).......
------------------------------------------------------------------------

Corporation M must include $100 in its gross income for 1966 under 
section 951(a)(1)(A)(ii) by reason of the application of section 970(b) 
as its pro rata share of the consolidated decrease in investments in 
export trade assets; and, for purposes of determining the amount under 
paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 with respect to M 
Corporation's interest in each of corporations A and B for a subsequent 
taxable year, such consolidated decrease for 1966 is allocated as 
follows: to M Corporation's interest in A Corporation, $75 ($100 times 
$75/$100); and to its interest in B Corporation, $25 ($100 times $25/
$100).

[T.D. 6754, 29 FR 12714, Sept. 9, 1964, as amended by T.D. 7893, 48 FR 
22512, May 19, 1983]



Sec. 1.981-0  Repeal of section 981; effective dates.

    The provisions of section 981 are not effective for taxable years 
beginning after December 31, 1976. For the treatment of the community 
income of aliens and their spouses for taxable years beginning after 
December 31, 1976, see section 879 and the regulations thereunder.

[T.D. 7670, 45 FR 6929, Jan. 31, 1980]



Sec. 1.981-1  Foreign law community income for taxable years beginning
after December 31, 1966, and before January 1, 1977.

    (a) Election for special treatment--(1) In general. An individual 
citizen of the United States who meets the requirements of section 
981(a)(1) and subparagraph (2) of this paragraph for any open taxable 
year beginning after December 31, 1966, and before January 1, 1977, may 
make a binding election with his nonresident alien spouse to have 
section 981(b) and paragraph (b) of this section apply to their income 
for such year which is treated as community income under the applicable 
community property laws of a foreign country or countries. Generally, 
the community property laws of a foreign country operate upon land 
situated within its jurisdiction and upon personal property owned

[[Page 601]]

by spouses domiciled therein. If the election is made for any taxable 
year, it shall also apply for all subsequent open taxable years of such 
citizen and his nonresident alien spouse for which all the requirements 
of section 981(a)(1) and subparagraph (2) of this paragraph are met, 
unless the Director of International Operations consents, in accordance 
with paragraph (c)(2) of this section, to a termination of the election. 
An election under section 981(a) and this section has no effect for any 
taxable year beginning before January 1, 1967, for which a separate 
election, if made, must be made under section 981(c)(1) and Sec. 1.981-
2. For the definition of ``open taxable year'' see section 981(e)(2) and 
paragraph (a) of Sec. 1.981-3. If the citizen and his nonresident alien 
spouse have different taxable years, see paragraph (c) of Sec. 1.981-3. 
If one of the spouses is deceased, see paragraph (d) of Sec. 1.981-3.
    (2) Requirements to be met. In order for a U.S. citizen and his 
nonresident alien spouse to make an election under section 981(a) and 
this section for any taxable year and in order for the election to apply 
for any subsequent taxable year it is required under section 981(a)(1) 
that, for each such taxable year, such citizen be (i) a citizen of the 
United States, (ii) a bona fide resident of a foreign country or 
countries during the entire taxable year, and (iii) married at the close 
of the taxable year to an individual who is (a) a nonresident alien 
during the entire taxable year and (b), in the case of any such 
subsequent taxable year, the same nonresident alien individual to whom 
the citizen was married at the close of the earliest of such taxable 
years. If either spouse dies during a taxable year, the taxable year of 
the surviving spouse shall be treated, solely for purposes of making the 
determination under subdivision (iii) of this subparagraph, as ending on 
the date of such death. A citizen of the United States shall be 
considered as not married at the close of his taxable year if he is 
legally separated from his spouse under a decree of divorce or of 
separate maintenance. However, the mere fact that spouses have not lived 
together during the course of the taxable year shall not cause them to 
be considered as not married at the close of the taxable year. A husband 
and wife who are separated under an interlocutory decree of divorce 
retain the relationship of husband and wife until the decree becomes 
final.
    (3) Determination of residence. The principles of paragraphs (a)(2) 
and (b)(7) of Sec. 1.911-1 (26 CFR 1.911-1 (1978)) shall apply in order 
to determine for purposes of this paragraph whether a U.S. citizen is a 
bona fide resident of a foreign country or countries during the entire 
taxable year. The principles of Sec. Sec. 1.871.2 through 1.871-5 shall 
apply in order to determine whether the alien spouse of a U.S. citizen 
is a nonresident during the entire taxable year.
    (4) Manner of electing. The election under section 981(a) and this 
section shall be made in accordance with the applicable rules set forth 
in paragraph (c) of this section.
    (b) Treatment of community income--(1) In general. Community income 
for any taxable year to which an election under section 981(a) and this 
section applies, and the deductions properly allocable to such income, 
shall be divided between the electing U.S. citizen and nonresident alien 
spouses in accordance with the rules set forth in section 981(b) and 
subparagraphs (2) through (6) of this paragraph. Community income for 
this purpose means all gross income, whether derived from sources within 
or without the United States, which is treated as community income of 
the spouses under the community property laws of the foreign country 
having jurisdiction to determine the legal ownership of the income. A 
spouse has ownership of the income for this purpose if under the 
applicable foreign law he has a proprietary vested interest in the 
income.
    (2) Earned income. Wages, salaries, or professional fees, and other 
amounts received as compensation for personal services actually 
performed, which are community income for the taxable year, shall be 
treated as the income of the spouse who actually performed the personal 
services. This subparagraph does not apply, however, to community income 
(i) derived from any trade or business carried on by the husband or the 
wife, (ii) attributable to a spouse's distributive share of the income 
of a

[[Page 602]]

partnership to which subparagraph (4) of this paragraph applies, (iii) 
consisting of compensation for personal services rendered to a 
corporation which represents a distribution of the earnings and profits 
of the corporation rather than a reasonable allowance as compensation 
for the personal services actually performed, or (iv) derived from 
property which is acquired as consideration for personal services 
performed.
    (3) Trade or business income. If any income derived from a trade or 
business carried on by the husband or wife is community income for the 
taxable year, all of the gross income, and the deductions attributable 
to such income, shall be treated as the gross income and deductions of 
the husband unless the wife exercises substantially all of the 
management and control of the trade or business, in which case all of 
the gross income and deductions shall be treated as the gross income and 
deductions of the wife. This subparagraph does not apply to any income 
derived from a trade or business carried on by a partnership of which 
both or one of the spouses is a member. For purposes of this 
subparagraph, income derived from a trade or business includes any 
income derived from a trade or business in which both personal services 
and capital are material income producing factors. The term ``management 
and control'' means management and control in fact, not the management 
and control imputed to the husband under the community property laws of 
a foreign country. For example, a wife who operates a beauty parlor 
without any appreciable collaboration on the part of a husband is 
considered as having substantially all of the management and control of 
the business despite the provisions of any community property laws of a 
foreign country vesting in the husband the right of management and 
control of community property; and the income and deductions 
attributable to the operation of the beauty parlor are considered the 
income and deductions of the wife.
    (4) Partnership income. If any portion of a spouse's distributive 
share of the income of a partnership of which such spouse is a member is 
community income for the taxable year, all of that distributive share 
shall be treated as the income of that spouse and shall not be taken 
into account in determining the income of the other spouse. If both 
spouses are members of the same partnership, the distributive share of 
the income of each spouse which is community income shall be treated as 
the income of that spouse. A spouse's distributive share of such income 
of a partnership shall be determined as provided in section 704, and the 
regulations thereunder.
    (5) Income from separate property. Any community income for the 
taxable year, other than income described in section 981(b)(1) or (2) 
and subparagraph (2), (3), or (4) of this paragraph, which is derived 
from the separate property of one of the spouses shall be treated as the 
income of that spouse. The determination of what property is separate 
property for this purpose shall be made in accordance with the laws of 
the foreign country which, in accordance with subparagraph (1) of this 
paragraph, has jurisdiction to determine that the income from such 
property is community income.
    (6) Other community income. Any community income for the taxable 
year, other than income described in section 981(b)(1), (2), or (3), and 
subparagraph (2), (3), (4), or (5) of this paragraph, shall be treated 
as the income of that spouse who has a proprietary vested interest in 
that income under the laws of the foreign country which, in accordance 
with subparagraph (1) of this paragraph, has jurisdiction to determine 
that such income is community income. Thus, for example, this 
subparagraph applies to community income not described in subparagraph 
(2), (3), (4), or (5) of this paragraph which consists of dividends, 
interest, rents, royalties, or gains, from community property or of the 
earnings of unemancipated minor children.
    (7) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. H, a nonresident alien individual and W, a U.S. citizen, 
each of whose taxable years is the calendar year, were married 
throughout 1967. H and W were residents of, and domiciled in, foreign 
country Z during the entire taxable year. During 1967, H

[[Page 603]]

earned $10,000 from the performance of personal services as an employee. 
H also received $500 in dividend income from stock which under the 
community property laws of country Z is considered to be the separate 
property of H. W had no separate income for 1967. Under the community 
property laws of country Z all income earned by either spouse is 
considered to be community income, and one-half of such income is 
considered to belong to the other spouse. In addition, such laws of 
country Z provide that all income derived from property held separately 
by either spouse is to be treated as community income and treated as 
belonging one-half to each spouse. Thus, under the community property 
laws of country Z, H and W are both considered to have realized income 
of $5,250 during 1967, even though such laws recognize the stock as the 
separate property of H. If the election under this section is in effect 
for 1967, under the rules of subparagraphs (2) and (5) of this paragraph 
all of the income of $10,500 derived during 1967 shall be treated, for 
U.S. income tax purposes, as the income of H.
    Example 2. The facts are the same as in example 1 except that H is 
the sole proprietor of a retail merchandising company and such company 
has a $10,000 profit during 1967. W exercises no management and control 
over the business. In addition, H is a partner in a wholesale 
distributing company, and his distributive share of the partnership 
profit is $5,000. Both of these amounts of income are treated as 
community income under the community property laws of country Z, and 
under such laws both H and W are treated as realizing $7,500 of such 
income. If the election under this section is in effect for 1967, under 
the rule of subparagraphs (3) and (4) of this paragraph all $15,000 of 
such income shall be treated as the income of H for U.S. income tax 
purposes.
    Example 3. The facts are the same as in example 1 except that H also 
received $1,000 in dividends on stock held separately in his name. Under 
the community property laws of country Z the stock is considered to be 
community property; and the dividends, to be community income, one-half 
of such income being treated as the income of each spouse. If the 
election under this section is in effect for 1967, under the rule of 
subparagraph (6) of this paragraph, $500 of the dividend income shall be 
treated, for U.S. income tax purposes, as the income of each spouse.

    (c) Time and manner of making or terminating an election--(1) In 
general. A citizen of the United States and his nonresident alien spouse 
shall, for the first taxable year beginning after December 31, 1966, for 
which an election under section 981(a) and this section is to apply, 
make the election by filing a return, an amended return, or a claim for 
refund, whichever is proper, for such taxable year and attaching thereto 
a statement that the election is being made and that the requirements of 
paragraph (a)(2) of this section are met for such taxable year. The 
statement must show the name, address, and account number, if any, of 
each spouse, the name and address of the executor, administrator, or 
other person making the election for a deceased spouse, the taxable year 
to which the election applies, and the name of the foreign country or 
countries having jurisdiction to determine the ownership of any income 
being treated in accordance with section 981(b) and paragraph (b) of 
this section. The statement must be signed by both persons making the 
election. An election under this section may be made only for a taxable 
year which, on the date of the election, as defined in paragraph (b) of 
Sec. 1.981-3, is open within the meaning of section 981(e)(2) and 
paragraph (a) of Sec. 1.981-3.
    (2) Termination only with consent of Director of International 
Operations--(i) In general. An election under this section for any 
taxable year is binding and may not be revoked. The election shall also 
remain in effect for all subsequent taxable years of the spouses for 
which the requirements of paragraph (a)(2) of this section are met and 
which on the date of the election are open, within the meaning of 
paragraph (a) of Sec. 1.981-3, unless the election is terminated for 
any such subsequent taxable year or years in accordance with subdivision 
(ii) of this subparagraph. Any return, amended return, or claim for 
refund in respect of any such subsequent taxable year for which the 
election is in effect shall have attached thereto a copy of the 
statement filed in accordance with subparagraph (1) of this paragraph 
and an additional signed statement that for such subsequent taxable year 
the requirements of paragraph (a)(2) of this section are met.
    (ii) Written request to terminate required. A request to terminate 
an election under this section for a subsequent taxable year or years 
shall be made in writing by the persons who made the election and shall 
be addressed to the Director of International

[[Page 604]]

Operations, Internal Revenue Service, Washington, DC 20225. The request 
must include the name, address, and account number, if any, of each 
spouse and must be signed by the persons making the request. It must 
specify the taxable year or years for which the termination is to be 
effective and the grounds which justify the termination. The request 
shall be filed not later than 90 days before the close of the period for 
assessing a deficiency against the U.S. citizen for the earliest taxable 
year of such citizen for which the termination is to be effective. The 
Director of International Operations may require such other information 
as may be necessary in order to determine whether the termination will 
be permitted. A copy of the consent by the Director of International 
Operations to terminate must be attached to an amended income tax return 
for each taxable year for which the termination is effective and for 
which a return has previously been filed.

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

[T.D. 7330, 39 FR 38372, Oct. 31, 1974, as amended by T.D. 7670, 45 FR 
6929, Jan. 31, 1980; T.D. 7736, 45 FR 76143, Nov. 18, 1980]



Sec. 1.981-2  Foreign law community income for taxable years beginning
before January 1, 1967.

    (a) Election for special treatment--(1) In general. For all open 
taxable years beginning before January 1, 1967, for which an individual 
citizen of the United States meets the requirements of subparagraphs (A) 
and (C) of section 981(a)(1) and subparagraph (2) of this paragraph, 
such citizen and his nonresident alien spouse may make a joint election 
to have section 981(c)(2) and paragraph (b) of this section apply to 
their income which is treated as community income under the applicable 
community property laws of a foreign country or countries. However, if 
the conditions prescribed by section 981(d)(3) and subparagraph (3) of 
this paragraph are met, the nonresident alien spouse is not required to 
join in the election and such citizen may make a separate election to 
have section 981(c)(2) and paragraph (b) of this section apply to such 
income for such taxable years. An election under section 981(c)(1) and 
this section shall apply to every open taxable year of such citizen and 
his nonresident alien spouse beginning before January 1, 1967, for which 
all the requirements of subparagraphs (A) and (C) of section 981(a)(1) 
and subparagraph (2) of this paragraph are met. It is immaterial whether 
such open taxable year is a taxable year subject to the provisions of 
the 1954 Code, the 1939 Code, or any other internal revenue law in 
effect before the 1939 Code. An election under section 981(c)(1) and 
this section has no effect for any taxable year beginning after December 
31, 1966. For the definition of ``open taxable year'' see section 
981(e)(2) and paragraph (a) of Sec. 1.981-3. If the citizen and his 
nonresident alien spouse have different taxable years, see paragraph (c) 
of Sec. 1.981-3. If one of the spouses is deceased, see paragraph (d) 
of Sec. 1.981-3. An election under section 981(c)(1) and this section 
is binding and may not be revoked.
    (2) Requirements to be met. In order for the citizen of the United 
States to make an election under this section, whether required to be 
made jointly with his nonresident alien spouse or permitted to be made 
separately, it is required under section 981(c)(1) that, for each 
taxable year to which the election applies, the citizen making the 
election be (i) a citizen of the United States and (ii) married at the 
close of the taxable year to an individual who is (a) a nonresident 
alien during the entire taxable year and (b), in the case of any such 
taxable years subsequent to the first, the same nonresident alien 
individual to whom the citizen was married at the close of such first 
taxable year. The provisions of paragraph (a)(2) of Sec. 1.981-1 apply 
to determine whether a U.S. citizen making an election under section 
981(c)(1) and this section is married at the close of a taxable year to 
an individual who is a nonresident alien during the entire taxable year.
    (3) Cases where joint election is not required. A nonresident alien 
spouse is not required to join in an election under section 981(c)(1) 
and this section if the Director of International Operations determines 
in accordance with paragraph (c)(4) of this section--

[[Page 605]]

    (i) That an election under section 981(c)(1) and this section would 
not affect the liability for Federal income tax of the nonresident alien 
spouse for any taxable year, whether beginning on, before, or after 
January 1, 1967, or
    (ii) That the effect of the election on the liability of the 
nonresident alien spouse for Federal income tax for any such taxable 
year cannot be ascertained and that to deny the election to the U.S. 
citizen spouse would be inequitable and cause undue hardship to the U.S. 
citizen.


If in accordance with this subparagraph the nonresident alien spouse is 
not required to join in the election by the U.S. citizen, the provisions 
of section 981(d)(2) and paragraph (e) of Sec. 1.981-3 shall not apply 
so as to extend the period for assessing deficiencies or filing a claim 
for credit or refund for any taxable year of the nonresident alien 
spouse.
    (4) Manner of electing. The election under section 981(c)(1) and 
this section shall be made in accordance with the applicable rules set 
forth in paragraph (c) of this section.
    (b) Treatment of community income--(1) In general. Community income, 
as defined in paragraph (b)(1) of Sec. 1.981-1, for any taxable year 
beginning before January 1, 1967, to which an election under section 
981(c)(1) and this section applies, and the deductions properly 
allocable to such income, shall be divided between the U.S. citizen and 
his nonresident alien spouse in accordance with the rules set forth in 
section 981(c)(2) and subparagraphs (2) and (3) of this paragraph. The 
income shall be divided in such manner even though the nonresident alien 
spouse is not required, in accordance with paragraph (a)(3) of this 
section, to join in the election by the U.S. citizen.
    (2) Earned income, business income, partnership income, and income 
from separate property. All community income for any taxable year to 
which this paragraph applies which is treated as the income of one of 
the spouses in accordance with section 981(b)(1), (2), or (3) and 
paragraph (b)(2), (3), (4), or (5) of Sec. 1.981-1 shall be treated as 
the income of that spouse for purposes of this paragraph.
    (3) Other community income. All community income for any taxable 
year to which this paragraph applies, other than income described in 
subparagraph (2) of this paragraph, shall be treated as the income of 
the spouse who, for such taxable year, has a greater amount of gross 
income than the other spouse, determined by adding to the amount of 
gross income which is treated as the gross income of that spouse in 
accordance with subparagraph (2) of this paragraph the amount of the 
gross income for the taxable year which is treated as the separate 
income of that spouse under the community property laws of the foreign 
country having jurisdiction to determine the legal ownership of the 
income. If either spouse dies during a taxable year, the taxable year of 
the surviving spouse shall be treated as ending on the date of such 
death for the purpose of determining which spouse has the greater amount 
of gross income for such taxable year. Moreover, if the U.S. citizen and 
his nonresident alien spouse do not have the same taxable year, as 
defined in section 441(b) and the regulations thereunder, the periods 
for which the amounts of gross income are to be compared under this 
subparagraph are (i) the taxable year of the citizen and (ii) that 
period falling within the consecutive taxable years of the nonresident 
alien spouse which coincides with the period covered by such taxable 
year of the citizen. See paragraph (c) of Sec. 1.981-3.
    (c) Time and manner of making election--(1) In general. A citizen of 
the United States and his nonresident alien spouse or, if subparagraph 
(4) of this paragraph applies, such citizen alone may make an election 
under section 981(c)(1) and this section at any time on or after 
November 13, 1966, for each and every taxable year beginning before 
January 1, 1967, which on the date of the election, as defined in 
paragraph (b) of Sec. 1.981-3, is open within the meaning of section 
981(e)(2) and paragraph (a) of Sec. 1.981-3. The election shall be made 
by filing a return, an amended return, or a claim for refund, whichever 
is proper, for each taxable year to

[[Page 606]]

which the election applies and attaching thereto a statement that the 
election is being made and that the requirements of paragraph (a)(2) of 
this section are met for each such taxable year. The statement must also 
show the information required by subparagraph (2) of this paragraph and 
must, where applicable, be signed by both persons making the election.
    (2) Information required. The statement described in subparagraph 
(1) of this paragraph must show--
    (i) The name, address, and account number, if any, of each spouse,
    (ii) The name and address of the executor, administrator, or other 
person making the election for a deceased spouse,
    (iii) The taxable years to which the election applies,
    (iv) The office of the district director, or the service center, 
where the return or returns, if any, for such taxable year or years were 
filed,
    (v) The dates on which such return or returns, if any, were filed 
and on which the tax for such taxable year or years was paid, if the tax 
has been paid, and
    (vi) The name of the foreign country or countries having 
jurisdiction to determine the ownership of any income being treated in 
accordance with section 981(c)(2) and paragraph (b) of this section.
    (3) Place for filing. Any return, amended return, or claim for 
refund filed under subparagraph (1) of this paragraph in respect of any 
taxable year shall be filed with the Director of International 
Operations, Internal Revenue Service, Washington, DC 20225. (See Sec. 
1.6091-3.)
    (4) Determination that joint election is not required. A U.S. 
citizen spouse entitled to make an election under section 981(c)(1) and 
this section for open taxable years beginning before January 1, 1967, 
may apply to the Director of International Operations for a 
determination under section 981(d)(3) that the nonresident alien spouse 
is not required to join in the election by such citizen. This 
application shall be made by filing with the Director of International 
Operations, Internal Revenue Service, Washington, DC 20225, a statement 
setting forth the same information required by subparagraph (2) of this 
paragraph and such other information as is required by the Director of 
International Operations to justify a claim that the requirements of 
section 981(d)(3) and paragraph (a)(3) of this section are met. The 
Director of International Operations shall notify the U.S. citizen by 
letter of his determination with respect to the application. If the 
determination is that the nonresident alien spouse is not required to 
join in the election, a copy of the letter of determination shall be 
attached to each return, amended return, or claim for refund, to be 
filed pursuant to subparagraph (1) of this paragraph.

[T.D. 7330, 39 FR 38373, Oct. 31, 1974]



Sec. 1.981-3  Definitions and other special rules.

    (a) Open taxable years. (1) For purposes of paragraph (a) of Sec. 
1.981-1, and paragraph (a) of Sec. 1.981-2, a taxable year of the U.S. 
citizen, and the taxable year or years of his nonresident alien spouse 
ending or beginning within such taxable year of such citizen, shall be 
treated as open if the period prescribed by section 6501(a) (or section 
6501(c)(4) if the period is extended by agreement) for assessing a 
deficiency against the citizen for his taxable year has not expired 
before the date of the election, determined under paragraph (b) of this 
section. Thus, for example, a taxable year of a U.S. citizen beginning 
before January 1, 1967, is open for purposes of this subparagraph if, 
before the election under section 981(c)(1) and Sec. 1.981-2, such 
citizen has never filed a return for such year and a return was required 
under section 6012 without reference to section 981. For example, if a 
U.S. citizen spouse on a calendar year basis who has never filed a 
return for 1960 decides in 1975 that he wishes to make the election 
under section 981(c)(1) and Sec. 1.981-2 in order to avoid being 
subject to tax for 1960 on his share of the community income for that 
year, he may in 1975 elect the benefits of section 981(c)(2) by filing 
an election in accordance with paragraph (c) of Sec. 1.981-2. In such 
case, a taxable year or years of the nonresident alien spouse of such 
citizen ending or beginning within 1960 shall be treated in 1975 as an 
open taxable year.

[[Page 607]]

    (2) Subparagraph (1) of this paragraph shall apply even though the 
period prescribed by section 6501 for assessing a deficiency against the 
nonresident alien spouse for his taxable year or years ending or 
beginning within the taxable year of the U.S. citizen has expired before 
the election is made.
    (3) If either spouse dies during a taxable year to which an election 
under Sec. 1.981-1 or Sec. 1.981-2 applies, the taxable year of the 
decedent and the surviving spouse shall be determined under this 
paragraph without regard to section 981(e)(4), relating to death of 
spouse during the taxable year. See paragraph (a)(2) of Sec. 1.443-1.
    (4) For definition of the term ``taxable year'', see section 441(b) 
and the regulations thereunder.
    (b) Date of election. (1) For purposes of Sec. 1.981-1 and this 
section the date of an election made under section 981(a) and Sec. 
1.981-1 is the date on which the return, amended return, or claim for 
refund required by paragraph (c)(1) of Sec. 1.981-1 is filed.
    (2) For purposes of Sec. 1.981-2 and this section the date of an 
election made under section 981(c)(1) and Sec. 1.981-2 is the date on 
which the returns, amended returns, or claims for refund, required by 
paragraph (c)(1) of Sec. 1.981-2 are filed.
    (3) For provisions treating timely mailing as timely filing, see 
section 7502 and the regulations thereunder.
    (c) Spouses with different taxable years. If the U.S. citizen and 
his nonresident alien spouse do not have the same taxable year, as 
defined in section 441(b) and the regulations thereunder, the election 
under Sec. 1.981-1 or Sec. 1.981-2 shall apply to each taxable year of 
such citizen in respect of which the election is made and to that period 
falling within the consecutive taxable years of the nonresident alien 
spouse which coincides with the period covered by such taxable year of 
the citizen.
    (d) Election on behalf of deceased spouse. Any election, statement, 
or request, required to be made under paragraph (c) of Sec. 1.981-1, or 
paragraph (c) of Sec. 1.981-2, by one of the spouses may, if such 
spouse is deceased, be made by the executor, administrator, or other 
person charged with the property of such deceased spouse.
    (e) Extension of period of limitations on assessment or refund--(1) 
Assessment of deficiency. Except as provided in subparagraph (3) of this 
paragraph, if an election under section 981(a) and Sec. 1.981-1, or 
under section 981(c)(1) and Sec. 1.981-2, is properly made, the period 
within which a deficiency may be assessed for any taxable year to which 
the election applies shall, to the extent the deficiency is attributable 
to the application of such election, not expire before one year after 
the date of the election, determined under paragraph (b) of this 
section.
    (2) Refund of tax. Except as provided in subparagraph (3) of this 
paragraph, if an election under section 981(a) and Sec. 1.981-1, or 
under section 981(c)(1) and Sec. 1.981-2, is properly made, the period 
within which a claim for credit or refund of an overpayment for any 
taxable year to which the election applies may be filed shall, to the 
extent the overpayment is attributable to the application of the 
election, not expire before one year after the date of the election, 
determined under paragraph (b) of this section.
    (3) Exception in case of nonelecting alien. Subparagraphs (1) and 
(2) of this paragraph shall not apply to any taxable year of a 
nonresident alien spouse who, in accordance with paragraph (a)(3) of 
Sec. 1.981-2, is not required to join in the election by the U.S. 
citizen spouse under section 981(c)(1) and Sec. 1.981-2.
    (f) Payment of interest for extension period. To the extent that an 
overpayment or deficiency for any taxable year is attributable to an 
election made under Sec. 1.981-1 or Sec. 1.981-2, no interest shall be 
allowed or paid for any period ending with the day before the date which 
is one year after the date of the election, determined under paragraph 
(b) of this section.

[T.D. 7330, 39 FR 38374, Oct. 31, 1974]



Sec. 1.985-0  Outline of regulation.

    This section lists the paragraphs contained in Sec. Sec. 1.985-1 
through 1.985-6.

                   Sec. 1.985-1 Functional currency.

    (a) Applicability and effective date.
    (b) Dollar functional currency.
    (c) Functional currency of a QBU that is not required to use the 
dollar.

[[Page 608]]

    (d) Single functional currency for a foreign corporation.
    (e) Translation of nonfunctional currency transactions.
    (f) Examples.

Sec. 1.985-2 Election to use the United States dollar as the functional 
                           currency of a QBU.

    (a) Background and scope.
    (b) Eligible QBU.
    (c) Time and manner for dollar election.
    (d) Effect of dollar election.

  Sec. 1.985-3 United States dollar approximate separate transactions 
                                 method.

    (a) Scope and effective date.
    (b) Statement of method.
    (c) Translation into United States dollars.
    (d) Computation of DASTM gain or loss.
    (e) Effect of DASTM gain or loss on gross income, taxable income, or 
earnings and profits.

                   Sec. 1.985-4 Method of accounting.

    (a) Adoption or election.
    (b) Condition for changing functional currencies.
    (c) Relationship to certain other sections of the Code.

 Sec. 1.985-5 Adjustments required upon change in functional currency.

    (a) In general.
    (b) Step 1--Taking into account exchange gain or loss on certain 
section 988 transactions.
    (c) Step 2--Determining the new functional currency basis of 
property and the new functional currency amount of liabilities and any 
other relevant items.
    (d) Step 3A--Additional adjustments that are necessary when a branch 
changes functional currency.
    (e) Step 3B--Additional adjustments that are necessary when a 
taxpayer changes functional currency.
    (f) Examples.

    Section 1.985-6 Transition rules for a QBU that uses the dollar 
  approximate separate transactions method for its first taxable year 
                           beginning in 1987.

    (a) In general.
    (b) Certain controlled foreign corporations.
    (c) All other foreign corporations.
    (d) Pre-1987 section 902 amounts.
    (e) Net worth branch.
    (f) Profit and loss branch.

[T.D. 8263, 54 FR 38653, Sept. 20, 1989, as amended by T.D. 8464, 58 FR 
232, Jan. 5, 1993; T.D. 8556, 59 FR 37672, July 25, 1994]



Sec. 1.985-1  Functional currency.

    (a) Applicability and effective date--(1) Purpose and scope. These 
regulations provide guidance with respect to defining the functional 
currency of a taxpayer and each qualified business unit (QBU), as 
defined in section 989(a). Generally, a taxpayer and each QBU must make 
all determinations under subtitle A of the Code (relating to income 
taxes) in its respective functional currency. This section sets forth 
rules for determining when the functional currency is the United States 
dollar (dollar) or a currency other than the dollar. Section 1.985-2 
provides an election to use the dollar as the functional currency for 
certain QBUs that absent the election would have a functional currency 
that is a hyperinflationary currency, and explains the effect of making 
the election. Section 1.985-3 sets forth the dollar approximate separate 
transactions method that certain QBUs must use to compute their income 
or loss or earnings and profits. Section 1.985-4 provides that the 
adoption of a functional currency is a method of accounting and sets 
forth conditions for a change in functional currency. Section 1.985-5 
provides adjustments that are required to be made upon a change in 
functional currency. Finally, Sec. 1.985-6 provides transition rules 
for a QBU that uses the dollar approximate separate transactions method 
for its first taxable year beginning after December 31, 1986.
    (2) Effective date. These regulations apply to taxable years 
beginning after December 31, 1986. However, any taxpayer desiring to 
apply temporary Income Tax Regulations Sec. 1.985-0T through Sec. 
1.985-4T in lieu of these regulations to all taxable years beginning 
after December 31, 1986, and on or before October 20, 1989 may (on a 
consistent basis) so choose. For the text of the temporary regulations, 
see 53 FR 20308 (1988).
    (b) Dollar functional currency--(1) In general. The dollar shall be 
the functional currency of a taxpayer or QBU described in paragraph 
(b)(1)(i) through (v) of this section regardless of the currency used in 
keeping its books and records (as defined in Sec. 1.989(a)-1(d)). The 
dollar shall be the functional currency of--
    (i) A taxpayer that is not a QBU (e.g., an individual);

[[Page 609]]

    (ii) A QBU that conducts its activities primarily in dollars. A QBU 
conducts its activities primarily in dollars if the currency of the 
economic environment in which the QBU conducts its activities is 
primarily the dollar. The facts and circumstances test set forth in 
paragraph (c)(2) of this section shall apply in making this 
determination;
    (iii) Except as otherwise provided by ruling or administrative 
pronouncement, a QBU that has the United States, or any possession or 
territory of the United States where the dollar is the standard 
currency, as its residence (as defined in section 988(a)(3)(B));
    (iv) A QBU that does not keep books and records in the currency of 
any economic environment in which a significant part of its activities 
is conducted. Whether a QBU keeps such books and records is determined 
in accordance with paragraph (c)(3) of this section; or
    (v) A QBU that produces income or loss that is, or is treated as, 
effectively connected with the conduct of a trade or business within the 
United States.
    (2) QBUs operating in a hyperinflationary environment--(i) Taxable 
years beginning on or before August 24, 1994. For taxable years 
beginning on or before August 24, 1994, see Sec. 1.985-2 with respect 
to a QBU that elects to use, or is otherwise required to use, the dollar 
as its functional currency.
    (ii) Taxable years beginning after August 24, 1994--(A) In general. 
For taxable years beginning after August 24, 1994, except as otherwise 
provided in paragraph (b)(2)(ii)(B) of this section, any QBU that 
otherwise would be required to use a hyperinflationary currency as its 
functional currency must use the dollar as its functional currency and 
compute income or loss or earnings and profits under the rules of Sec. 
1.985-3.
    (B) Exceptions--(1) Certain QBU branches. The functional currency of 
a QBU that otherwise would be required to use a hyperinflationary 
currency as its functional currency and that is a branch of a foreign 
corporation having a non-dollar functional currency that is not 
hyperinflationary shall be the functional currency of the foreign 
corporation. Such QBU's income or loss or earnings and profits shall be 
determined under Sec. 1.985-3 by substituting the functional currency 
of the foreign corporation for the dollar.
    (2) Corporation that is not a controlled foreign corporation. A 
foreign corporation (or its QBU branch) operating in a hyperinflationary 
environment is not required to use the dollar as its functional currency 
pursuant to paragraph (b)(2)(ii)(A) of this section if that foreign 
corporation is not a controlled foreign corporation as defined in 
section 957 or 953(c)(1)(B). However, a noncontrolled section 902 
corporation, as defined in section 904(d)(2)(E), may elect to use the 
dollar (or, if appropriate, the currency specified in paragraph 
(b)(2)(ii)(B)(1) of this section) as its (or its QBU branch's) 
functional currency under the procedures set forth in Sec. 1.985-
2(c)(3).
    (C) Change in functional currency--(1) In general. If a QBU is 
required to change its functional currency to the dollar under paragraph 
(b)(2)(ii)(A) of this section, or chooses or is required to change its 
functional currency to the dollar for any open taxable year (and all 
subsequent taxable years) under Sec. 1.985-3(a)(2)(ii), the change is 
considered to be made with the consent of the Commissioner for purposes 
of Sec. 1.985-4. A QBU changing functional currency must make 
adjustments described in Sec. 1.985-7 if the year of change (as defined 
in Sec. 1.481-1(a)(1)) begins after 1987, or the adjustments described 
in Sec. 1.985-6 if the year of change begins in 1987. No adjustments 
under section 481 are required solely because of a change in functional 
currency described in this paragraph (b)(2)(ii)(C).
    (2) Effective date. This paragraph (b)(2)(ii)(C) applies to taxable 
years beginning after April 6, 1998. However, a taxpayer may choose to 
apply this paragraph (b)(2)(ii)(C) to all open years after December 31, 
1986, provided each person, and each QBU branch of a person, that is 
related (within the meaning of Sec. 1.985-2(d)(3)) also applies to this 
paragraph (b)(2)(ii)(C).
    (D) Hyperinflationary currency. For purposes of sections 985 through 
989, the term hyperinflationary currency means the currency of a country 
in which there is cumulative inflation during the base period of at 
least 100 percent as determined by reference to

[[Page 610]]

the consumer price index of the country listed in the monthly issues of 
the ``International Financial Statistics'' or a successor publication of 
the International Monetary Fund. If a country's currency is not listed 
in the monthly issues of ``International Financial Statistics,'' a QBU 
may use any other reasonable method consistently applied for determining 
the country's consumer price index. Base period means, with respect to 
any taxable year, the thirty-six calendar months immediately preceding 
the first day of the current calendar year. For this purpose, the 
cumulative inflation rate for the base period is based on compounded 
inflation rates. Thus, if for 1991, 1992, and 1993, a country's annual 
inflation rates are 29 percent, 25 percent, and 30 percent, 
respectively, the cumulative inflation rate for the three-year base 
period is 110 percent [((1.29 x 1.25 x 1.3)-1.0 x 1.10) x 100 = 110%] 
and the currency of the country for the QBU's 1994 year is considered 
hyperinflationary. In making the determination whether a currency is 
hyperinflationary, the determination for purposes of United States 
generally accepted accounting principles may be used for income tax 
purposes provided the determination is based on criteria that is 
substantially similar to the rules previously set forth in this 
paragraph (b)(2)(ii)(D), the method of determination is applied 
consistently from year to year, and the same method is applied to all 
related persons as defined in Sec. 1.985-3(e)(2)(vi).
    (E) Change in functional currency when currency ceases to be 
hyperinflationary--(1) In general. A QBU that has been required to use 
the dollar as its functional currency under paragraph (b)(2) of this 
section, or has elected to use the dollar as its functional currency 
under paragraph (b)(2)(ii)(B)(2) of this section or Sec. 1.985-2, must 
change its functional currency as of the first day of the first taxable 
year that follows three consecutive taxable years in which the currency 
of its economic environment, determined under paragraph (c)(2) of this 
section, is not a hyperinflationary currency. The functional currency of 
the QBU for such year shall be determined in accordance with paragraph 
(c) of this section. For purposes of Sec. 1.985-4, the change is 
considered to be made with the consent of the Commissioner. See Sec. 
1.985-5 for adjustments that are required upon a change in functional 
currency.
    (2) Effective Date. This paragraph (b)(2)(ii)(E) of this section 
applies to taxable years beginning after April 6, 1998.
    (c) Functional currency of a QBU that is not required to use the 
dollar--(1) General rule. The functional currency of a QBU that is not 
required to use the dollar under paragraph (b) of this section shall be 
the currency of the economic environment in which a significant part of 
the QBU's activities is conducted, if the QBU keeps, or is presumed 
under paragraph (c)(3) of this section to keep, its books and records in 
such currency.
    (2) Economic environment. For purposes of section 985 and the 
regulations thereunder, the economic environment in which a significant 
part of a QBU's activities is conducted shall be determined by taking 
into account all the facts and circumstances.
    (i) Facts and circumstances. The facts and circumstances that are 
considered in determining the economic environment in which a 
significant part of a QBU's activities is conducted include, but are not 
limited to, the following:
    (A) The currency of the country in which the QBU is a resident as 
determined under section 988(a)(3)(B);
    (B) The currencies of the QBU's cash flows;
    (C) The currencies in which the QBU generates revenues and incurs 
expenses;
    (D) The currencies in which the QBU borrows and lends;
    (E) The currencies of the QBU's sales markets;
    (F) The currencies in which pricing and other financial decisions 
are made;
    (G) The duration of the QBU's business operations; and
    (H) The significance and/or volume of the QBU's independent 
activities.
    (ii) Rate of inflation. The rate of inflation (regardless of how it 
is determined) shall not be a factor used to determine a QBU's economic 
environment.

[[Page 611]]

    (iii) Consistency. A taxpayer must consistently apply the facts and 
circumstances test set forth in this paragraph (c)(2) in evaluating the 
economic environment of its QBUs, e.g., its branches, that engage in the 
same or similar trades or businesses.
    (3) Books and records presumption. A QBU shall be presumed to keep 
books and records in the currency of the economic environment in which a 
significant part of its activities are conducted. The presumption may be 
overcome only if the QBU can demonstrate to the satisfaction of the 
district director that a substantial nontax purpose exists for not 
keeping any books and records in such currency. A taxpayer may not use 
this presumption affirmatively in determining a QBU's functional 
currency.
    (4) Multiple currencies. If a QBU has more than one currency that 
satisfies the requirements of paragraph (c)(1) of this section, the QBU 
may choose any such currency as its functional currency.
    (5) Relationship of United States accounting principles. In making 
the functional currency determination under this paragraph (c), the 
currency of the QBU for purposes of United States generally accepted 
accounting principles (GAAP) will ordinarily be accepted as the 
functional currency of the QBU for income tax purposes, provided that 
the GAAP determination is based on facts and circumstances substantially 
similar to those set forth in paragraph (c)(2) of this section.
    (6) Effect of changed circumstances. Regardless of any change in 
circumstances, a QBU may change its functional currency determined under 
this paragraph (c) only if the QBU complies with Sec. 1.985-4 or the 
Commissioner's consent is considered to have been granted under Sec. 
1.985-2(d)(4) or Sec. 1.985-3(a)(2)(ii). For special rules relating to 
the conversion to the euro, see Sec. 1.985-8.
    (d) Single functional currency for a foreign corporation--(1) 
General rule. This paragraph (d) applies to a foreign corporation that 
has two or more QBUs that do not have the same functional currency. The 
foreign corporation shall be treated as having a single functional 
currency for the corporation as a whole that is different from the 
functional currency of one or more of its QBUs. The determination of a 
foreign corporation's functional currency shall be made by first 
applying paragraph (d)(1)(i) and then paragraph (d)(l)(ii) of this 
section.
    (i) Step 1. Each QBU of the foreign corporation determines its 
functional currency in accordance with the rules set forth in paragraphs 
(b) and (c) of this section and Sec. 1.985-2.
    (ii) Step 2. The foreign corporation determines its functional 
currency applying the principles of paragraphs (b) and (c) of this 
section to the corporation's activities as a whole. Thus, if a foreign 
corporation has two branches, the corporation shall determine its 
functional currency by applying the principles of paragraphs (b) and (c) 
of this section to the combined activities of the corporation and the 
branches. For purposes of this paragraph (d)(1), if a QBU of a foreign 
corporation has the dollar as its functional currency under paragraph 
(b)(2) of this section, the QBU's activities shall be considered dollar 
activities of the corporation.
    (2) Translation of income or loss of QBUs having different 
functional currencies than the foreign corporation as a whole. Where the 
functional currency of a foreign corporation as a whole differs from the 
functional currency of one or more of its QBUs, each such QBU shall 
determine the amount of its income or loss or earnings and profits (or 
deficit in earnings and profits) in its functional currency under the 
principles of section 987 (relating to branch transactions). The amount 
of income or loss or earnings and profits (or deficit in earnings and 
profits) of each QBU in its functional currency shall then be translated 
into the foreign corporation's functional currency using the appropriate 
exchange rate as defined in section 989(b)(4) for purposes of 
determining the corporation's income or loss or earnings and profits (or 
deficit in earnings and profits).
    (e) Translation of nonfunctional currency transactions. Except for a 
QBU using the dollar approximate separate transactions method described 
in Sec. 1.985-3, see section 988 and the regulations thereunder for the 
treatment of nonfunctional currency transactions.

[[Page 612]]

    (f) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. P, a domestic corporation, operates exclusively through 
foreign branch X in Country A. X is a QBU within the meaning of section 
989(a) and its residence is Country A as determined under section 988 
(a)(3)(B). The currency of Country A is the LC. All of X's purchases, 
sales, and expenses are in the LC. The laws of A require X to keep books 
and records in the LC. It is determined that the LC is the currency of X 
under United States generally accepted accounting principles. This 
determination is based on facts and circumstances substantially similar 
to those set forth in paragraph (c)(2) of this section. Under these 
facts, while the functional currency of P is the dollar since its 
residence is the United States, the functional currency of X is the LC.
    Example 2. P, a publicly-held domestic regulated investment company 
(as defined under section 851), operates exclusively through foreign 
branch B in Country R. B is a QBU within the meaning of section 989(a) 
and its residence is Country R as determined under section 988(a)(3)(B). 
The currency of Country R is the LC. B's principal activities consist of 
purchasing and selling stock and securities of Country R companies and 
securities issued by Country R. It is determined that the dollar is the 
currency of B under United States generally accepted accounting 
principles. This determination is not based on facts and circumstances 
substantially similar to those set forth in paragraph (c)(2) of this 
section. Under these facts, while the functional currency of P is the 
dollar since its residence is the United States, B may choose the LC as 
its functional currency because it has significant activities in the LC 
provided it keeps books and records in the LC. The fact that the dollar 
is the currency of B under generally accepted accounting principles is 
irrelevant for purposes of determining B's functional currency because 
the GAAP determination was not based on factors similar to those set 
forth in paragraph (c)(2) of this section.
    Example 3. P, a domestic bank, operates through foreign branch X in 
Country R. X is a QBU within the meaning of section 989(a) and its 
residence is Country R as determined under section 988(a)(3)(B). The 
currency of Country R is the LC. The laws of R require X to keep books 
and records in the LC. The branch customarily loans dollars and LCs. In 
the case of its LC loans, X ordinarily fixes the terms of the loans by 
reference to a contemporary London Inter-Bank Offered Rate (LIBOR) on 
dollar deposits. For instance, the interest on the amount of the 
outstanding LC loan principal might equal LIBOR plus 2 percent and the 
amount of the outstanding LC loan principal would be adjusted to reflect 
changes in the dollar value of the LC. X is primarily funded with 
dollar-denominated funds borrowed from related and unrelated parties. 
X's only LC activities are paying local taxes, employee wages, and local 
expenses such as rent and electricity. Under these facts, X's activities 
are primarily conducted in dollars. Thus, although X keeps its books and 
records in LCs, X's functional currency is the dollar.
    Example 4. S, a foreign corporation organized in Country U, is 
wholly-owned by P, a domestic corporation. The currency of Country U is 
the LC. S's sole function is acting as a financing vehicle for P and 
domestic corporations that are affiliated with P. All borrowing and 
lending transactions between S and P and its domestic affiliates are in 
dollars. Furthermore, primarily all of S's other borrowings are dollar-
denominated or based on a dollar index. S's only LC activities are 
paying local taxes, employee wages, and local expenses such as rent and 
electricity. S keeps its books and records in the LC. Under these facts, 
S's activities are primarily conducted in dollars. Thus, although S 
keeps its books and records in LCs, S's functional currency is the 
dollar.
    Example 5. D is a domestic corporation whose primary activity is the 
extraction of natural gas and oil through foreign branch X in Country Y. 
X is a QBU within the meaning of section 989(a) and its residence is 
Country Y as determined under section 988(a)(3)(B). The currency of 
Country Y is the LC. X bills a significant amount of its natural gas and 
oil sales in dollars and a significant amount in LCs. X also incurs 
significant LC and dollar expenses and liabilities. The laws of Country 
Y require X to keep its books and records in the LC. It is determined 
that the LC is the currency of X under United States generally accepted 
accounting principles. This determination is based on facts and 
circumstances substantially similar to those set forth in paragraph 
(c)(2) of this section. Absent other factors indicating that X primarily 
conducts its activities in the dollar, D could choose either the dollar 
or the LC as X's functional currency because X has significant 
activities in both the dollar and the LC, provided the books and records 
requirement is satisfied. If, instead, X's activities were determined to 
be primarily in the dollar, then X would have to use the dollar as its 
functional currency.
    Example 6. S, a foreign corporation organized in Country U, is 
wholly-owned by P, a domestic corporation. The currency of U is the LC. 
S purchases the products it sells from related and unrelated parties, 
including P. These purchases are made in the LC. In addition, most of 
S's gross receipts are generated by transactions denominated in the LC. 
S attempts to determine its LC price for goods sold in such a manner as 
to obtain an LC equivalent of a certain dollar amount

[[Page 613]]

after reduction for all LC costs. However, local market conditions 
sometimes result in pricing adjustments. Thus, changes in the LC-dollar 
exchange rate from period to period generally result in corresponding 
changes in the LC price of S's products. S pays local taxes, employee 
wages, and other local expenses in the LC. It is determined that the 
dollar is the currency of S under United States generally accepted 
accounting principles. This determination is not based on facts and 
circumstances substantially similar to those set forth in paragraph 
(c)(2) of this section. Under these facts, S could choose either the 
dollar or the LC as its functional currency because S has significant 
activities in both the dollar and the LC, provided that the books and 
records requirement is satisfied.
    Example 7. S, a foreign corporation organized in Country X, is 
wholly-owned by P, a domestic corporation. S conducts all of its 
operations through two branches. Branch A is located in Country F and 
branch B is located in Country G. S, A, and B are QBUs within the 
meaning of section 989(a). Branch A's and branch B's residences are 
Country F and Country G respectively as determined under section 
988(a)(3)(B). The currency of Country F is the FC and the currency of 
Country G is the LC. The functional currencies of S, A, and B are 
determined in a two step procedure.
    Step 1: The functional currency of branches A and B. Branch A and 
branch B both conduct all activities in their respective local 
currencies. The FC is the currency of branch A and the LC is the 
currency of branch B under United States generally accepted accounting 
principles. This determination is based on facts and circumstances 
substantially similar to those set forth in paragraph (c)(2) of this 
section. Under these facts, the functional currency of branch A is the 
FC and the functional currency of branch B is the LC.
    Step 2: The functional currency of S. S's functional currency is 
determined by disregarding the fact that A and B are branches. When A's 
activities and B's activities are viewed as a whole, S determines that 
it only conducts significant activities in the LC. Therefore, S's 
functional currency is the LC. See Examples 9, 10, and 11 for how the 
earnings and profits of a foreign corporation, which has branches with 
different functional currencies, are determined.
    Example 8. Assume the same facts as in Example 7, except that S does 
not exist and P conducts all of its operations through branch A and 
branch B. In this instance P's functional currency in Step 2 is the 
dollar, regardless of the fact that its branches' activities viewed as a 
whole are in the LC, because P is a taxpayer whose residence is the 
United States under section 988(a)(3)(B)(i). Therefore, while the 
functional currency of branch A is the FC and the functional currency of 
branch B is the LC, the functional currency of P is the dollar because 
its residence is the United States.
    Example 9. The facts are the same as in Example 7. ln addition, 
assume that in 1987 branch A has earnings of 100 FC and branch B has 
earnings of 100 LC as determined under section 987. The weighted average 
exchange rate for the year is 1 FC/2 LC. Branch A's earnings are 
translated into 200 LC for purposes of computing S's earnings and 
profits in 1987. Thus, the total earnings and profits of S from branch A 
and branch B for 1987 is 300 LC.
    Example 10. (i) X, a foreign corporation organized in Country W, is 
wholly-owned by P, a domestic corporation. Both X and P are calendar 
year taxpayers that began business during 1987. X operates exclusively 
through two branches, A and B both of which are located outside of 
Country W. The functional currency of X and A is the LC, while the 
functional currency of B is the DC as determined under section 985 and 
Sec. 1.985-1. The earnings of B must be computed under section 987, 
relating to branch transactions. In 1987, A earns 900 LCs of nonsubpart 
F income and B earns 200 DCs of nonsubpart F income. Under section 
904(d)(2), A's income is financial service income and B's income is 
general limitation income. In order to determine X's earnings and 
profits, B's income must be translated into LCs (the functional currency 
of X). The weighted average exchange rate for 1987 is 1 LC/2 DC. Thus, 
in 1987 X's current earnings and profits (and its post-1986 
undistributed earnings) are 1000 LCs consisting of 900 LCs of financial 
services income earned by A and 100 LCs (200 DC/2) of general limitation 
income earned by B. Neither A nor B makes any remittances during 1987.
    (ii) In 1988, neither A nor B earns any income or generates any 
loss. On December 31, 1988, A remits 50 LCs directly to P. The 
remittance to P is considered to be remitted by A to X and then 
immediately distributed by X as a dividend. The 50 LC remittance does 
not result in an exchange gain or loss under section 987 to X because 
the functional currency of X and A is the LC. See section 987(3). Under 
section 904(d)(3)(D), the 50 LC dividend is treated as income in a 
separate category to the extent of the dividend's pro rata share of X's 
earnings and profits in each separate limitation category. Thus, 90 
percent, or 45 LCs, is treated as financial services income, and 10 
percent, or 5 LCs, is treated as general limitation income. After the 
dividend distribution, X has 950 LCs of accumulated earnings and profits 
(and post-1986 undistributed earnings) consisting of 855 LCs of 
financial service limitation income and 95 LCs of general limitation 
income.

[[Page 614]]

    Example 11. The facts are the same as in Example 10, except that A 
makes no remittance during 1988 but B remits 120 DCs to X on December 
31, 1988, which X immediately converts into LCs, and X makes no dividend 
distribution during 1988. Assume that the appropriate exchange rate for 
the remittance is 1 LC/3 DCs. B's remittance triggers exchange loss to 
X. See section 987(3). Under section 987, the exchange loss on the 
remittance is 20 LCs calculated as follows: 40 LCs, which is the LC 
value of the 120 DC remittance (120 DCs/3), less 60 LCs, their LC basis 
(120 DCs/2). This loss is sourced and characterized under section 987 
and regulations thereunder.
    Example 12. F, a foreign corporation, has gain from the disposition 
of a United States real property interest (as defined in section 
897(c)). The gain is taken into account as if F were engaged in a trade 
or business within the United States during the taxable year and as if 
such gain were effectively connected with such trade or business. F's 
disposition activity shall be treated as a separate QBU with a dollar 
functional currency because such activity produced income that is 
treated as effectively connected with a trade or business within the 
United States. Therefore, F must compute its gain from the disposition 
by giving the United States real property interest an historic dollar 
basis.

[T.D. 8263, 54 FR 38653, Sept. 20, 1989, as amended by T.D. 8556, 59 FR 
37672, July 25, 1994; T.D. 8765, 63 FR 10774, Mar. 5, 1998; 63 FR 15760, 
Apr. 1, 1998; T.D. 8776, 63 FR 40368, July 29, 1998; T.D. 8927, 66 FR 
2216, Jan. 11, 2001]



Sec. 1.985-2  Election to use the United States dollar as the 
functional currency of a QBU.

    (a) Background and scope--(1) In general. This section permits an 
eligible QBU to elect to use the dollar as its functional currency for 
taxable years beginning on or before August 24, 1994. An election to use 
a dollar functional currency is not permitted for a QBU other than an 
eligible QBU. Paragraph (b) of this section defines an eligible QBU. 
Paragraph (c) of this section describes the time and manner for making 
the dollar election and paragraph (d) of this section describes the 
effect of making the election. For the definition of a QBU, see section 
989(a). See Sec. 1.985-1(b)(2)(ii) for rules requiring a QBU to use the 
dollar as its functional currency in taxable years beginning after 
August 24, 1994.
    (2) Exception. Pursuant to Sec. 1.985-1(b)(2)(ii)(B)(2), the rules 
of paragraph (c)(3) of this section shall apply with respect to the 
procedure required to be followed by a noncontrolled section 902 
corporation as defined in section 904(d)(2)(E) to elect the dollar as 
its (or its QBU branch's) functional currency and the application of 
Sec. 1.985-3.
    (b) Eligible QBU--(1) In general. The term ``eligible QBU'' means a 
QBU that could have used a hyperinflationary currency as its functional 
currency absent the dollar election. See Sec. 1.985-1 for how a QBU 
determines its functional currency absent the dollar election.
    (2) Hyperinflationary currency. See Sec. 1.985-1(b)(2)(ii)(D) for 
the definition of hyperinflationary currency.
    (c) Time and manner for dollar election--(1) QBUs that are branches 
of United States persons--(i) Rule. If an eligible QBU is a branch of a 
United States person, the dollar election shall be made by attaching a 
completed Form 8819 to the United States person's timely filed (taking 
extensions into account) tax return for the first taxable year for which 
the election is to be effective.
    (ii) Procedure prior to the issuance of Form 8819. In the absence of 
Form 8819, the election shall be made in accordance with Sec. 1.985-
2T(c)(1). Failure to file an amended return within the time period 
prescribed in Sec. 1.985-2T(c)(1) shall not invalidate the dollar 
election if it is established to the satisfaction of the district 
director that reasonable cause existed for such failure. A subsequent 
election for 1988 will not prejudice the taxpayer with respect to such 
reasonable cause determination. Nevertheless, each United States person 
making an election under the Sec. 1.985-2T(c)(1) must file a Form 8819 
in the time and manner provided in the Form's instructions.
    (2) Eligible QBUs that are controlled foreign corporations or 
branches of controlled foreign corporations--(i) Rule. If an eligible 
QBU is a controlled foreign corporation (as described in section 957), 
or a branch of a controlled foreign corporation, the election may be 
made either by the foreign corporation or by the controlling United 
States shareholders on behalf of the foreign corporation by--
    (A) Filing a completed Form 8819 in the time and manner provided in 
the Form's instructions, and

[[Page 615]]

    (B) Providing the written notice required by paragraph (c)(2)(ii) of 
this section at the time and in the manner prescribed therein.


The term controlling United States shareholders means those United 
States shareholders (as defined in section 951(b)) who, in the 
aggregate, own (within the meaning of section 958(a)) greater than 50 
percent of the total combined voting power of all classes of stock of 
the foreign corporation entitled to vote. If the foreign corporation is 
a controlled foreign corporation (as described in section 957) but the 
United States shareholders do not, in the aggregate, own the requisite 
voting power, the term ``controlling United States shareholders'' means 
all the United States shareholders (as defined in section 951(b)) who 
own (within the meaning of section 958(a)) stock of the controlled 
foreign corporation.
    (ii) Notice. Prior to filing Form 8819, the controlling United 
States shareholders (or the foreign corporation, if the dollar election 
is made by the corporation) shall provide written notice that the dollar 
election will be made to all United States persons known to be 
shareholders who own (within the meaning of section 958(a)) stock of the 
foreign corporation. Such notice shall also include all information 
required in Form 8819.
    (iii) Reasonable cause exception. Failure of the controlling United 
States shareholders (or the foreign corporation, if the dollar election 
is made by the corporation) to timely file Form 8819 or provide written 
notice to a United States person required to be notified by paragraph 
(c)(2)(ii) of this section shall not invalidate the dollar election, if 
it is established to the satisfaction of the district director that 
reasonable cause existed for such failure.
    (iv) Procedure prior to the issuance of Form 8819. In the absence of 
Form 8819, an eligible QBU described in paragraph (c)(2)(i) of this 
section shall make the dollar election in accordance with Sec. 1.985-
2T(c)(2). Nevertheless, the person or persons that made such election 
must file a Form 8819 in the time and manner provided in the Form's 
instructions.
    (3) Eligible QBUs that are noncontrolled foreign corporations or 
branches of noncontrolled foreign corporations--(i) Rule. If an eligible 
QBU is a noncontrolled foreign corporation (a foreign corporation not 
described in section 957), or a branch of a noncontrolled foreign 
corporation, the dollar election must be made by the corporation or the 
majority domestic corporate shareholders on behalf of the corporation by 
applying the rules provided in paragraph (c)(2)(i)(A) and (B), (ii), 
(iii), and (iv) of this section substituting ``majority domestic 
corporate shareholders'' for ``controlling United States shareholders'' 
wherever it appears therein. The term ``majority domestic corporate 
shareholders'' means those domestic corporate shareholders (as described 
in section 902(a)) who, in the aggregate, own (within the meaning of 
section 958(a)) greater than 50 percent of the total combined voting 
stock of all classes of stock of the noncontrolled foreign corporation 
entitled to vote that is owned (within the meaning of section 958(a)) by 
all the domestic corporate shareholders.
    (ii) Procedure prior to the issuance of Form 8819. In the absence of 
Form 8819, an eligible QBU described in paragraph (c)(3)(i) of this 
section shall make the dollar election in accordance with Sec. 1.985-
2T(c)(3). Nevertheless, the person or persons that made such election 
must file a Form 8819 in the time and manner provided in the Form's 
instructions.
    (4) Others. Any other person making a dollar election under this 
section shall elect by filing Form 8819 and fulfilling any other notice 
requirements that may be required by the Commissioner.
    (d) Effect of dollar election--(1) General rule. If a dollar 
election is made (or considered made under paragraph (d)(3) of this 
section) by or on behalf of an eligible QBU, the QBU shall be deemed to 
have the dollar as its functional currency. Each United States person 
that owns (within the meaning of section 958(a)) stock of a foreign 
corporation which has the dollar as its functional currency under Sec. 
1.985-2 must make all of its federal income tax calculations with 
respect to the foreign corporation using the dollar as the corporation's

[[Page 616]]

functional currency (regardless of when ownership was acquired or 
whether the United States person received the written notice required by 
paragraph (c)(2)(i)(B) of this section).
    (2) Computation--(i) In general. Except as provided in paragraph 
(d)(2)(ii) of this section, any eligible QBU that pursuant to this Sec. 
1.985-2 has a dollar functional currency must compute income or loss or 
earnings and profits (or deficit in earnings and profits) in dollars 
using the dollar approximate separate transactions method described in 
Sec. 1.985-3.
    (ii) Alternative method. An eligible QBU that has a dollar 
functional currency pursuant to this Sec. 1.985-2 may use a method 
other than the dollar approximate separate transactions method described 
in Sec. 1.985-3 only if the QBU demonstrates to the satisfaction of the 
Commissioner that it can properly employ such method. Generally, the QBU 
must show that it could compute foreign currency gain or loss under the 
principles of section 988 with respect to each of its section 988 
transactions. If subsequently the QBU can no longer demonstrate to the 
satisfaction of the district director that it can properly employ such 
an alternative method, then the QBU will be deemed to have changed its 
method of accounting to the dollar approximate separate transactions 
method described in Sec. 1.985-3. This change in accounting will be 
treated as having been made with the consent of the Commissioner. No 
adjustments under either Sec. 1.985-5T (or any succeeding final 
regulation) or section 481(a) shall be required solely because of the 
change. Rather the QBU shall begin accounting for its operations under 
Sec. 1.985-3 based on its dollar books and records as of the time of 
the change.
    (3) Conformity--(i) General rule. If a dollar election is made under 
this Sec. 1.985-2 for an eligible QBU (``electing QBU''), then the 
dollar shall be the functional currency of any related person 
(regardless of when such person became related to the electing QBU) that 
is an eligible QBU, or any branch of any such related person that is an 
eligible QBU. For purposes of the preceding sentence, the term ``related 
person'' means any person with a relationship defined in section 267 (b) 
to the electing QBU (or to the United States or foreign person of which 
the electing QBU is a part). In determining whether two or more 
corporations are members of the same controlled group under section 
267(b)(3), a person is considered to own stock owned directly by such 
person, stock owned with the application of section 1563(e)(1), and 
stock owned with the application of section 267(c).
    (ii) Branches of United States and foreign persons. If a dollar 
election is made for a QBU branch of any person, each eligible QBU 
branch of such person shall have the dollar as its functional currency.
    (4) Required adjustments. If an eligible QBU's functional currency 
changes due to a dollar election, or due to the conformity requirements 
of paragraph (d)(3) of this section, such change shall be deemed for 
purposes of Sec. 1.9B5-4 to be consented to by the Commissioner. No 
adjustments under section 481(a) shall be required solely because of the 
change. However, the QBU must make those adjustments required by Sec. 
1.985-5T (or any succeeding final regulation).
    (5) Taxable year conformity required. Generally, the adjustments 
required by paragraph (d)(4) of this section shall be made for a related 
person's taxable year--
    (i) That includes the date in which the electing QBU made the dollar 
election if the person was related to such electing QBU at any time 
during the QBU's taxable year that includes such date, or
    (ii) During which the person first becomes related to any electing 
QBU, in all other cases.


For purposes of this paragraph (d)(5), the date in which the electing 
QBU makes the dollar election shall be the last day of the electing 
QBU's taxable year. The district director may permit the related party 
to make such adjustments beginning one taxable year later if, in the 
district director's sole judgment, reasonable cause exists for the 
related party not being able to make the required adjustments for the 
earlier year.
    (6) Availability of election. A dollar election may be made by or on 
behalf of a QBU, or considered made under the conformity rule of 
paragraph (d)(3), in

[[Page 617]]

any year in which the QBU is an eligible QBU. If a dollar election is 
not made by or on behalf of a QBU for its first taxable year beginning 
after December 31, 1986 in which it is an eligible QBU, then any dollar 
election made by or on behalf of the QBU, or considered made under the 
conformity rules of paragraph (d)(3) of this section, that results in a 
change in the QBU's functional currency shall be treated as having been 
made with the consent of the Commissioner. In such a case, however, the 
taxpayer must make those adjustments required by Sec. 1.985-5T (or any 
succeeding final regulation).
    (7) Effect of changed circumstances. Regardless of any change in 
circumstances (e.g., a currency ceases to qualify as hyperinflationary), 
a QBU whose functional currency is the dollar under this section may 
change its functional currency only if the QBU complies with Sec. 
1.985-4.
    (8) Examples. The provisions of this section are illustrated by the 
following examples.

    Example 1. X is a calendar year domestic corporation that in 1987 
establishes a branch, A, in Country Z. A's functional currency under 
sections 985(b)(1) and (2) and Sec. 1.985-1 is the ``h'', the currency 
of Country Z. The cumulative inflation in Country Z exceeds 100 percent 
for the thirty-six months prior to January 1987, as measured by the 
consumer price index of Country Z listed in the monthly issues of the 
``International Financial Statistics''. Accordingly, A is an eligible 
QBU in 1987 because the h is a hyperinflationary currency. Thus, X may 
elect the dollar as the functional currency of A for 1987.
    Example 2. The facts are the same as in Example (1). X does not 
elect the dollar as the functional currency of A for 1987. Rather, X 
elects the dollar as the functional currency of A for l991, a year A is 
an eligible QBU. The election constitutes a change in A's functional 
currency that is made with the consent of the Commissioner. However, A 
must make the adjustments required under Sec. 1.985-5T (or any 
succeeding final regulation).
    Example 3. X is a domestic corporation that establishes A, an 
eligible QBU branch. X is wholly owned by domestic corporation Y. Y has 
an eligible QBU branch, B. Both X and Y are calendar year taxpayers. X 
makes a dollar election for A in 1987. Thus, A is an electing QBU. X and 
Y are related persons as defined in section 267(b) (i.e., Y has a 
relationship under section 267(b)(3) to X, the corporation of which A is 
a part). Therefore, the dollar election by X for A in 1987 results in B, 
the eligible QBU branch of Y, also having the dollar as its functional 
currency for 1987.
    Example 4. The facts are the same as in Example 3, except that Y 
does not have an eligible QBU branch but owns all the stock of C, a 
calendar year controlled foreign corporation, which is not itself an 
eligible QBU but which has an eligible QBU branch, D. X and C are 
related persons as defined in section 267(b) (i.e., C has a relationship 
under section 267(b)(3) to X, the corporation of which A is a part). 
Therefore, the dollar election by X for A in 1987 results in D, the 
eligible QBU branch of C, also having the dollar as its functional 
currency for 1987.
    Example 5. X, whose taxable year ends September 30, is an eligible 
QBU that does not use the dollar as its functional currency. X is 
wholly-owned by domestic corporation W. On January 1, 1989, X acquires 
all the stock of Y, an unrelated eligible QBU that made the dollar 
election under Sec. 1.985-2. Y is a calendar year taxpayer. After the 
stock purchase, X and Y are related persons as defined in section 
267(b). Under Sec. Sec. 1.985-2(d)(3) and (5), the dollar shall be the 
functional currency of X, any person related to X, and any branch of 
such related person that is an eligible QBU beginning with the taxable 
year that includes December 31, 1989. Thus, X must change to the dollar 
for its taxable year beginning October 1, 1988. However, the district 
director may allow X to change to the dollar for its taxable year 
beginning October 1, 1989, provided reasonable cause exists. Those QBUs 
changing to the dollar as their functional currency as the result of the 
conformity requirements must make the adjustments required under Sec. 
1.985-5T (or any succeeding final regulation).
    Example 6. The facts are the same as in Example 5, except that 
before X purchased the Y stock, X made the dollar election under Sec. 
1.985-2 but Y did not use the dollar as its functional currency. Under 
Sec. Sec. 1.985-2(d)(3) and (5) the dollar shall be the functional 
currency of Y, any person related to Y, and any branch of such related 
person that is an eligible QBU beginning with the taxable year that 
includes September 30, 1989. Thus, Y must change to the dollar for its 
taxable year beginning January 1, 1989. However the district director 
may allow Y to change to the dollar for its taxable year beginning 
January 1, 1990, provided reasonable cause exists. Those QBUs changing 
to the dollar as their functional currency as the result of the 
conformity requirements must make the adjustments required under Sec. 
1.985-5T (or any succeeding final regulation).

[T.D. 8263, 54 FR 38656, Sept. 20, 1989, as amended by T.D. 8556, 59 FR 
37673, July 25, 1994]

[[Page 618]]



Sec. 1.985-3  United States dollar approximate separate transactions
method.

    (a) Scope and effective date--(1) Scope. This section describes the 
United States dollar (dollar) approximate separate transactions method 
of accounting (DASTM). For all purposes of subtitle A, this method of 
accounting must be used to compute the gross income, taxable income or 
loss, or earnings and profits (or deficit in earnings and profits) of a 
QBU (as defined in section 989(a)) that has the dollar as its functional 
currency pursuant to Sec. 1.985-1(b)(2).
    (2) Effective date--(i) In general. This section is effective for 
taxable years beginning after August 24, 1994.
    (ii) DASTM prior-year election. A taxpayer may elect to apply this 
section to any open taxable year beginning after December 31, 1986 
(whether or not DASTM has been previously elected for some or all of 
those years). In order to make this election, the taxpayer must apply 
Sec. 1.985-3 to that year and all subsequent years. In addition, each 
person that is related (within the meaning of Sec. 1.985-3(e)(2)(vi)) 
to the taxpayer on the last day of any taxable year for which the 
election is effective and that would have been eligible to elect DASTM 
must also apply these rules to that year and all subsequent years. A 
taxpayer that has not previously elected to apply DASTM to its prior 
taxable years may make the DASTM election for the pertinent years by 
filing amended returns and complying with the applicable election 
procedures of Sec. 1.985-2. Form 8819 shall be attached to the return 
for the first year for which the election is to be effective. A taxpayer 
that has elected DASTM for prior taxable years and applied the rules 
under Sec. 1.985-3 (as contained in the April 1, 1994 edition of 26 CFR 
part 1 (1.908 to 1.1000)) may amend its returns to apply the rules of 
this Sec. 1.985-3. In either case, the DASTM election for prior taxable 
years shall be deemed to be made with the consent of the Commissioner.
    (b) Statement of method. Under DASTM, income or loss or earnings and 
profits (or a deficit in earnings and profits) of a QBU for its taxable 
year shall be determined in dollars by--
    (1) Preparing an income or loss statement from the QBU's books and 
records (within the meaning of Sec. 1.989(a)-1(d)) as recorded in the 
QBU's hyperinflationary currency (as defined in Sec. 1.985-
1(b)(2)(ii)(D));
    (2) Making the adjustments necessary to conform such statement to 
United States generally accepted accounting principles and tax 
accounting principles (including reversing monetary correction 
adjustments required by local accounting principles);
    (3) Translating the amounts of hyperinflationary currency as shown 
on such adjusted statement into dollars in accordance with paragraph (c) 
of this section; and
    (4) Adjusting the resulting dollar income or loss or earnings and 
profits (or deficit in earnings and profits) and, where necessary, 
particular items of gross income, deductible expense or other amounts, 
in accordance with paragraph (e) of this section to reflect the amount 
of DASTM gain or loss as determined under paragraph (d) of this section.
    (c) Translation into United States dollars--(1) In general. Except 
as otherwise provided in this paragraph (c), the amounts shown on the 
income or loss statement, as adjusted under paragraph (b)(2) of this 
section, shall be translated into dollars at the exchange rate (as 
defined in paragraph (c)(6) of this section) for the translation period 
(as defined in paragraph (c)(7) of this section) to which they relate. 
However, if the QBU previously changed its functional currency to the 
dollar, and the rules of Sec. 1.985-5 (or, if applicable, Sec. 1.985-
5T, as contained in the April 1, 1993 edition of 26 CFR part 1 (1.908 to 
1.1000)) applied in translating its balance sheet amounts into dollars, 
then the spot exchange rate applied under those rules shall be used to 
translate any amount that would otherwise be translated at a rate 
determined by reference to a translation period prior to the change in 
functional currency. For example, depreciation with respect to an asset 
acquired while the QBU had a nondollar functional currency shall be 
translated into dollars at the spot rate on the last day of the taxable 
year before the year of change to a dollar functional currency, rather 
than at the

[[Page 619]]

rate for the period in which the asset was acquired.
    (2) Cost of goods sold. The dollar value of cost of goods sold shall 
equal the sum of the dollar values of beginning inventory and purchases 
less the dollar value of closing inventory as these amounts are 
determined under paragraph (c)(3) of this section.
    (3) Beginning inventory, purchases, and closing inventory--(i) 
Beginning inventory. Amounts representing beginning inventory shall be 
translated so as to obtain the same amount of dollars which represented 
such items in the closing inventory balance for the preceding taxable 
year.
    (ii) Purchases. Amounts representing items purchased or otherwise 
first included in inventory during the taxable year shall be translated 
at the exchange rate for the translation period in which the cost of 
such items was incurred.
    (iii) Closing inventory--(A) In general. Amounts representing items 
included in the closing inventory balance shall be translated at the 
exchange rate for the translation period in which the cost of such items 
was incurred. However, if amounts representing items included in the 
closing inventory balance are either valued at market or written down to 
market value, they shall be translated at the exchange rate existing on 
the last day of the taxable year. For purposes of determining lower of 
cost or market, items of inventory included in the closing inventory 
balance shall be translated into dollars at the exchange rate for the 
translation period in which the cost of such items was incurred and 
compared with market as determined in the QBU's hyperinflationary 
currency translated into dollars at the exchange rate existing on the 
last day of the taxable year.
    (B) Determination of translation period. The method used to 
determine the translation period of amounts representing items of 
closing inventory for purposes of paragraph (c)(3)(iii)(A) of this 
section may be based upon reasonable approximations and averages, 
including rates of turnover, provided that the method is used 
consistently from year to year.
    (4) Depreciation, depletion, and amortization. Amounts representing 
allowances for depreciation, depletion, or amortization shall be 
translated at the exchange rate for the translation period in which the 
cost of the underlying asset was incurred, except as provided in 
paragraph (c)(1) of this section.
    (5) Prepaid expenses or income. Amounts representing expense or 
income paid or received in a prior taxable year shall be translated at 
the exchange rate for the translation period during which they were paid 
or received.
    (6) Exchange rate. The exchange rate for a translation period may be 
determined under any reasonable method, provided that the method is 
consistently applied to all translation periods and conforms to the 
taxpayer's method of financial accounting. Reasonable methods include 
the average of beginning and ending exchange rates for the translation 
period and the spot rate on the last day of the translation period. Once 
chosen, a method for determining an exchange rate can be changed only 
with the consent of the district director.
    (7) Translation period--(i) In general. Except as provided in 
paragraphs (c)(3)(iii)(B) and (c)(7)(ii) of this section, a translation 
period shall be each month within a QBU's taxable year.
    (ii) Exception. A taxpayer may divide its taxable year into 
translation periods of equal length (with not more than one short period 
annually) that are less than one month. Once such a translation period 
is established, it may not be changed without the consent of the 
district director.
    (8) Dollar transactions--(i) In general. Except as provided in 
paragraph (c)(8)(ii) of this section, no DASTM gain or loss is realized 
with respect to dollar transactions since the dollar is the functional 
currency of the QBU. Thus, the amount of any payment or receipt of 
dollars shall be reflected in the income or loss statement by the amount 
of such dollars. Also, the income or loss attributable to any 
transaction in which the amount that a QBU is entitled to receive (or is 
required to pay) by reason of such transaction is denominated in terms 
of the dollar, or is determined by reference to the value

[[Page 620]]

of the dollar, must be computed transaction by transaction. For example, 
if a foreign corporation lends 20 LC when 20 LC = $20 and is entitled to 
receive the LC equivalent of $20 at maturity plus a market rate of 
interest in dollars (or its LC equivalent), the loan is a dollar 
transaction. Similarly, this paragraph applies to any transaction that 
is determined to be a dollar transaction under section 988.
    (ii) Non-dollar functional currency. If pursuant to Sec. 1.985-
1(b)(2)(ii)(B)(1), a QBU is required to use a functional currency other 
than the dollar, then that currency shall be substituted for the dollar 
in applying paragraph (c)(8)(i) of this section.
    (9) Third currency transactions. A taxpayer may use any reasonable 
method of accounting for transactions described in sections 988(c)(1)(B) 
and (C) that are denominated in, or determined by reference to, a 
currency other than the QBU's hyperinflationary currency or the dollar 
(third currency transactions) so long as such method is consistent with 
its method of financial accounting.
    (10) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. S is an accrual basis QBU that is required to use the 
dollar as its functional currency for its first taxable year beginning 
in 1994. S's hyperinflationary currency is the ``h.'' During 1994, S 
accrues 100 dollars attributable to dollar-denominated sales. Because 
this is a dollar transaction under paragraph (c)(8) of this section, S's 
income or loss for 1994 shall reflect the 100 dollars (not the 
hyperinflationary value of such dollars when accrued).
    Example 2. (i) S is an accrual basis QBU that is required to use the 
dollar as its functional currency for its first taxable year beginning 
in 1994. S's hyperinflationary currency is the ``h.'' During 1994, S's 
sales amounted to 240,000,000h, its currently deductible expenses were 
26,000,000h, and its total inventory purchases amounted to 100,000,000h. 
During January and February of 1994, S purchased depreciable assets for 
80,000,000h and was allowed depreciation of 4,000,000h. At the end of 
1994, S's closing inventory was 23,000,000h. No election to use a 
translation period other than the month is made, S had no transactions 
described in paragraph (c)(8) or (c)(9) of this section, and S's closing 
inventory was computed on the first-in, first-out inventory method. S's 
adjusted income or loss statement for 1994 is translated into dollars as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                  Hyperinflationary   Exchange    United States
                                                                       currency         rate         dollars
----------------------------------------------------------------------------------------------------------------
                              Sales
 
(Jan.-Feb.).....................................................       10,000,000h     \1\ 20:1        $500,000
(Mar.-Apr.).....................................................        20,000,000         21:1         952,381
(May.-June.)....................................................        50,000,000         22:1       2,272,727
(July)..........................................................        50,000,000         23:1       2,173,913
(August)........................................................        20,000,000         26:1         769,231
(Sept.).........................................................        20,000,000         28:1         714,286
(Oct.)..........................................................        20,000,000         29:1         689,655
(Nov.)..........................................................        20,000,000         30:1         666,667
(Dec.)..........................................................        30,000,000         31:1         967,742
                                                                 -------------------            ----------------
      Total.....................................................      240,000,000h   ..........       9,706,602
 
                       Cost of Goods Sold
 
Opening Inventory Purchases:                                                     0   ..........               0
    (Jan.-Feb.).................................................       15,000,000h         20:1         750,000
    (Mar.-Apr.).................................................        10,000,000         21:1         476,190
    (May-June)..................................................        30,000,000         22:1       1,363,636
    (July)......................................................        20,000,000         23:1         869,565
    (August)....................................................        10,000,000         26:1         384,615
    (Sept.).....................................................         5,000,000         28:1         178,571
    (Oct.)......................................................         5,000,000         29:1         172,414
    (Nov.)......................................................         2,500,000         30:1          83,333
    (Dec.)......................................................         2,500,000         31:1          80,645
Less Closing Inventory..........................................      (23,000,000)        (\2\)        (822,655)
                                                                 -------------------            ----------------
                                                                       77,000,000h   ..........       3,536,314
----------------------------------------------------------------------------------------------------------------
\1\ Where multiple months are indicated, the exchange rate applies for all months.
\2\ See paragraph (ii) of this Example.


[[Page 621]]

    (ii) Since S uses the first-in, first-out inventory method, the 
closing inventory is assumed to consist of purchases made during the 
most recent translation period as follows:

----------------------------------------------------------------------------------------------------------------
                                                               Hyperinflationary                   United States
                                                                    currency       Exchange rate      dollars
----------------------------------------------------------------------------------------------------------------
December.....................................................        2,500,000h             31:1         $80,645
November.....................................................         2,500,000             30:1          83,333
October......................................................         5,000,000             29:1         172,414
September....................................................         5,000,000             28:1         178,571
August.......................................................         8,000,000             26:1         307,692
                                                              -------------------                ---------------
      Total..................................................       23,000,000h   ..............         822,655
                                                              ===================                ===============
 
                   Non-Capitalized Expenses
 
(Jan.-Feb.)..................................................        4,000,000h             20:1         200,000
(Mar.-Apr.)..................................................         2,500,000             21:1         119,048
(May-June)...................................................         2,500,000             22:1         113,636
(July).......................................................         2,000,000             23:1          86,957
(August).....................................................         3,000,000             26:1         115,385
(Sept.)......................................................         3,000,000             28:1         107,143
(Oct.).......................................................         2,000,000             29:1          68,966
(Nov.).......................................................         3,000,000             30:1         100,000
(Dec.).......................................................         4,000,000             31:1         129,032
                                                              -------------------                ---------------
      Total..................................................       26,000,000h   ..............       1,040,167
Depreciation.................................................        4,000,000h             20:1         200,000
      Total Cost & Expenses..................................      107,000,000h   ..............       4,776,481
                                                              -------------------                ---------------
Operating Profit.............................................      133,000,000h   ..............       4,930,121
                                                              ===================                ===============
----------------------------------------------------------------------------------------------------------------

    (d) Computation of DASTM gain or loss--(1) Rule. DASTM gain or loss 
of a QBU equals--
    (i) The net worth of the QBU (as determined under paragraph (d)(2) 
of this section) at the end of the taxable year minus the net worth of 
the QBU at the end of the preceding taxable year; plus
    (ii) The dollar amount of the items described in paragraph (d)(3) of 
this section and minus the dollar amount of the items described in 
paragraph (d)(4) of this section; minus
    (iii) The amount of dollar income or earnings and profits (or plus 
the amount of any dollar loss or deficit in earnings and profits) as 
determined for the taxable year pursuant to paragraphs (b)(1) through 
(b)(3) of this section.
    (2) Net worth. Net worth of a QBU at the end of any taxable year 
equals the aggregate dollar amount representing assets on the QBU's 
balance sheet at the end of the taxable year less the aggregate dollar 
amount representing liabilities on the balance sheet. Notwithstanding 
any other provision in this paragraph (d)(2), the district director may 
adjust the amount of any asset or liability if a purpose for acquiring 
(or disposing of) the asset or incurring (or discharging) the liability 
is to manipulate the composition of the balance sheet for any period 
during the taxable year in order to avoid tax. The taxpayer shall 
determine net worth by--
    (i) Preparing a balance sheet as of the end of the taxable year from 
the QBU's books and records (within the meaning of Sec. 1.989(a)-1(d)) 
as recorded in the QBU's hyperinflationary currency;
    (ii) Making adjustments necessary to conform such balance sheet to 
United States generally accepted accounting principles and tax 
accounting principles (including reversing monetary correction 
adjustments required by local accounting principles); and
    (iii) Translating the asset and liability amounts shown on the 
balance sheet into United States dollars in accordance with paragraph 
(d)(5) of this section.
    (3) Positive adjustments--(i) In general. The items described in 
this paragraph (d)(3) are dividend distributions for the taxable year 
and any items that decrease net worth for the taxable year but that 
generally do not affect income

[[Page 622]]

or loss or earnings and profits (or a deficit in earnings and profits). 
Such items include a transfer to the home office of a QBU branch and a 
return of capital.
    (ii) Translation. Except as provided by ruling or administrative 
pronouncement, items described in paragraph (d)(3)(i) of this section 
shall be translated into dollars as follows:
    (A) If the item giving rise to the adjustment would be translated 
under paragraph (d)(5) of this section at the exchange rate for the last 
translation period of the taxable year if it were shown on the QBU's 
year-end balance sheet, such item shall be translated at the exchange 
rate on the date the item is transferred.
    (B) If the item giving rise to the adjustment would be translated 
under paragraph (d)(5) of this section at the exchange rate for the 
translation period in which the cost of the item was incurred if it were 
shown on the QBU's year-end balance sheet, such item shall be translated 
at the same historical rate.
    (iii) Effective date. Paragraph (d)(3)(ii) of this section is 
applicable for any transfer, dividend, or distribution that is a return 
of capital that is made after March 8, 2005, and that gives rise to an 
adjustment under this paragraph (d)(3).
    (4) Negative adjustments. The items described in this paragraph 
(d)(4) are items that increase net worth for the taxable year but that 
generally do not affect income or loss or earnings and profits (or a 
deficit in earnings and profits). Such items include a capital 
contribution or a transfer from a home office to a QBU branch. Except as 
otherwise provided by ruling or administrative pronouncement, if the 
contribution or transfer is not in dollars, the amount of a capital 
contribution or transfer shall be translated into dollars at the 
exchange rate on the date made.
    (5) Translation of balance sheet. Asset and liability amounts shown 
on the balance sheet in hyperinflationary currency (adjusted pursuant to 
paragraph (d)(2)(ii) of this section) shall be translated into dollars 
as provided in this paragraph (d)(5). However, if the QBU previously 
changed its functional currency to the dollar and the rules of Sec. 
1.985-5 (or, if applicable, Sec. 1.985-5T, as contained in the April 1, 
1993 edition of 26 CFR part 1 (1.908 to 1.1000)) applied in translating 
its balance sheet amounts into dollars, then the spot exchange rate 
applied under those rules shall be used to translate any amount that 
would otherwise be translated at a rate determined by reference to a 
translation period prior to the change in functional currency. For 
example, the basis of real property acquired while the QBU had a 
nondollar functional currency shall be translated into dollars at the 
spot rate on the last day of the taxable year before the year of change 
to a dollar functional currency, rather than at the rate for the period 
in which the cost was incurred.
    (i) Closing inventory. Amounts representing items of inventory 
included in the closing inventory balance shall be translated in 
accordance with paragraph (c)(3)(iii) of this section.
    (ii) Bad debt reserves. Amounts representing bad debt reserves shall 
be translated at the exchange rate for the last translation period for 
the taxable year.
    (iii) Prepaid income or expense. Amounts representing expenses or 
income paid or received in a prior taxable year shall be translated in 
accordance with paragraph (c)(5) of this section.
    (iv) Hyperinflationary currency. Amounts of the hyperinflationary 
currency and hyperinflationary demand deposit balances shall be 
translated at the exchange rate for the last translation period of the 
taxable year.
    (v) Certain assets--(A) In general. Amounts representing plant, real 
property, equipment, goodwill, and patents and other intangibles shall 
be translated at the exchange rate for the translation period in which 
the cost of the asset was incurred.
    (B) Adjustment to certain assets. Amounts representing depreciation, 
depletion, and amortization reserves shall be translated in accordance 
with paragraph (c)(4) of this section.
    (vi) Hyperinflationary debt obligations. Except as provided in 
paragraph (d)(5)(vii) of this section, amounts representing a 
hyperinflationary debt obligation (including accounts receivable and 
payable) shall be translated at the

[[Page 623]]

exchange rate for the last translation period for the taxable year.
    (vii) Accrued foreign income taxes. Amounts representing an accrued 
but unpaid foreign income tax shall be translated at the exchange rate 
on the last day of the last translation period of the taxable year of 
accrual.
    (viii) Certain hyperinflationary financial instruments. Amounts 
representing any item described in section 988(c)(1)(B)(iii) (relating 
to forward contracts, futures contracts, options, or similar financial 
instruments) denominated in or determined by reference to the 
hyperinflationary currency shall be translated at the exchange rate for 
the last translation period for the taxable year.
    (ix) Other assets and liabilities. Amounts representing assets and 
liabilities, other than those described in paragraphs (d)(5)(i) through 
(viii) of this section, shall be translated at the exchange rate for the 
translation period in which the cost of the asset or the amount of the 
liability was incurred.
    (6) Dollar transactions. Notwithstanding any other provisions of 
this paragraph (d), where the amount representing an item shown on the 
balance sheet reflects a dollar transaction (described in paragraph 
(c)(8) of this section), the transaction shall be taken into account in 
accordance with that paragraph.
    (7) Third currency transactions. A taxpayer may use any reasonable 
method of accounting for transactions described in section 988(c)(1)(B) 
and (C) that are denominated in, or determined by reference to, a 
currency other than the QBU's hyperinflationary currency or the dollar 
(third currency transactions), so long as such method is consistent with 
its method of financial accounting.
    (8) Character. The amount of DASTM gain or loss determined under 
paragraph (d)(1) of this section shall be ordinary income or loss.
    (9) Example. The provisions of this paragraph (d) are illustrated by 
the following example:

    Example. (i) S, an accrual method calendar year foreign corporation, 
uses DASTM. S's hyperinflationary currency is the ``h.'' S's net worth 
at December 31, 1993 was $3,246,495. For 1994, S's operating profit is 
81,340,000h, or $2,038,200. S made a 5,000,000h distribution in April 
and again in December of 1994. S's translation period is the month. None 
of S's assets or liabilities reflect a dollar or third currency 
transaction described in paragraph (c)(8) or (c)(9) of this section, 
respectively. The exchange rate for each month in 1994 is as follows:

        January..........................  32h:$1
        Feb.-Mar.........................  33:1
        April-May........................  34:1
        June.............................  35:1
        July.............................  36:1
        Aug.-Sept........................  37:1
        Oct..............................  38:1
        Nov..............................  39:1
        Dec..............................  40:1
 

    (ii) At the end of 1994, S's assets and liabilities, as adjusted and 
translated pursuant to paragraphs (d)(2) and (d)(5) of this section, are 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Hyperin-
                                                                    flationary     Exchange rate    U.S. dollar
----------------------------------------------------------------------------------------------------------------
Hyperinflationary cash on hand..................................         40,000h            40:1          $1,000
  Checking account..............................................         400,000            40:1          10,000
Accounts Receivable- 30 Day Accounts............................      20,000,000        \1\ 40:1         500,000
    60 Day Accounts.............................................      25,000,000            40:1         625,000
Inventory.......................................................      65,000,000           (\2\)       2,500,000
Fixed assets--Property..........................................      90,000,000            27:1       3,333,333
    Plant.......................................................     190,000,000           (\3\)       6,785,714
        Accumulated Depreciation................................       (600,000)           (\3\)        (21,428)
    Equipment...................................................      10,000,000           (\4\)         340,000
        Accumulated Depreciation................................       (400,000)           (\4\)        (13,333)
Common Stock--Stock A...........................................         500,000            34:1          14,706
      Stock B...................................................         400,000            26:1          15,385
Preferred Stock.................................................       1,000,000            32:1          31,250
C.D.s...........................................................       5,000,000            40:1         125,000
      Total Assets..............................................     406,340,000  ..............      14,246,627
Accounts Payable Long-term liabilities:                               35,000,000            40:1         875,000
    Liability A.................................................     150,000,000            40:1       3,750,000
    Liability B.................................................      80,000,000            40:1       2,000,000
    Liability C.................................................      30,000,000            40:1         750,000
                                                                 ----------------                ---------------

[[Page 624]]

 
      Total Liabilities.........................................    295,000,000h  ..............      $7,375,000
----------------------------------------------------------------------------------------------------------------
\1\ S ages its accounts receivable and groups them into two categories--those outstanding for 30 days and those
  outstanding for 60 days.
\2\ Translated the same as closing inventory under paragraph (c)(3)(iii).
\3\ The cost of S's plant was incurred in several translation periods. Therefore, the dollar cost and dollar
  depreciation reflect several translation rates.
\4\ S has a variety of equipment. Therefore, S's dollar basis represents the sum of the hyperinflationary cost
  of each, translated according to the exchange rate for the translation period incurred.

    (iii) The DASTM gain of S for 1994 is computed as follows:

Net worth--1994.........................  ..............      $6,871,627
Less--Net worth--1993...................  ..............      $3,246,495
Plus--1994 Dividends:...................
  April.................................        $149,254
  December..............................     \1\ 126,582         275,836
Less Operating Profit--1994.............  ..............       2,038,200
DASTM Gain..............................  ..............      $1,862,768
                                                         ===============
 
\1\ The exchange rates on the date of the April and December dividends
  were 33.5h:$1 and 39.5h:$1, respectively.

    (iv) Thus, total profit = $2,038,200 + $1,862,768 = $3,900,968

    (e) Effect of DASTM gain or loss on gross income, taxable income, or 
earnings and profits--(1) In general. For all purposes of subtitle A, 
the amount of DASTM gain or loss of a QBU determined under paragraph (d) 
of this section is taken into account by the QBU for purposes of 
determining the amount of its gross income, taxable income or loss, 
earnings and profits (or deficit in earnings and profits), and, where 
necessary, particular items of income, expense or other amounts. DASTM 
gain or loss is allocated under one of two methods. Certain small QBUs 
may elect the small QBU DASTM allocation described in paragraph (e)(2) 
of this section. All other QBUs must use the 9-step procedure described 
in paragraph (e)(3) of this section.
    (2) Small QBU DASTM allocation--(i) Election threshold. A taxpayer 
may elect to use the small QBU DASTM allocation described in paragraph 
(e)(2)(iv) of this section with respect to a QBU that has an adjusted 
basis in assets (translated as provided in paragraph (d)(5) of this 
section) of $10 million or less at the end of any taxable year. In 
calculating the $10 million threshold, a QBU shall be treated as owning 
all of the assets of each related QBU (as defined in paragraph 
(e)(2)(vi) of this section) having its residence (as defined in section 
988(a)(3)(B)) in the QBU's country of residence (related same- country 
QBU). For this purpose, appropriate adjustment shall be made to 
eliminate the double counting of assets created in transactions between 
related QBUs resident in the same country. For example, assume QBU-1, 
resident in country X, sells inventory to related QBU-2, also resident 
in country X, in exchange for an account receivable. For purposes of 
determining the assets of QBU-1 under this paragraph (e)(2)(i), the 
taxpayer shall take into account either the inventory shown on the books 
of QBU-2 or QBU-1's receivable from QBU-2 (but not both).
    (ii) Consent to election. The election of the small QBU DASTM 
allocation or subsequent application of the rules of paragraph (e)(3) of 
this section due to an increase in the adjusted basis of the QBU's 
assets shall be deemed to have been made with the consent of the 
Commissioner. Once the election under paragraph (e)(2)(iii) of this 
section is made, it shall apply for all years in which the adjusted 
basis of the assets of the QBU (and any related same-country QBU) is $10 
million or less, unless revoked with the Commissioner's consent. If the 
adjusted basis of the assets of the QBU (and any related same- country 
QBU) exceeds $10 million at the end of any taxable year, the rules of 
paragraph (e)(3) of this section shall apply to that QBU (and any 
related same-country QBU) for such year and each subsequent year unless 
such QBU again qualifies, and applies for and obtains the Commissioner's 
consent, to use the small QBU DASTM allocation. However, if a QBU 
acquires assets with a principal purpose of avoiding the application of 
paragraph (e)(2)(iv) of this section, the Commissioner may disregard the 
acquisition of such assets.
    (iii) Manner of making election--(A) QBUs that are branches of 
United States persons. For the first year in which this

[[Page 625]]

election is effective, in the case of a QBU branch of a United States 
person, a statement shall be attached to the United States person's 
timely filed Federal income tax return (taking extensions into account). 
The statement shall identify the QBU (or QBUs) for which the election is 
being made by describing its business and its country of residence, 
state the adjusted basis of the assets of the QBU (and any related same-
country QBUs) to which the election applies, and include a statement 
that the election is being made pursuant to Sec. 1.985-3(e)(2).
    (B) Other QBUs. In the case of a QBU other than one described in 
paragraph (e)(2)(iii)(A) of this section, an election must be made in 
the manner prescribed in Sec. 1.964-1. The statement filed with the 
Internal Revenue Service as required under Sec. 1.964-1 must include 
the information required under paragraph (e)(2)(iii)(A) of this section.
    (iv) Effect of election. If a taxpayer elects under this paragraph 
(e)(2) to use the small QBU DASTM allocation, DASTM gain or loss, as 
determined under paragraph (d) of this section, of a small QBU shall be 
allocated ratably to all items of the QBU's gross income (determined 
prior to adjustment for DASTM gain or loss). Therefore, for purposes of 
the foreign tax credit, DASTM gain or loss shall be allocated on the 
basis of the relative amounts of gross income in each separate category 
as defined in Sec. 1.904-5(a)(4)(v). In the case of a controlled 
foreign corporation (within the meaning of section 957 or 953(c)(1)(B)), 
for purposes of section 952, DASTM gain or loss shall be allocated to 
subpart F income in a separate category in the same ratio that the gross 
subpart F income in that category for the taxable year bears to its 
total gross income in that category for the taxable year.
    (v) Conformity. If a person (or a QBU of such person) makes an 
election under this paragraph (e)(2) to use the small QBU DASTM 
allocation, then each QBU of any related person (as defined in paragraph 
(e)(2)(vi) of this section) that satisfies the threshold requirement of 
paragraph (e)(2)(i) of this section (after application of the 
aggregation rule of paragraph (e)(2)(i) of this section) shall be deemed 
to have made the election.
    (vi) Related person. The term related person means any person with a 
relationship to the QBU (or to the United States or foreign person of 
which the electing QBU is a part) that is defined in section 267(b) or 
section 707(b).
    (3) DASTM 9-step procedure--(i) Step 1--prepare balance sheets. The 
taxpayer shall prepare an opening and a closing balance sheet for the 
QBU for each balance sheet period during the taxable year. The balance 
sheet period is the most frequent period for which balance sheet data 
are reasonably available (but in no event less frequently than 
quarterly). The balance sheet period may not be changed without the 
consent of the district director. The balance sheets must be prepared 
under the principles of paragraph (d)(2) of this section.
    (ii) Step 2--identify certain assets and liabilities. The taxpayer 
shall identify each item on the balance sheet that is described in 
section 988(c)(1)(B) or (C) and that would have been translated under 
paragraph (d)(5) of this section into dollars at the exchange rate for 
the last translation period for the taxable year (or the exchange rate 
on the last day of the last translation period of the taxable year in 
the case of an accrued foreign income tax liability).
    (iii) Step 3--characterize the assets. The taxpayer shall 
characterize and group the assets identified in paragraph (e)(3)(ii) of 
this section (Step 2) according to the source and the type of income 
that they generate, have generated, or may reasonably be expected to 
generate by applying the principles of Sec. 1.861-9T(g)(3) or its 
successor regulation (relating to characterization of assets for 
purposes of interest expense allocation). If a purpose for a taxpayer's 
business practices is to manipulate asset characterization or groupings, 
the district director may allocate or apportion DASTM gain or loss 
attributable to the assets. Thus, if a taxpayer that previously did not 
separately state interest on accounts receivable begins to impose an 
interest charge and a purpose for the change was to manipulate tax 
characterizations or groupings, then the district director may require 
that none of the

[[Page 626]]

DASTM gain or loss attributable to those receivables be allocated or 
apportioned to interest income.
    (iv) Step 4--determine DASTM gain or loss attributable to certain 
assets--(A) General rule. The taxpayer shall determine the dollar amount 
of DASTM gain or loss attributable to assets in each group identified in 
paragraph (e)(3)(iii) of this section (Step 3) as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.062

where

bb = the hyperinflationary currency adjusted basis of the assets in the 
          group at the beginning of the balance sheet period.
eb = the hyperinflationary currency adjusted basis of the assets in the 
          group at the end of the balance sheet period.
er = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the end of the balance sheet 
          period.
br = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the beginning of the balance 
          sheet period.

    (B) Weighting to prevent distortion. If averaging the adjusted basis 
of assets in a group at the beginning and end of a balance sheet period 
results in an allocation of DASTM gain or loss that does not clearly 
reflect income, as might be the case in the event of a purchase or 
disposition of an asset that is not in the normal course of business, 
the taxpayer must use a weighting method that reflects the time the 
assets are held by the QBU during the translation period.
    (C) Example. The provisions of this paragraph (e)(3)(iv) are 
illustrated by the following example:

    Example. S is a foreign corporation that operates in the 
hyperinflationary currency ``h'' and computes its income or loss or 
earnings and profits under DASTM. S's adjusted basis in a group of 
assets described in section 988(c)(1)(B) or (C) that generate general 
limitation foreign source income (as characterized under paragraph 
(e)(3)(iii) of this section) at the beginning of the balance sheet 
period is 750,000h. S's basis in such assets at the end of the balance 
sheet period is 1,250,000h. The exchange rate at the beginning of the 
balance sheet period is $1 = 200h. The exchange rate at the end of the 
balance sheet period is $1 = 500h. The DASTM loss attributable to the 
assets described above is $3,000, determined as follows:

[(750,000h + 1,250,000h) / 2] x [($1 / 500h) - ($1 / 200h)] = ($3000)

    (v) Step 5--adjust dollar gross income by DASTM gain or loss from 
assets. The taxpayer shall adjust the dollar amount of the QBU's gross 
income (computed under paragraphs (b)(1) through (b)(3) of this section) 
generated by each group of assets characterized in paragraph (e)(3)(iii) 
of this section (Step 3) by the amount of DASTM gain or loss 
attributable to those assets computed under paragraph (e)(3)(iv) of this 
section (Step 4). Thus, if a group of assets, such as accounts 
receivable, generates both a category of income described in section 
904(d)(1)(I) (relating to general limitation income) that is not foreign 
base company income as defined in section 954 and a DASTM loss under 
paragraph (e)(3)(iv) of this section (Step 4), the amount of the DASTM 
loss would reduce the amount of the QBU's gross income in that category. 
Similarly, if a group of assets, such as short-term bank deposits, 
generates both foreign personal holding company income that is passive 
income (described in sections 954(c)(1)(A) and 904(d)(1)(A)) and a DASTM 
loss under paragraph (e)(3)(iv) of this section (Step 4), the amount of 
the DASTM loss would reduce the amount of the QBU's foreign personal 
holding company income and passive income. See section 904(f) and the 
regulations thereunder in the case where that section would apply and 
DASTM loss attributable to a group of assets exceeds the income 
generated by such assets.
    (vi) Step 6--determine DASTM gain or loss attributable to 
liabilities--(A) General rule. The taxpayer shall determine the dollar 
amount of DASTM gain or loss attributable to liabilities identified in 
paragraph (e)(3)(ii) of this section (Step 2), and described in 
paragraph (e)(3)(vi)(B) of this section as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.063

where

bl = the hyperinflationary currency amount of liabilities at the 
          beginning of the balance sheet period.
el = the hyperinflationary currency amount of liabilities at the end of 
          the balance sheet translation period.

[[Page 627]]

br = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the beginning of the balance 
          sheet period.
er = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the end of the balance sheet 
          period.

    (B) Separate calculation. The calculation shall be made separately 
for interest-bearing liabilities described in paragraph (e)(3)(vii) of 
this section (Step 7) and for each of the classes of non-interest-
bearing liabilities described in paragraph (e)(3)(viii) of this section 
(Step 8).
    (C) Weighting to prevent distortion. Where a distortion would result 
from averaging the amount of liabilities at the beginning and end of a 
balance sheet period, as might be the case where a taxpayer incurs or 
retires a substantial liability, the taxpayer must use a different 
method that more clearly reflects the average amount of liabilities 
weighted to reflect the time the liability was outstanding during the 
balance sheet period.
    (vii) Step 7--adjust dollar income and expense by DASTM gain or loss 
from interest-bearing liabilities--(A) In general. The taxpayer shall 
apply the amount of DASTM gain on interest-bearing liabilities computed 
under paragraph (e)(3)(vi) of this section (Step 6) to reduce interest 
expense generated by such liabilities (e.g., prior to the application of 
Sec. 1.861-9T or its successor regulation). To the extent DASTM gain on 
such liabilities exceeds interest expense, it shall be sourced or 
otherwise classified in the same manner that interest expense is 
allocated and apportioned under Sec. 1.861-9T or its successor 
regulation. The amount of DASTM loss on interest-bearing liabilities 
computed under paragraph (e)(3)(vi) of this section (Step 6) shall be 
allocated and apportioned in the same manner that interest expense is 
allocated and apportioned under Sec. 1.861-9T or its successor 
regulation (without regard to the exceptions to fungibility in Sec. 
1.861-10T or its successor regulation). For purposes of this section, an 
interest-bearing liability is a liability that requires payment of 
periodic interest (whether fixed or variable), has original issue 
discount, or would have interest imputed under subtitle A.
    (B) Allocation of DASTM gain or loss from interest-bearing 
liabilities that generate related person interest expense. DASTM gain or 
loss from interest-bearing liabilities that generate related person 
interest expense (as provided in section 954(b)(5)) shall be allocated 
for purposes of subtitle A (including sections 904 and 952) in the same 
manner that the related person interest expense of that debt is required 
to be allocated under the rules of section 954(b)(5) and Sec. 1.904-
5(c)(2).
    (C) Modified gross income method. In applying the modified gross 
income method described in Sec. 1.861-9T(j) or its successor 
regulation, gross income shall be adjusted for any DASTM gain or loss 
from assets as provided in paragraph (e)(3)(v) of this section (Step 5) 
and any DASTM gain or loss with respect to short-term, non-interest-
bearing trade payables as provided in paragraph (e)(3)(viii)(A) of this 
section.
    (viii) Step 8--adjust dollar income and expense by DASTM gain or 
loss from non-interest bearing liabilities--(A) Short-term, non-
interest-bearing trade payables. The taxpayer shall allocate DASTM gain 
or loss on short-term non-interest-bearing trade payables for purposes 
of subtitle A (including sections 904 and 952) to the same category or 
type of gross income as the cost or expense to which the trade payable 
relates. For this purpose, a short-term, non-interest-bearing trade 
payable is a non-interest-bearing liability with a term of 183 days or 
less that is incurred to purchase property or services to be used by the 
obligor in an active trade or business.
    (B) Excise tax payables. The taxpayer shall allocate DASTM gain or 
loss on excise tax payables for purposes of subtitle A (including 
sections 904 and 952) to the same category or type of gross income as 
would be derived from the activity to which the excise tax relates.
    (C) Other non-interest-bearing liabilities--(1) In general. Except 
as provided in paragraphs (e)(3)(viii)(A), (e)(3)(viii)(B), and 
(e)(3)(viii)(C)(2) of this section, DASTM gain or loss on non-interest-
bearing liabilities shall be allocated under paragraph (e)(3)(ix) of 
this section (Step 9).

[[Page 628]]

    (2) Tracing if substantial distortion of income. DASTM gains and 
losses on liabilities described in paragraph (e)(3)(viii)(C)(1) of this 
section may be attributed to the same section 904(d) separate category 
or subpart F category as the transaction to which the liability relates 
if the taxpayer demonstrates to the satisfaction of the district 
director, or it is determined by the district director, that application 
of paragraph (e)(3)(viii)(C)(1) of this section results in a substantial 
distortion of income.
    (ix) Step 9--allocate residual DASTM gain or loss. If there is a 
difference between the net DASTM gain or loss determined under 
paragraphs (e)(3)(i) through (viii) of this section (Steps 1 through 8) 
and the DASTM gain or loss determined under paragraph (d) of this 
section, the amount of the difference must be allocated for purposes of 
subtitle A (including sections 904 and 952) to the QBU's gross income 
(computed under paragraphs (b)(1) through (3) of this section, as 
adjusted under paragraphs (e)(3)(i) through (viii) of this section 
(Steps 1 through 8)) on the basis of the relative amounts of each 
category or type of gross income.

[T.D. 8556, 59 FR 37673, July 25, 1994, as amended by T.D. 9320, 72 FR 
15044, Mar. 30, 2007; T.D. 9882, 84 FR 69120, Dec. 17, 2019]



Sec. 1.985-4  Method of accounting.

    (a) Adoption of election. The adoption of, or the election to use, a 
functional currency shall be treated as a method of accounting. The 
functional currency shall be used for the year of adoption (or election) 
and for all subsequent taxable years unless permission to change is 
granted, or considered to be granted under Sec. 1.985-2 or Sec. 1.985-
8, by the Commissioner.
    (b) Condition for changing functional currencies. Generally, 
permission to change functional currencies shall not be granted unless 
significant changes in the facts and circumstances of the QBU's economic 
environment occur. If the determination of the functional currency of 
the QBU for purposes of United States generally accepted accounting 
principles (GAAP) is based on facts and circumstances substantially 
similar to those set forth in Sec. 1.985-1(c)(2), then ordinarily the 
Commissioner will grant a taxpayer's request to change its functional 
currency (or the functional currency of its branch that is a QBU) to a 
new functional currency only if the taxpayer (or its QBU) also changes 
to the new functional currency for purposes of GAAP. However, permission 
to change will not necessarily be granted merely because the new 
functional currency will conform to the taxpayer's GAAP functional 
currency.
    (c) Relationship to certain other sections of the Code. Nothing in 
this section shall be construed to override the provisions of any other 
sections of the Code of regulations that require the use of consistent 
accounting methods. Such provisions must be independently satisfied 
separate and apart from the identification of a functional currency. For 
instance, while separate geographical divisions of a taxpayer's trade or 
business may have different functional currencies, such geographical 
divisions may nevertheless be required to consistently use other methods 
of accounting.

[T.D. 8263, 54 FR 38661, Sept. 20, 1989, as amended by T.D. 8776, 63 FR 
40368, July 29, 1998; T.D. 8927, Jan. 11, 2001]



Sec. 1.985-5  Adjustments required upon change in functional currency.

    (a) In general. This section applies in the case of a taxpayer or 
qualified business unit (QBU) (including a section 987 QBU (as defined 
in Sec. 1.987-1(b)(2)) changing from one functional currency (old 
functional currency) to another functional currency (new functional 
currency). A taxpayer or QBU subject to the rules of this section shall 
make the adjustments set forth in the 3-step procedure described in 
paragraphs (b) through (e) of this section. Except as otherwise provided 
in this section, the adjustments shall be made on the last day of the 
last taxable year ending before the year of change (as defined in Sec. 
1.481-1(a)(1)). Gain or loss required to be recognized under paragraphs 
(b), (d)(2), (e)(2), and (e)(4)(iii) of this section is not subject to 
section 481 and, therefore, the full amount of the gain or loss must be 
included in income on the last day of the last taxable year ending 
before the year of change.

[[Page 629]]

    (b) Step 1--Taking into account exchange gain or loss on certain 
section 988 transactions. The taxpayer or QBU shall recognize or 
otherwise take into account for all purposes of the Internal Revenue 
Code the amount of any unrealized exchange gain or loss attributable to 
a section 988 transaction (as defined in section 988(c)(1)(A) through 
(C)) that, after applying section 988(d), is denominated in terms of or 
determined by reference to the new functional currency. The amount of 
such gain or loss shall be determined without regard to the limitations 
of section 988(b) (that is, whether any gain or loss would be realized 
on the transaction as a whole). The character and source of such gain or 
loss shall be determined under section 988.
    (c) Step 2--Determining the new functional currency basis of 
property and the new functional currency amount of liabilities and any 
other relevant items. Except as otherwise provided in this section, the 
new functional currency adjusted basis of property and the new 
functional currency amount of liabilities and any other relevant items 
(for example, items described in section 988(c)(1)(B)(iii)) shall equal 
the product of the old functional currency adjusted basis or liability 
and the new functional currency/old functional currency spot rate on the 
last day of the last taxable year ending before the year of change.
    (d) Step 3A--Additional adjustments that are necessary when a QBU 
changes functional currency--(1) QBU changing to a functional currency 
other than the owner's functional currency--(i) Rule. If a QBU changes 
its functional currency, and after the change the QBU is a section 987 
QBU that is subject to Sec. Sec. 1.987-1 through 1.987-11 pursuant to 
Sec. 1.987-1(b)(1), then the adjustments described in either paragraph 
(d)(1)(ii) or (d)(1)(iii) of this section shall be taken into account 
for purposes of section 987.
    (ii) QBU and the owner had different functional currencies prior to 
the change. If the QBU and the owner of the QBU had different functional 
currencies prior to the change and as a result the QBU was a section 987 
QBU prior to the change, then the adjustments described in paragraphs 
(d)(1)(ii)(A) and (d)(1)(ii)(B) of this section shall be taken into 
account.
    (A) Determining new historic rates. The historic rate (as defined in 
Sec. 1.987-1(c)(3)) for the year of change and subsequent taxable years 
with respect to a historic item (as defined in Sec. 1.987-1(e)) 
reflected on the balance sheet of the section 987 QBU immediately prior 
to the year of change shall be equal to the historic rate prior to the 
year of change (that is, a rate that translates the section 987 QBU's 
old functional currency into the owner's functional currency) divided by 
the spot rate (as defined in Sec. 1.987-1(c)(1)) for translating an 
amount denominated in the section 987 QBU's old functional currency into 
the section 987 QBU's new functional currency on the last day of the 
last taxable year ending before the year of change. For example, if a 
taxpayer with a U.S. dollar (USD) functional currency owns a section 987 
QBU that changes from a British pound (GBP) functional currency to a 
euro (EUR) functional currency, the historic rate for translating a 
specific historic item of this section 987 QBU from GBP to USD is 1.50, 
and the spot rate for translating GBP to EUR on the last day of the last 
taxable year before the change is 1.30, then the new historic rate for 
translating this historic item from EUR to USD is 1.15 (1.50/1.30).
    (B) Determining the owner functional currency net value of the QBU 
on the last day of the last taxable year ending before the year of 
change under Sec. 1.987-4(d)(1)(i)(B). For purposes of determining the 
owner functional currency net value of the section 987 QBU on the last 
day of the last taxable year ending before the year of change under 
Sec. 1.987-4(d)(1)(i)(B) and Sec. 1.987-4(e), the section 987 QBU's 
marked items (as defined in Sec. 1.987-1(d)) shall be translated from 
the section 987 QBU's old functional currency into the owner's 
functional currency using the spot rate on the last day of the last 
taxable year ending before the year of change.
    (iii) QBU and the taxpayer had the same functional currency prior to 
the change. If a QBU that has the same functional currency as a taxpayer 
changes its functional currency to a new functional currency that is 
different than the functional currency of

[[Page 630]]

the taxpayer, and as a result the taxpayer becomes an owner of a section 
987 QBU (see Sec. 1.987-1), the taxpayer and section 987 QBU will 
become subject to section 987 for the year of change and subsequent 
years.
    (2) QBU changing to the owner's functional currency. If a section 
987 QBU changes its functional currency to the functional currency of 
its owner, the section 987 QBU shall be treated as if it terminated on 
the last day of the last taxable year ending before the year of change. 
See Sec. Sec. 1.987-5 and 1.987-8 for the effect of a termination of a 
section 987 QBU that is subject to Sec. Sec. 1.987-1 through 1.987-11.
    (e) Step 3B--Additional adjustments that are necessary when a 
taxpayer/owner changes functional currency--(1) Corporations. The amount 
of a corporation's new functional currency earnings and profits and the 
amount of its new functional currency paid-in capital shall equal the 
old functional currency amounts of such items multiplied by the spot 
rate for translating an amount denominated in the corporation's old 
functional currency into the corporation's new functional currency on 
the last day of the last taxable year ending before the year of change. 
The foreign income taxes and accumulated profits or deficits in 
accumulated profits of a foreign corporation that were maintained in 
foreign currency for purposes of section 902 and that are attributable 
to taxable years of the foreign corporation beginning before January 1, 
1987, also shall be translated into the new functional currency at the 
spot rate.
    (2) Collateral consequences to a United States shareholder of a 
corporation changing to the United States dollar as its functional 
currency. A United States shareholder (within the meaning of section 
951(b) or section 953(c)(1)(A)) of a controlled foreign corporation 
(within the meaning of section 957 or section 953(c)(1)(B)) changing its 
functional currency to the dollar shall recognize foreign currency gain 
or loss computed under section 986(c) as if all previously taxed 
earnings and profits, if any, (including amounts attributable to pre-
1987 taxable years that were translated from dollars into functional 
currency in the foreign corporation's first post-1986 taxable year) were 
distributed immediately prior to the change.
    (3) Taxpayers that are not corporations. [Reserved]
    (4) Adjustments to a section 987 QBU's balance sheet and net 
accumulated unrecognized section 987 gain or loss when an owner changes 
functional currency--(i) Owner changing to a functional currency other 
than the section 987 QBU's functional currency. If an owner of a section 
987 QBU, subject to Sec. Sec. 1.987-1 through 1.987-11 pursuant to 
Sec. 1.987-1(b)(1), changes to a functional currency other than the 
functional currency of the section 987 QBU, the adjustments described in 
paragraphs (e)(4)(i)(A) through (C) of this section shall be taken into 
account for purposes of section 987.
    (A) Determining new historic rates. The historic rate (as defined in 
Sec. 1.987-1(c)(3)) for the year of change and subsequent taxable years 
with respect to a historic item (as defined in Sec. 1.987-1(e)) 
reflected on the balance sheet of the section 987 QBU immediately prior 
to the year of change shall be equal to the historic rate prior to the 
year of change (that is, a rate that translates the section 987 QBU's 
functional currency into the owner's old functional currency) divided by 
the spot rate for translating an amount denominated in the owner's new 
functional currency into the owner's old functional currency on the last 
day of the last taxable year ending before the year of change. For 
example, if a taxpayer that owns a section 987 QBU with a British pound 
functional currency changes from a U.S. dollar functional currency to a 
euro functional currency, and the historic rate for translating a 
specific item of the section 987 QBU from GBP to USD is 1.50 and the 
spot rate for translating EUR to USD on the last day of the last taxable 
year before the change is 1.10, then the new historic rate for 
translating this historic item from GBP to EUR is 1.36 (1.50/1.10).
    (B) Determining the owner functional currency net value of the 
section 987 QBU on the last day of the last taxable year ending before 
the year of change under Sec. 1.987-4(d)(1)(i)(B). For purposes of 
determining the change in the owner functional currency net value of the 
section 987 QBU on the last day of the

[[Page 631]]

last taxable year preceding the year of change under Sec. Sec. 1.987-
4(d)(1)(i)(B) and 1.987-4(e), the section 987 QBU's marked items shall 
be translated into the owner's new functional currency at the spot rate 
on the last day of the last taxable year ending before the year of 
change.
    (C) Translation of net accumulated unrecognized section 987 gain or 
loss. Any net accumulated unrecognized section 987 gain or loss 
determined under Sec. 1.987-4 shall be translated from the owner's old 
functional currency into the owner's new functional currency using the 
spot rate for translating an amount denominated in the owner's old 
functional currency into the owner's new functional currency on the last 
day of the last taxable year ending before the year of change.
    (ii) Taxpayer with the same functional currency as its QBU changing 
to a different functional currency. If a taxpayer with the same 
functional currency as its QBU changes to a new functional currency and 
as a result the taxpayer becomes an owner of a section 987 QBU (see 
Sec. 1.987-1), the taxpayer and the section 987 QBU shall become 
subject to section 987 for the year of change and subsequent years.
    (iii) Owner changing to the same functional currency as the section 
987 QBU. If an owner changes its functional currency to the functional 
currency of its section 987 QBU, the section 987 QBU shall be treated as 
if it terminated on the last day of the last taxable year ending before 
the year of change. See Sec. Sec. 1.987-5 and 1.987-8 for the 
consequences of a termination of a section 987 QBU that is subject to 
Sec. Sec. 1.987-1 through 1.987-11.
    (f) Example. The provisions of this section are illustrated by the 
following example:

    Example. (i) Facts. FC, a foreign corporation, owns all of the stock 
of DC, a domestic corporation. The Commissioner granted permission to 
change FC's functional currency from the British pound to the euro 
beginning January 1, 2020. The EUR/GBP exchange rate on December 31, 
2019, is [euro]1:[pound]0.50.
    (ii) Determining new functional currency basis of property and 
liabilities. The following table shows how FC must convert the items on 
its balance sheet from the British pound to the euro on December 31, 
2019.

------------------------------------------------------------------------
                                                GBP             EUR
------------------------------------------------------------------------
Assets:
    Cash on hand........................   [pound]40,000    [euro]80,000
    Accounts Receivable.................          10,000          20,000
    Inventory...........................         100,000         200,000
    [euro]100,000 Euro Bond                       50,000         100,000
     ([pound]100,000 historical basis)..
Fixed assets:
    Property............................         200,000         400,000
    Plant...............................         500,000       1,000,000
        Accumulated Depreciation........       (200,000)       (400,000)
    Equipment...........................       1,000,000       2,000,000
        Accumulated Depreciation........       (400,000)       (800,000)
                                         -------------------------------
            Total Assets................       1,300,000       2,600,000
Liabilities:
    Accounts Payable....................          50,000         100,000
    Long-term Liabilities...............         400,000         800,000
    Paid-in-Capital.....................         800,000       1,600,000
    Retained Earnings...................          50,000         100,000
                                         -------------------------------
                Total Liabilities and          1,300,000       2,600,000
                 Equity.................
------------------------------------------------------------------------

    (iii) Exchange gain or loss on section 988 transactions. Under 
paragraph (b) of this section, FC will recognize a [pound]50,000 loss 
([pound]50,000 current value minus [pound]100,000 historical basis) on 
the Euro Bond resulting from the change in functional currency because, 
after the change, the Euro Bond will no longer be an asset denominated 
in a non-functional currency. The amount of FC's retained earnings on 
its December 31, 2019, balance sheet reflects the [pound]50,000 loss on 
the Euro Bond.

    (g) Effective/applicability date. Generally, this regulation 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

[[Page 632]]

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 this section shall 
apply to taxable years of the taxpayer beginning on or after the first 
day of such prior taxable year.

[T.D. 9794, 81 FR 88819, Dec. 8, 2016]



Sec. 1.985-6  Transition rules for a QBU that uses the dollar
approximate separate transactions method for its first taxable year
beginning in 1987.

    (a) In general. This section sets forth transition rules for a QBU 
that used the dollar approximate separate transactions method of 
accounting set forth in Sec. 1.985-3 or Sec. 1.985-3T (as contained in 
the April 1, 1989 edition of 26 CFR part 1 (1.908 to 1.1000)) for its 
first taxable year beginning in 1987 (DASTM QBU). A DASTM QBU must 
determine the dollar and hyperinflationary currency basis of its assets 
and the dollar and hyperinflationary currency amount of its liabilities 
that were acquired or incurred in taxable years beginning before January 
1, 1987. In addition, a DASTM QBU must determine its net worth, 
including its retained earnings, at the end of the QBU's last taxable 
year beginning before January 1, 1987. This section provides rules for 
controlled foreign corporations (as defined in section 957 or section 
953(c)(1)(B)), other foreign corporations, and branches of United States 
persons that must make these determinations.
    (b) Certain controlled foreign corporations. If a DASTM QBU was a 
controlled foreign corporation for its last taxable year beginning 
before January 1, 1987, and it had a significant event as described in 
Sec. 1.964-1(c)(6) in a taxable year beginning before January 1, 1987, 
then the rules of this paragraph (b) shall apply.
    (1) Basis in assets and amount of liabilities. The hyperinflationary 
currency adjusted basis of the QBU's assets and the hyperinflationary 
currency amount of the QBU's liabilities acquired or incurred by the QBU 
in a taxable year beginning before January 1, 1987, shall be the basis 
or the amount as determined under Sec. 1.964-1(e) prior to translation 
under Sec. 1.964-1(e)(4). The dollar adjusted basis of such assets and 
the dollar amount of such liabilities shall be the adjusted basis or the 
amount as determined under the rules of Sec. 1.964-1(e) after 
translation under Sec. 1.964-1(e)(4).
    (2) Retained earnings. The dollar amount of the QBU's retained 
earnings at the end of its last taxable year beginning before January 1, 
1987, shall be the dollar amount determined under Sec. 1.964-1(e)(3).
    (c) All other foreign corporations. If a foreign corporation is a 
DASTM QBU that is not described in paragraph (b) of this section, then 
the hyperinflationary currency and dollar adjusted basis in the QBU's 
assets acquired in taxable years beginning before January 1, 1987, the 
hyperinflationary currency and dollar amount of the QBU's liabilities 
acquired or incurred in taxable years beginning before January 1, 1987, 
and the dollar amount of the QBU's net worth, including its retained 
earnings, at the end of its last taxable year beginning before January 
1, 1987, shall be determined by applying the principles of Sec. 1.985-
3T or Sec. 1.985-3. Thus, for example, the dollar basis of plant and 
equipment shall be determined using the appropriate historical exchange 
rate.
    (d) Pre-1987 section 902 amounts--(1) Translation of pre-1987 
section 902 accumulated profits and taxes into United States dollars. 
The foreign income taxes and accumulated profits or deficits in 
accumulated profits of a foreign corporation that were maintained in 
foreign currency for purposes of section 902 and that are attributable 
to taxable years of the foreign corporation beginning before January 1, 
1987, shall be translated into dollars at the spot exchange rate on the 
first day of its first taxable year beginning after December 31, 1986. 
Once translated into dollars, these accumulated profits and taxes shall 
(absent a change in functional currency) remain in dollars for all 
federal income tax purposes.
    (2) Carryforward of accumulated deficits in accumulated profits from 
pre-1987 taxable years to post-1986 taxable years. For purposes of 
sections 902 and 960, the post-1986 undistributed earnings of a foreign 
corporation that is subject to

[[Page 633]]

the rules of this section shall be reduced by the dollar amount of the 
corporation's deficit in accumulated profits, if any, determined under 
section 902 and the regulations thereunder, that was accumulated at the 
end of the corporation's last taxable year beginning before January 1, 
1987. The dollar amount of the accumulated deficit shall be determined 
by multiplying the foreign currency amount of such deficit by the spot 
exchange rate on the last day of the corporation's last taxable year 
beginning before January 1, 1987, and shall be taken into account on the 
first day of the corporation's first taxable year beginning after 
December 31, 1986. Post-1986 undistributed earnings may not be reduced 
by the dollar amount of a pre-1987 deficit in retained earnings 
determined under Sec. 1.964-1(e).
    (e) Net worth branch. If a DASTM QBU is a branch of a United States 
person and the QBU used a net worth method of accounting for its last 
taxable year beginning before January 1, 1987, then the rules of this 
paragraph (e) shall apply. A net worth method of accounting is any 
method of accounting under which the taxpayer calculates the taxable 
income of a QBU based on the net change in the dollar value of the QBU's 
equity (assets minus liabilities) during the course of a taxable year, 
taking into account any contributions or remittances made during the 
year. See, e.g., Rev. Rul. 75-106, 1975-1 C.B. 31. (See Sec. 
601.601(d)(2)(ii)(b) of this chapter).
    (1) Basis in assets and amount of liabilities--(i) Hyperinflationary 
amounts. For the first taxable year beginning in 1987, the 
hyperinflationary currency adjusted basis of a QBU's assets or the 
hyperinflationary currency amounts of its liabilities acquired or 
incurred in a taxable year beginning before January 1, 1987 is the 
hyperinflationary currency basis or amount at the date when acquired or 
incurred, as adjusted according to United States generally accepted 
accounting and tax accounting principles. If a hyperinflationary 
currency basis or amount was not determined at such date, the dollar 
basis or amount, as adjusted according to United States generally 
accepted accounting and tax accounting principles, shall be translated 
into hyperinflationary currency at the spot exchange rate on the date 
when the asset or liability was acquired or incurred.
    (ii) Dollar amounts. For the first taxable year beginning in 1987, 
the dollar adjusted basis of the QBU's assets and the amounts of its 
liabilities shall be those amounts reflected on the QBU's dollar books 
and records at the end of the taxpayer's last taxable year beginning 
before January 1, 1987, after adjusting the books and records according 
to United States generally accepted accounting and tax accounting 
principles.
    (2) Ending net worth. The dollar amount of the QBU's net worth at 
the end of its last taxable year beginning before January 1, 1987 shall 
equal the QBU's net worth at that date as determined under paragraph 
(e)(1)(ii) of this section.
    (f) Profit and loss branch. If a DASTM QBU is a branch of a United 
States person and the QBU used a profit and loss method of accounting 
for its last taxable year beginning before January 1, 1987, then the 
United States person shall first apply the transition rules of Sec. 
1.987-5 in order to determine the beginning amount and dollar basis of 
the branch's EQ pool, the hyperinflationary currency basis of the 
branch's assets, and the hyperinflationary currency amounts of its 
liabilities. A profit and loss method of accounting is any method of 
accounting under which the taxpayer calculates the profits of a QBU by 
computing the QBU's profits in its functional currency and translating 
the net result into dollars. See e.g., Rev. Rul. 75-107, 1975-1 C.B. 32. 
(See Sec. 601.601(d)(2)(ii)(b) of this chapter). The QBU and the 
taxpayer must then make the adjustments required by Sec. 1.985-5, e.g., 
the QBU must take into account unrealized exchange gain or loss on 
dollar-denominated section 988 transactions, the taxpayer must account 
for the deemed termination of the branch, and the taxpayer must 
translate the QBU's balance sheet items from hyperinflationary currency 
into dollars at the spot rate.

[T.D. 8464, 58 FR 234, Jan. 5, 1993]

[[Page 634]]



Sec. 1.985-7  Adjustments required in connection with a change
to DASTM.

    (a) In general. If a QBU begins to use the dollar approximate 
separate transactions method of accounting set forth in Sec. 1.985-3 
(DASTM) in a taxable year beginning after April 6, 1998, adjustments 
shall be made as provided by this section. For the rules with respect to 
foreign corporations, see paragraph (b) of this section. For the rules 
with respect to adjustments to the income of United States shareholders 
of controlled foreign corporations, see paragraph (c) of this section. 
For the rules with respect to adjustments relating to QBU branches, see 
paragraph (d) of this section. For the effective date of this section, 
see paragraph (e). For purposes of applying this section, the look-back 
period shall be the period beginning with the first taxable year after 
the transition date and ending on the last day prior to the taxable year 
of change. The term transition date means the later of the last day of 
the last taxable year ending before the base period as defined in Sec. 
1.985-1(b)(2)(ii)(D) or the last day of the taxable year in which the 
QBU last applied DASTM. The taxable year of change shall mean the 
taxable year of change as defined in Sec. 1.481-1(a)(1). The 
application of this paragraph may be illustrated by the following 
examples:

    Example 1. A calendar year QBU that has not previously used DASTM 
operates in a country in which the functional currency of the country is 
hyperinflationary as defined under Sec. 1.985-1(b)(2)(ii)(D) for the 
QBU's 1999 tax year. The look-back period is the period from January 1, 
1996 through December 31, 1998, the transition date is December 31, 
1995, and the taxable year of change is the taxable year beginning 
January 1, 1999.
    Example 2. A QBU that has not previously used DASTM with a taxable 
year ending June 30, operates in a country in which the functional 
currency of the country is hyperinflationary for the QBU's tax year 
beginning July 1, 1999 as defined under Sec. 1.985-1(b)(2)(ii)(D) 
(where the base period is the thirty-six calendar months immediately 
preceding the first day of the current calendar year 1999). The look-
back period is the period from July 1, 1995 through June 30, 1999, the 
transition date is June 30, 1995, and the taxable year of change is the 
taxable year beginning July 1, 1999.

    (b) Adjustments to foreign corporations--(1) In general. In the case 
of a foreign corporation, the corporation shall make the adjustments set 
forth in paragraphs (b)(2) through (4) of this section. The adjustments 
shall be made on the first day of the taxable year of change.
    (2) Treatment of certain section 988 transactions--(i) Exchange gain 
or loss from section 988 transactions unrealized as of the transition 
date. A foreign corporation shall adjust earnings and profits by the 
amount of any unrealized exchange gain or loss that was attributable to 
a section 988 transaction (as defined in sections 988(c)(1)(A), (B), and 
(C)) that was denominated in terms of (or determined by reference to) 
the dollar and was held by the corporation on the transition date. Such 
gain or loss shall be computed as if recognized on the transition date 
and shall be reduced by any gain and increased by any loss recognized by 
the corporation with respect to such transaction during the look-back 
period. The amount of such gain or loss shall be determined without 
regard to the limitations of section 988(b) (i.e., whether any gain or 
loss would be realized on the transaction as a whole). The character and 
source of such gain or loss shall be determined under section 988. 
Proper adjustments shall be made to account for gain or loss taken into 
account by reason of this paragraph (b)(2). See Sec. 1.985-5(f) Example 
1, footnote 1.
    (ii) Treatment of a section 988 transaction entered into and 
terminated during the look-back period. A foreign corporation shall 
reduce earnings and profits by the amount of any gain, and increase 
earnings and profits by the amount of any loss, that was recognized with 
respect to any dollar denominated section 988 transactions entered into 
and terminated during the look-back period.
    (3) Opening balance sheet. The opening balance sheet of a foreign 
corporation for the taxable year of change shall be determined as if the 
corporation had changed its functional currency to the dollar by 
applying Sec. 1.985-5(c) on the transition date and had translated its 
assets and liabilities acquired and incurred during the look-back period 
under Sec. 1.985-3.

[[Page 635]]

    (4) Earnings and profits adjustments--(i) Pre-1987 accumulated 
profits. The foreign income taxes and accumulated profits or deficits in 
accumulated profits of a foreign corporation that are attributable to 
taxable years beginning before January 1, 1987, as stated on the 
transition date, and that were maintained for purposes of section 902 in 
the old functional currency, shall be translated into dollars at the 
spot rate in effect on the transition date. The applicable accumulated 
profits shall be reduced on a last-in, first-out basis by the aggregate 
dollar amount (translated from functional currency in accordance with 
the rules of section 989(b)) attributable to earnings and profits that 
were distributed (or treated as distributed) during the look-back period 
to the extent such amounts distributed exceed the earnings and profits 
calculated under (b)(4)(ii) or (b)(4)(iii), as applicable. See Sec. 
1.902-1(b)(2)(ii). Once translated into dollars, these pre-1987 taxes 
and accumulated profits or deficits in accumulated profits shall (absent 
a change in functional currency) remain in dollars for all federal 
income tax purposes.
    (ii) Post-1986 undistributed earnings of a CFC. In the case of a 
controlled foreign corporation (within the meaning of section 957 or 
section 953(c)(1)(B))(CFC) or a foreign corporation subject to the rules 
of Sec. 1.904-6(a)(2), the corporation's post-1986 undistributed 
earnings in each separate category as defined in Sec. 1.904-5(a)(1) as 
of the first day of the taxable year of change (and prior to adjustment 
under paragraph (c)(1) of this section) shall equal the sum of--
    (A) The corporation's post-1986 undistributed earnings and profits 
(or deficit in earnings and profits) in each separate category as 
defined in Sec. 1.904-5(a)(1) as stated on the transition date 
translated into dollars at the spot rate in effect on the transition 
date; and
    (B) The sum of the earnings and profits (or deficit in earnings and 
profits) in each separate category determined under Sec. 1.985-3 for 
each post-transition date taxable year prior to the taxable year of 
change.
    Such amount shall be reduced by the aggregate dollar amount 
(translated from functional currency in accordance with the rules of 
section 989(b)) attributable to earnings and profits that were 
distributed (or treated as distributed) during the look-back period out 
of post-1986 earnings and profits in such separate category. For 
purposes of applying this paragraph (b)(4)(ii)(B), the opening balance 
sheet for calculating earnings and profits under Sec. 1.985-3 for the 
first post-transition year shall be translated into dollars pursuant to 
Sec. 1.985-5(c).
    (iii) Post-1986 undistributed earnings of other foreign 
corporations. In the case of a foreign corporation that is not a CFC or 
subject to the rules of Sec. 1.904-6(a)(2), the corporation's post-1986 
undistributed earnings shall equal the sum of--
    (A) The corporation's post-1986 undistributed earnings (or deficit) 
on the transition date translated into dollars at the spot rate in 
effect on the transition date; and
    (B) The sum of the earnings and profits (or deficit in earnings and 
profits) determined under Sec. 1.985-3 for each post-transition date 
taxable year (or such later year determined under section 902(c)(3)(A)) 
prior to the taxable year of change.
    Such amount shall be reduced by the aggregate dollar amount 
(translated from functional currency in accordance with the rules of 
section 989(b)) that was distributed (or treated as distributed) during 
the look-back period out of post-1986 earnings and profits. For purposes 
of applying this paragraph (b)(4)(iii)(B), the opening balance sheet for 
calculating earnings and profits under Sec. 1.985-3 for the first post-
transition year shall be translated into dollars pursuant to Sec. 
1.985-5(c).
    (c) United States shareholders of controlled foreign corporations--
(1) In general. A United States shareholder (within the meaning of 
section 951(b) or section 953(c)(1)(B)) of a CFC that changes to DASTM 
shall make the adjustments set forth in paragraphs (c) (2) through (5) 
of this section on the first day of the taxable year of change. 
Adjustments under this section shall be taken into account by the 
shareholder (or such shareholder s successor in interest) ratably over 
four taxable years beginning with the taxable year of change. Similar 
rules shall apply in determining adjustments to income of

[[Page 636]]

United States persons who have made an election under section 1295 to 
treat a passive foreign investment company as a qualified electing fund.
    (2) Treatment under subpart F of income recognized on section 988 
transactions. The character of amounts taken into account under 
paragraph (b)(2) of this section for purposes of sections 951 through 
964, shall be determined on the transition date and to the extent 
characterized as subpart F income shall be taken into account in 
accordance with the rules of paragraph (c)(1) of this section. Such 
amounts shall retain their character for all federal income tax purposes 
(including sections 902, 959, 960, 961, 1248, and 6038).
    (3) Recognition of foreign currency gain or loss on previously taxed 
earnings and profits on the transition date. Gain or loss is recognized 
under section 986(c) as if all previously taxed earnings and profits as 
determined on the transition date, if any, were distributed on such 
date. Such gain or loss shall be reduced by any foreign currency gain 
and increased by any foreign currency loss that was recognized under 
section 986(c) with respect to distributions of previously taxed 
earnings and profits during the look-back period. Such amount shall be 
characterized in accordance with section 986(c) and taken into account 
in accordance with the rules of paragraph (c)(1) of this section.
    (4) Subpart F income adjustment. Subpart F income in a separate 
category shall be determined under Sec. 1.985-3 for each look-back 
year. For this purpose, the opening DASTM balance sheet shall be 
determined under Sec. 1.985-5. The sum of the difference (positive or 
negative) between the amount computed pursuant to Sec. 1.985-3 and 
amount that was included in income for each year shall be taken into 
account in the taxable year of change pursuant to paragraph (c)(1) of 
this section. Such amounts shall retain their character for all federal 
income tax purposes (including sections 902, 959, 960, 961, 1248, and 
6038). For rules applicable if an adjustment under this section results 
in a loss for the taxable year in a separate category, see section 
904(f) and the regulations thereunder. The amount of previously taxed 
earnings and profits as determined under section 959(c)(2) shall be 
adjusted (positively or negatively) by the amount taken into account 
under this paragraph (c)(4) as of the first day of the taxable year of 
change.
    (5) Foreign tax credit. A United States shareholder of a CFC shall 
compute an amount of foreign taxes deemed paid under section 960 with 
respect to any positive adjustments determined under paragraph (c) of 
this section. The amount of foreign tax deemed paid shall be computed 
with reference to the full amount of the adjustment and to the post-1986 
undistributed earnings determined under paragraph (b)(4) (i) and (ii) of 
this section and the post-1986 foreign income taxes of the CFC on the 
first day of the taxable year of change (i.e., without taking into 
account earnings and taxes for the taxable year of change). For purposes 
of section 960, the associated taxes in each separate category shall be 
allocated pro rata among, and deemed paid in, the shareholder's taxable 
years in which the income is taken into account. (No adjustment to 
foreign taxes deemed paid in prior years is required solely by reason of 
a negative adjustment to income under paragraph (c)(1) of this section).
    (d) QBU branches--(1) In general. In the case of a QBU branch, the 
taxpayer shall make the adjustments set forth in paragraphs (d)(2) 
through (d)(4) of this section. Adjustments under this section shall be 
taken into account by the taxpayer ratably over four taxable years 
beginning with the taxable year of change.
    (2) Treatment of certain section 988 transactions--(i) Exchange gain 
or loss from section 988 transactions unrealized as of the transition 
date. A QBU branch shall adjust income by the amount of any unrealized 
exchange gain or loss that was attributable to a section 988 transaction 
(as defined in sections 988(c)(1) (A), (B), and (C)) that was 
denominated in terms of (or determined by reference to) the dollar and 
was held by the QBU branch on the transition date. Such gain or loss 
shall be computed as if recognized on the transition date and shall be 
reduced by any gain and increased by any loss recognized by the QBU 
branch with respect to such transaction during the look-back period. The 
amount of such gain or loss

[[Page 637]]

shall be determined without regard to the limitations of section 988(b) 
(i.e., whether any gain or loss would be realized on the transaction as 
a whole). The character and source of such gain or loss shall be 
determined under section 988. Proper adjustments shall be made to 
account for gain or loss taken into account by reason of this paragraph 
(d)(2). See Sec. 1.985-5(f) Example 1, footnote 1.
    (ii) Treatment of a section 988 transaction entered into and 
terminated during the look-back period. A QBU branch shall reduce income 
by the amount of any gain, and increase income by the amount of any 
loss, that was recognized with respect to any dollar denominated section 
988 transactions entered into and terminated during the look-back 
period.
    (3) Deemed termination income adjustment. The taxpayer shall realize 
gain or loss attributable to the QBU branch's equity pool (as stated on 
the transition date) under the principles of section 987, computed as if 
the branch terminated on the transition date. Such amount shall be 
reduced by section 987 gain and increased by section 987 loss that was 
recognized by such taxpayer with respect to remittances during the look-
back period.
    (4) Branch income adjustment. Branch income in a separate category 
shall be determined under Sec. 1.985-3 for each look-back year. For 
this purpose, the opening DASTM balance sheet shall be determined under 
Sec. 1.985-5. The sum of the difference (positive or negative) between 
the amount computed pursuant to Sec. 1.985-3 and amount taken into 
account for each year shall be taken into account in the taxable year of 
change pursuant to paragraph (d)(1) of this section. Such amounts shall 
retain their character for all federal income tax purposes.
    (5) Opening balance sheet. The opening balance sheet of a QBU branch 
for the taxable year of change shall be determined as if the branch had 
changed its functional currency to the dollar by applying Sec. 1.985-
5(c) on the transition date and had translated its assets and 
liabilities acquired and incurred during the look-back period under 
Sec. 1.985-3.
    (e) Effective date. This section is effective for taxable years 
beginning after April 6, 1998. However, a taxpayer may choose to apply 
this section to all open taxable years beginning after December 31, 
1986, provided each person, and each QBU branch of a person, that is 
related (within the meaning of Sec. 1.985-2(d)(3)) to the taxpayer also 
applies this section.

[T.D. 8765, 63 FR 10774, Mar. 5, 1998]



Sec. 1.985-8  Special rules applicable to the European Monetary
Union (conversion to euro).

    (a) Definitions--(1) Legacy currency. A legacy currency is the 
former currency of a Member State of the European Community which is 
substituted for the euro in accordance with the Treaty establishing the 
European Community signed February 7, 1992. The term legacy currency 
shall also include the European Currency Unit.
    (2) Conversion rate. The conversion rate is the rate at which the 
euro is substituted for a legacy currency.
    (b) Operative rules--(1) Initial adoption. A QBU (as defined in 
Sec. 1.989(a)-1(b)) whose first taxable year begins after the euro has 
been substituted for a legacy currency may not adopt a legacy currency 
as its functional currency.
    (2) QBU with a legacy currency as its functional currency--(i) 
Required change. A QBU with a legacy currency as its functional currency 
is required to change its functional currency to the euro beginning the 
first day of the first taxable year--
    (A) That begins on or after the day that the euro is substituted for 
that legacy currency (in accordance with the Treaty on European Union); 
and
    (B) In which the QBU begins to maintain its books and records (as 
described in Sec. 1.989(a)-1(d)) in the euro.
    (ii) Notwithstanding paragraph (b)(2)(i) of this section, a QBU with 
a legacy currency as its functional currency is required to change its 
functional currency to the euro no later than the last taxable year 
beginning on or before the first day such legacy currency is no longer 
valid legal tender.
    (3) QBU with a non-legacy currency as its functional currency--(i) 
In general. A QBU with a non-legacy currency as its functional currency 
may change its

[[Page 638]]

functional currency to the euro pursuant to this Sec. 1.985-8 if--
    (A) Under the rules set forth in Sec. 1.985-1(c), the euro is the 
currency of the economic environment in which a significant part of the 
QBU's activities are conducted;
    (B) After conversion, the QBU maintains its books and records (as 
described in Sec. 1.989(a)-1(d)) in the euro; and
    (C) The QBU is not required to use the dollar as its functional 
currency under Sec. 1.985-1(b).
    (ii) Time period for change. A QBU with a non-legacy currency as its 
functional currency may change its functional currency to the euro under 
this section only if it does so within the period set forth in paragraph 
(b)(2) of this section as if the functional currency of the QBU was a 
legacy currency.
    (4) Consent of Commissioner. A change made pursuant to paragraph (b) 
of this section shall be deemed to be made with the consent of the 
Commissioner for purposes of Sec. 1.985-4. A QBU changing its 
functional currency to the euro pursuant to paragraph (b)(2) of this 
section must make adjustments as provided in paragraph (c) of this 
section. A QBU changing its functional currency to the euro pursuant to 
paragraph (b)(3) must make adjustments as provided in Sec. 1.985-5.
    (5) Statement to file upon change. With respect to a QBU that 
changes its functional currency to the euro under paragraph (b) of this 
section, an affected taxpayer shall attach to its return for the taxable 
year of change a statement that includes the following: ``TAXPAYER 
CERTIFIES THAT A QBU OF THE TAXPAYER HAS CHANGED ITS FUNCTIONAL CURRENCY 
TO THE EURO PURSUANT TO TREAS. REG. Sec. 1.985-8.'' For purposes of 
this paragraph (b)(5), an affected taxpayer shall be in the case where 
the QBU is: a QBU of an individual U.S. resident (as a result of the 
activities of such individual), the individual; a QBU branch of a U.S. 
corporation, the corporation; a controlled foreign corporation (as 
described in section 957)(or QBU branch thereof), each United States 
shareholder (as described in section 951(b)); a partnership, each 
partner separately; a noncontrolled section 902 corporation (as 
described in section 904(d)(2)(E)) (or branch thereof), each domestic 
shareholder as described in Sec. 1.902-1(a)(1); or a trust or estate, 
the fiduciary of such trust or estate.
    (c) Adjustments required when a QBU changes its functional currency 
from a legacy currency to the euro pursuant to paragraph (b)(2) of this 
section--(1) In general. A QBU that changes its functional currency from 
a legacy currency to the euro pursuant to paragraph (b)(2) of this 
section must make the adjustments described in paragraphs (c)(2) through 
(5) of this section. Section 1.985-5 shall not apply.
    (2) Determining the euro basis of property and the euro amount of 
liabilities and other relevant items. The euro basis in property and the 
euro amount of liabilities and other relevant items shall equal the 
product of the legacy functional currency adjusted basis or amount of 
liabilities multiplied by the applicable conversion rate.
    (3) Taking into account exchange gain or loss on legacy currency 
section 988 transactions--(i) In general. Except as provided in 
paragraphs (c)(3)(iii) and (iv) of this section, a legacy currency 
denominated section 988 transaction (determined after applying section 
988(d)) outstanding on the last day of the taxable year immediately 
prior to the year of change shall continue to be treated as a section 
988 transaction after the change and the principles of section 988 shall 
apply.
    (ii) Examples. The application of this paragraph (c)(3) may be 
illustrated by the following examples:

    Example 1. X, a calendar year QBU on the cash method of accounting, 
uses the deutschmark as its functional currency. X is not described in 
section 1281(b). On July 1, 1998, X converts 10,000 deutschmarks (DM) 
into Dutch guilders (fl) at the spot rate of fl1 = DM1 and loans the 
10,000 guilders to Y (an unrelated party) for one year at a rate of 10% 
with principal and interest to be paid on June 30, 1999. On January 1, 
1999, X changes its functional currency to the euro pursuant to this 
section. Assume that the euro/deutschmark conversion rate is set by the 
European Council at [euro]1= DM2. Assume further that the euro/guilder 
conversion rate is set at [euro]1 = fl2.25. Accordingly, under the terms 
of the note, on June 30, 1999, X will receive [euro]4444.44 (fl10,000/
2.25) of principal and [euro]444.44 (fl1,000/2.25) of interest. Pursuant 
to

[[Page 639]]

this paragraph (c)(3), X will realize an exchange loss on the principal 
computed under the principles of Sec. 1.988-2(b)(5). For this purpose, 
the exchange rate used under Sec. 1.988-2(b)(5)(i) shall be the 
guilder/euro conversion rate. The amount under Sec. 1.988-2(b)(5)(ii) 
is determined by translating the fl10,000 at the guilder/deutschmark 
spot rate on July 1, 1998, and translating that deutschmark amount into 
euros at the deutschmark/euro conversion rate. Thus, X will compute an 
exchange loss for 1999 of [euro]555.56 determined as follows: 
[[euro]4444.44 (fl10,000/2.25)-5000 ((fl10,000/1)/2) = -[euro]555.56]. 
Pursuant to this paragraph (c)(3), the character and source of the loss 
are determined pursuant to section 988 and regulations thereunder. 
Because X uses the cash method of accounting for the interest on this 
debt instrument, X does not realize exchange gain or loss on the receipt 
of that interest.
    Example 2. (i) X, a calendar year QBU on the accrual method of 
accounting, uses the deutschmark as its functional currency. On February 
1, 1998, X converts 12,000 deutschmarks into Dutch guilders at the spot 
rate of fl1 = DM1 and loans the 12,000 guilders to Y (an unrelated 
party) for one year at a rate of 10% with principal and interest to be 
paid on January 31, 1999. In addition, assume the average rate 
(deutschmark/guilder) for the period from February 1, 1998, through 
December 31, 1998 is fl1.07 = DM1. Pursuant to Sec. 1.988-
2(b)(2)(ii)(C), X will accrue eleven months of interest on the note and 
recognize interest income of DM1028.04 (fl1100/1.07) in the 1998 taxable 
year.
    (ii) On January 1, 1999, the euro will replace the deutschmark as 
the national currency of Germany pursuant to the Treaty on European 
Union signed February 7, 1992. Assume that on January 1, 1999, X changes 
its functional currency to the euro pursuant to this section. Assume 
that the euro/deutschmark conversion rate is set by the European Council 
at [euro]1 = DM2. Assume further that the euro/guilder conversion rate 
is set at [euro]1 = fl2.25. In 1999, X will accrue one month of interest 
equal to [euro]44.44 (fl100/2.25). On January 31, 1999, pursuant to the 
note, X will receive interest denominated in euros of [euro]533.33 
(fl1200/2.25). Pursuant to this paragraph (c)(3), X will realize an 
exchange loss in the 1999 taxable year with respect to accrued interest 
computed under the principles of Sec. 1.988-2(b)(3). For this purpose, 
the exchange rate used under Sec. 1.988-2(b)(3)(i) is the guilder/euro 
conversion rate and the exchange rate used under Sec. 1.988-2(b)(3)(ii) 
is the deutschmark/euro conversion rate. Thus, with respect to the 
interest accrued in 1998, X will realize exchange loss of [euro]25.13 
under Sec. 1.988-2(b)(3) as follows: [[euro]488.89 (fl1100/2.25) - 
[euro]514.02 (DM1028.04/2) = -[euro]25.13]. With respect to the one 
month of interest accrued in 1999, X will realize no exchange gain or 
loss since the exchange rate when the interest accrued and the spot rate 
on the payment date are the same.
    (iii) X will realize exchange loss of [euro]666.67 on repayment of 
the loan principal computed in the same manner as in Example 1 
[[euro]5333.33 (fl12,000/2.25) - [euro]6000 fl12,000/1)/2)]. The losses 
with respect to accrued interest and principal are characterized and 
sourced under the rules of section 988.

    (iii) Special rule for legacy nonfunctional currency. The QBU shall 
realize or otherwise take into account for all purposes of the Internal 
Revenue Code the amount of any unrealized exchange gain or loss 
attributable to nonfunctional currency (as described in section 
988(c)(1)(C)(ii)) that is denominated in a legacy currency as if the 
currency were disposed of on the last day of the taxable year 
immediately prior to the year of change. The character and source of the 
gain or loss are determined under section 988.
    (iv) Legacy currency denominated accounts receivable and payable--
(A) In general. A QBU may elect to realize or otherwise take into 
account for all purposes of the Internal Revenue Code the amount of any 
unrealized exchange gain or loss attributable to a legacy currency 
denominated item described in section 988(c)(1)(B)(ii) as if the item 
were terminated on the last day of the taxable year ending prior to the 
year of change.
    (B) Time and manner of election. With respect to a QBU that makes an 
election described in paragraph (c)(3)(iv)(A) of this section, an 
affected taxpayer (as described in paragraph (b)(5) of this section) 
shall attach a statement to its tax return for the taxable year ending 
immediately prior to the year of change which includes the following: 
``TAXPAYER CERTIFIES THAT A QBU OF THE TAXPAYER HAS ELECTED TO REALIZE 
CURRENCY GAIN OR LOSS ON LEGACY CURRENCY DENOMINATED ACCOUNTS RECEIVABLE 
AND PAYABLE UPON CHANGE OF FUNCTIONAL CURRENCY TO THE EURO.'' A QBU 
making the election must do so for all legacy currency denominated items 
described in section 988(c)(1)(B)(ii).
    (4) Adjustments when a branch changes its functional currency to the 
euro--(i) Branch changing from a legacy currency to the euro in a 
taxable year during which taxpayer's functional currency is

[[Page 640]]

other than the euro. If a branch changes its functional currency from a 
legacy currency to the euro for a taxable year during which the 
taxpayer's functional currency is other than the euro, the branch's euro 
equity pool shall equal the product of the legacy currency amount of the 
equity pool multiplied by the applicable conversion rate. No adjustment 
to the basis pool is required.
    (ii) Branch changing from a legacy currency to the euro in a taxable 
year during which taxpayer's functional currency is the euro. If a 
branch changes its functional currency from a legacy currency to the 
euro for a taxable year during which the taxpayer's functional currency 
is the euro, the taxpayer shall realize gain or loss attributable to the 
branch's equity pool under the principles of section 987, computed as if 
the branch terminated on the last day prior to the year of change. 
Adjustments under this paragraph (c)(4)(ii) shall be taken into account 
by the taxpayer ratably over four taxable years beginning with the 
taxable year of change.
    (5) Adjustments to a branch's accounts when a taxpayer changes to 
the euro--(i) Taxpayer changing from a legacy currency to the euro in a 
taxable year during which a branch's functional currency is other than 
the euro. If a taxpayer changes its functional currency to the euro for 
a taxable year during which the functional currency of a branch of the 
taxpayer is other than the euro, the basis pool shall equal the product 
of the legacy currency amount of the basis pool multiplied by the 
applicable conversion rate. No adjustment to the equity pool is 
required.
    (ii) Taxpayer changing from a legacy currency to the euro in a 
taxable year during which a branch's functional currency is the euro. If 
a taxpayer changes its functional currency from a legacy currency to the 
euro for a taxable year during which the functional currency of a branch 
of the taxpayer is the euro, the taxpayer shall take into account gain 
or loss as determined under paragraph (c)(4)(ii) of this section.
    (6) Additional adjustments that are necessary when a corporation 
changes its functional currency to the euro. The amount of a 
corporation's euro currency earnings and profits and the amount of its 
euro paid-in capital shall equal the product of the legacy currency 
amounts of these items multiplied by the applicable conversion rate. The 
foreign income taxes and accumulated profits or deficits in accumulated 
profits of a foreign corporation that were maintained in foreign 
currency for purposes of section 902 and that are attributable to 
taxable years of the foreign corporation beginning before January 1, 
1987, also shall be translated into the euro at the conversion rate.
    (d) Treatment of legacy currency section 988 transactions with 
respect to a QBU that has the euro as its functional currency--(1) In 
general. This Sec. 1.985-8(d) applies to a QBU that has the euro as its 
functional currency and that holds a section 988 transaction denominated 
in, or determined by reference to, a currency that is substituted by the 
euro. For example, this paragraph (d) will apply to a German QBU with 
the euro as its functional currency if the QBU is holding Country X 
currency or other section 988 transactions denominated in such currency 
on the day in the year 2005 when the euro is substituted for the Country 
X currency.
    (2) Principles of paragraph (c)(3) of this section shall apply. With 
respect to a QBU described in paragraph (d) of this section, the 
principles of paragraph (c)(3) of this section shall apply. For example, 
if a German QBU with the euro as its functional currency is holding a 
Country X currency denominated debt instrument on the day in the year 
2005 when the euro is substituted for the Country X currency, the 
instrument shall continue to be treated as a section 988 transaction 
pursuant to the principles of paragraph (c)(3)(i) of this section. 
However, if such QBU holds Country X currency, the QBU shall take into 
account any unrealized exchange gain or loss pursuant to the principles 
of paragraph (c)(3)(iii) of this section as if the currency was disposed 
of on the day prior to the day the euro is substituted for the Country X 
currency. Similarly, if the QBU makes an election under the principles 
of paragraph (c)(3)(iv) of this section, the QBU shall take into account 
for all purposes of the Internal Revenue Code the amount of any 
unrealized exchange

[[Page 641]]

gain or loss attributable to a legacy currency denominated item 
described in section 988(c)(1)(B)(ii) as if the item were terminated on 
the day prior to the day the euro is substituted for the Country X 
currency.
    (e) Effective date. This section applies to tax years ending after 
July 29, 1998.

[T.D. 8927, 66 FR 2216, Jan. 11, 2001; T.D. 8927, 66 FR 21447, Apr. 30, 
2001]



Sec. 1.986(a)-1  Translation of foreign income taxes for purposes 
of the foreign tax credit.

    (a) Translation of foreign income taxes taken into account when 
accrued--(1) In general. For purposes of this section, the term section 
901 taxpayer means the ``taxpayer'' described in Sec. 1.901-2(f)(1) and 
so includes a partnership or a specified 10-percent owned foreign 
corporation (as defined in section 245A(b)) that has legal liability 
under foreign law for foreign income tax. Except as provided in 
paragraph (a)(2) of this section, in the case of a section 901 taxpayer 
that takes foreign income taxes (as defined in section 986(a)(4) 
(including taxes described in section 903)) into account when accrued, 
the amount of any foreign income taxes denominated in foreign currency 
that has been paid or accrued, including additional tax liability 
denominated in foreign currency, foreign income taxes withheld in 
foreign currency, or estimated foreign income taxes paid in foreign 
currency, are translated into dollars using the weighted average 
exchange rate (as defined in Sec. 1.989(b)-1) (the ``average exchange 
rate'') for the section 901 taxpayer's U.S. taxable year (as defined in 
Sec. 1.960-1(b)(37)) to which such foreign income taxes relate. See 
section 986(a)(1)(A). See section 988 and Sec. Sec. 1.988-1(a)(2)(ii) 
and 1.988-2(c) for rules for determining whether and the extent to which 
there is a foreign currency gain or loss when an accrued functional 
currency amount of foreign income tax denominated in nonfunctional 
currency differs from the functional currency amount paid.
    (2) Exceptions--(i) Foreign income taxes not paid within 24 months. 
Any foreign income taxes denominated in foreign currency that are paid 
more than 24 months after the close of the section 901 taxpayer's U.S. 
taxable year to which they relate are translated into dollars using the 
spot rate on the date of payment of the foreign income taxes. See 
section 986(a)(1)(B)(i) and (a)(2)(A). For purposes of this section and 
Sec. 1.905-3, the term spot rate has the meaning provided in Sec. 
1.988-1(d). To the extent any accrued foreign income taxes denominated 
in foreign currency remain unpaid more than 24 months after the close of 
the taxable year to which they relate, see Sec. 1.905-3 and paragraph 
(c) of this section for the required adjustments.
    (ii) Foreign income taxes paid before taxable year begins. Any 
foreign income taxes denominated in foreign currency that are paid 
before the beginning of the section 901 taxpayer's U.S. taxable year to 
which such taxes relate are translated into dollars using the spot rate 
on the date of payment of the foreign income taxes. See section 
986(a)(1)(B)(ii) and (a)(2)(A).
    (iii) Inflationary currency. Any foreign income taxes denominated in 
a foreign currency that is an inflationary currency in the section 901 
taxpayer's U.S. taxable year to which the foreign income taxes relate, 
or in any subsequent taxable year up to and including the taxable year 
in which the taxes are paid, are translated into dollars using the spot 
rate on the date of payment of such taxes. For purposes of section 
986(a)(1)(C) and this paragraph (a)(2)(iii), 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 
under the principles of Sec. 1.985-1(b)(2)(ii)(D), where the base 
period, with respect to any taxable year, is the 36 months ending on the 
last day of such taxable year (in lieu of the base period described in 
Sec. 1.985-1(b)(2)(ii)(D), which ends on the last day of the preceding 
calendar year). Accrued but unpaid foreign income taxes denominated in a 
foreign currency that is an inflationary currency in the taxable year 
accrued are translated into dollars at the spot rate on the last day of 
the section 901 taxpayer's U.S. taxable year to which such taxes relate 
(provisional year-end rate). However, a U.S. taxpayer that

[[Page 642]]

claims a foreign tax credit under section 901 may choose to translate 
accrued but unpaid foreign income taxes (including foreign income taxes 
deemed paid under section 960) denominated in a foreign currency that is 
an inflationary currency into dollars at the spot rate on the date of 
payment, in lieu of the provisional year-end rate, if such taxes are 
paid prior to the due date (with extensions) of the original Federal 
income tax return for the taxable year for which the credit is claimed 
and such return is timely filed. In all other cases, see Sec. 1.905-3 
and paragraph (c) of this section for required adjustments upon payment 
of accrued foreign income taxes denominated in an inflationary currency.
    (iv) Election to translate foreign income taxes using the spot rate 
as of date of payment--(A) Eligibility to make election. An individual 
or corporate taxpayer (including a specified 10-percent owned foreign 
corporation) 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 (a)(2)(iv) into dollars using the spot rate on the date 
of payment of the foreign income taxes, provided that the liability for 
such taxes is denominated in nonfunctional currency. For purposes of 
section 986(a)(1)(D) and this paragraph (a)(2)(iv), whether the currency 
in which a tax liability attributable to a qualified business unit 
(within the meaning of section 989(a)) (QBU) is denominated is a 
nonfunctional currency is determined by reference to the functional 
currency of the individual or corporate taxpayer and not that of the QBU 
of the taxpayer. Accrued but unpaid foreign income taxes subject to the 
election under this paragraph (a)(2)(iv) are translated at the 
provisional year-end rate. However, a taxpayer that claims a foreign tax 
credit under section 901 may choose to translate accrued but unpaid 
foreign income taxes (including foreign taxes deemed paid under section 
960 with respect to a specified 10-percent owned foreign corporation 
that has made an election under this paragraph (a)(2)(iv)) into dollars 
at the spot rate on the date of payment, in lieu of the provisional 
year-end rate, if such taxes are paid prior to the due date (with 
extensions) of the original return for the taxable year for which the 
credit is claimed and such return is timely filed. In all other cases, 
see Sec. 1.905-3 and paragraph (c) of this section for required 
adjustments upon payment of accrued foreign income taxes that are 
translated into dollars at the spot rate on the date of payment.
    (B) Scope of election. In general, an individual taxpayer may make 
an election under this paragraph (a)(2)(iv) for all foreign income taxes 
denominated in nonfunctional currency, or only for those foreign income 
taxes that are denominated in nonfunctional currency and that are 
attributable to the individual's non-QBU activities and all QBUs with 
dollar functional currencies. A corporate taxpayer may make an election 
under this paragraph (a)(2)(iv) for all foreign income taxes that are 
denominated in nonfunctional currency, or only for those foreign income 
taxes that are denominated in nonfunctional currency and that are 
attributable to all QBUs (including the corporate taxpayer) with dollar 
functional currencies. Therefore, an election under this paragraph 
(a)(2)(iv) may not be made for foreign income taxes that are denominated 
in a nonfunctional currency of the taxpayer and attributable to QBUs 
with non-dollar functional currencies, except as part of an election to 
translate all taxes denominated in nonfunctional currency at the spot 
rate on the date of payment. For purposes of this paragraph 
(a)(2)(iv)(B), foreign income tax is attributable to a QBU if the tax is 
properly recorded on the books and records of the QBU in accordance with 
sections 985 through 989. An election under this paragraph (a)(2)(iv) by 
a domestic corporation (or an individual that has made an election under 
section 962) does not apply to any taxes paid or accrued by foreign 
corporations with respect to which the individual or corporation is a 
United States shareholder. However, an election may be made on behalf of 
a foreign corporation to translate either all of the foreign 
corporation's foreign income taxes denominated in nonfunctional 
currency,

[[Page 643]]

or only the foreign income taxes denominated in nonfunctional currency 
that are attributable to the foreign corporation's QBUs with dollar 
functional currencies, using the spot rate on the date of payment. Such 
an election is made using the procedures under Sec. 1.964-1(c)(3) that 
apply to permit controlling domestic shareholders to make or change a 
tax accounting election on behalf of a foreign corporation.
    (C) Time and manner of election. The election under this paragraph 
(a)(2)(iv) must be made by attaching a statement to the taxpayer's 
timely filed Federal income tax or information return (including 
extensions) for the first taxable year to which the election applies. 
The statement must identify whether the election under this paragraph 
(a)(2)(iv) is made for all foreign income taxes denominated in 
nonfunctional currency or only for those foreign income taxes that are 
denominated in nonfunctional currency and that are either attributable 
to the taxpayer's QBUs with dollar functional currencies or, in the case 
of an individual, attributable to non-QBU activities. Once made, the 
election under this paragraph (a)(2)(iv) applies for the taxable year 
for which made and all subsequent taxable years unless revoked with the 
consent of the Commissioner.
    (D) Example--(1) Facts. USP, a domestic corporation that uses the 
calendar year as its taxable year, owns a partnership interest in PS, a 
non-hybrid partnership organized in Country X. USP also owns an equity 
interest in HPS, a Country X corporation that has filed an entity 
classification election under Sec. 301.7701-3 of this chapter to be 
treated as a partnership for Federal income tax purposes. USP also owns 
100% of CFC, a Country Y controlled foreign corporation that uses the 
U.S. dollar as its functional currency. PS and HPS each use a fiscal 
year ending November 30 as its taxable year both for Federal income tax 
purposes and for Country X tax purposes, and their functional currency 
is the Euro. HPS is the section 901 taxpayer of foreign income taxes 
denominated in Euros that it pays to Country X and properly records on 
its books and records. USP takes its distributive share of the HPS taxes 
into account under sections 702(a)(6) and 901(b)(5) and Sec. Sec. 
1.702-1(a)(6) and 1.704-1(b)(4)(viii) in computing its foreign tax 
credit. USP is the section 901 taxpayer of Euro-denominated foreign 
income taxes it pays to Country X with respect to its distributive share 
of the income of PS, and also pays Country X taxes withheld in Euros 
from distributions from HPS to USP and properly records these taxes on 
its books and records. Pursuant to Sec. 1.985-1(b)(1)(iii), USP's 
functional currency is the dollar. USP timely elects under Sec. 
1.986(a)-1(a)(2)(iv) to use the spot rate on the date of payment to 
translate into dollars its foreign income taxes denominated in 
nonfunctional currency that are attributable to all QBUs with dollar 
functional currencies.
    (2) Result. The Euro taxes paid by USP with respect to its 
distributive share of income from PS and the Euro taxes withheld from 
distributions from HPS are nonfunctional currency taxes attributable to 
USP, a QBU with a dollar functional currency. Accordingly, these taxes 
are translated into dollars at the spot rate on the date the taxes are 
paid. USP's distributive share of the Euro taxes paid by HPS are 
attributable to HPS, a Euro functional currency QBU of USP. Because 
these taxes are not attributable to a dollar QBU of USP, they are not 
covered by USP's election and so are translated into dollars at the 
average exchange rate for HPS's U.S. taxable year ending on November 30. 
See Sec. 1.986(a)-1(a)(1). Foreign income taxes paid by CFC are not 
covered by USP's election; however, if USP so chooses it may make a 
separate election on behalf of CFC to use the spot rate on the date of 
payment to translate either all of CFC's nonfunctional currency taxes, 
or only those taxes that are attributable to CFC's dollar QBUs (which 
includes CFC). If instead USP had elected to use the spot rate on the 
date of payment to translate all of its foreign income taxes denominated 
in nonfunctional currency, rather than only those taxes attributable to 
QBUs with dollar functional currencies, then the spot rate on the

[[Page 644]]

date of payment would apply to translate all of the Euro taxes paid or 
accrued by USP, including its distributive share of taxes paid by HPS. 
However, this election would still not apply to taxes paid or accrued by 
CFC. See Sec. 1.986(a)-1(a)(2)(iv)(B).
    (v) Regulated investment companies. In the case of a regulated 
investment company (as defined in section 851) which takes into account 
income on an accrual basis, foreign income taxes paid or accrued with 
respect to such income are translated into dollars using the spot rate 
on the date the income accrues. See section 986(a)(1)(E).
    (b) Translation of foreign income taxes taken into account when 
paid. In the case of a section 901 taxpayer that takes foreign income 
taxes into account when paid, the amount of any foreign income tax 
liability denominated in foreign currency, including additional income 
tax liability denominated in foreign currency or estimated foreign 
income taxes paid in foreign currency, are translated into dollars using 
the spot rate on the date of payment of such taxes. See section 
986(a)(2)(A). Foreign income taxes withheld in foreign currency are 
translated into dollars using the spot rate on the date on which such 
taxes were withheld.
    (c) Refunds or other reductions of foreign income tax liability. In 
the case of a section 901 taxpayer that takes foreign income taxes into 
account when accrued, a reduction in the amount of previously-accrued 
foreign income taxes that is attributable to a refund of foreign income 
taxes, a credit allowed in lieu of a refund, or a reduction in or other 
downward adjustment to an accrued amount, including an adjustment on 
account of accrued foreign income taxes that were not paid by the date 
24 months after the close of the U.S. taxable year to which such taxes 
relate, is translated into dollars using the exchange rate that was used 
to translate such amount when claimed as a credit or added to PTEP group 
taxes (as defined in Sec. 1.960-3(d)(1)). In the case of foreign income 
taxes taken into account when accrued but translated into dollars on the 
date of payment, see Sec. 1.905-3(b) for required adjustments to 
reflect a foreign tax redetermination (as defined in Sec. 1.905-3(a)) 
attributable to a reduction in the amount of previously-accrued foreign 
income taxes that is attributable to a difference in exchange rates 
between the date or taxable year of accrual and the date of payment. In 
the case of a section 901 taxpayer that takes foreign income taxes into 
account when paid, a refund or other reduction in or downward adjustment 
to the amount of foreign income taxes is translated into dollars using 
the exchange rate that was used to translate such amount when claimed as 
a credit. If a refund or other reduction of foreign income taxes relates 
to foreign income taxes paid or accrued on more than one date, then the 
refund or other reduction is deemed to be derived from, and reduces, the 
payments of foreign income taxes in order, starting with the most recent 
payment of foreign income taxes first, to the extent thereof.
    (d) Allocation of refunds of foreign income taxes. Refunds of 
foreign income taxes are allocated to the same separate category as the 
foreign income taxes to which the refunded taxes relate. Refunds are 
related to foreign income taxes in a separate category if the foreign 
income tax that was refunded was imposed with respect to that separate 
category. See Sec. 1.904-6 concerning the allocation of foreign income 
taxes to separate categories of income.
    (e) Basis of foreign currency refunded--(1) Nonfunctional currency 
tax liability and dollar functional currency. If the functional currency 
of the QBU that paid the tax and received the refund is the dollar or 
the person receiving the refund is not a QBU, then the recipient's basis 
in the foreign currency refunded is the dollar value of the refund 
determined under paragraph (c) of this section by using the exchange 
rate that was used to translate such amount into dollars when claimed as 
a credit or added to PTEP group taxes.
    (2) Nonfunctional currency tax liability and non-dollar functional 
currency. If the functional currency of the QBU receiving the refund is 
not the dollar and is different from the currency in which the foreign 
income taxes were paid, then the recipient's basis in the refunded 
foreign currency is equal to the

[[Page 645]]

functional currency value of the nonfunctional currency refund, 
translated into functional currency at the appropriate exchange rate 
between the functional currency and the nonfunctional currency. Such 
exchange rate is determined under the principles of paragraph (c) of 
this section, substituting the words ``functional currency'' for the 
word ``dollar'' and using the exchange rate that was used to translate 
such amount into the QBU's functional currency when claimed as a credit 
or added to PTEP group taxes (as defined in Sec. 1.960-3(d)(1)). If a 
QBU receives a refund of nonfunctional currency tax that is denominated 
in a currency that was the functional currency of the QBU when the 
refunded tax was claimed as a credit or added to PTEP group taxes, the 
QBU's basis in the nonfunctional currency received in the refund is 
determined by using the exchange rate used under Sec. 1.985-5(c) when 
the QBU's functional currency changed. See Sec. 1.905-3(b)(1)(ii)(C) 
(Example 3).
    (3) 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 is the amount 
of the functional currency received. If the QBU receives a refund of 
functional currency tax that was denominated in a nonfunctional currency 
of the QBU when the tax was claimed as a credit or added to PTEP group 
taxes, the QBU will recognize the section 988 gain or loss that would 
have been recognized under Sec. 1.985-5(b) if the refund had been 
received immediately before the QBU's functional currency changed.
    (4) Foreign currency gain or loss. For rules for determining 
subsequent foreign currency gain or loss on the disposition of 
nonfunctional currency, the basis of which is determined under this 
paragraph (e), see section 988(c)(1)(C).
    (f) Applicability dates. This section applies to taxable years 
ending on or after December 16, 2019, and to taxable years of foreign 
corporations which end with or within a taxable year of a United States 
shareholder ending on or after December 16, 2019.

[T.D. 9882, 84 FR 69120, Dec. 17, 2019]



Sec. 1.986(c)-1  Coordination with section 965.

    (a) Amount of foreign currency gain or loss. Foreign currency gain 
or loss with respect to distributions of section 965(a) previously taxed 
earnings and profits (as defined in Sec. 1.965-1(f)(39)) is determined 
based on movements in the exchange rate between December 31, 2017, and 
the time such distributions are made.
    (b) Section 965(a) previously taxed earnings and profits. Any gain 
or loss recognized under section 986(c) with respect to distributions of 
section 965(a) previously taxed earnings and profits is reduced in the 
same proportion as the reduction by a section 965(c) deduction amount 
(as defined in Sec. 1.965-1(f)(42)) of the section 965(a) inclusion 
amount (as defined in Sec. 1.965-1(f)(38)) that gave rise to such 
section 965(a) previously taxed earnings and profits.
    (c) Section 965(b) previously taxed earnings and profits. Section 
986(c) does not apply with respect to distributions of section 965(b) 
previously taxed earnings and profits (as defined in Sec. 1.965-
1(f)(40)).
    (d) Applicability dates. The section applies beginning the last 
taxable year of a foreign corporation that begins before January 1, 
2018, and with respect to a United States person, for the taxable year 
in which or with which such taxable year of the foreign corporation 
ends.

[T.D. 9846, 84 FR 1915, Feb. 5, 2019]



Sec. 1.987-0  Section 987; table of contents.

    This section lists captioned paragraphs contained in Sec. Sec. 
1.987-1 through 1.987-11.

           Sec. 1.987-1 Scope, definitions and special rules.

    (a) In general.
    (b) Scope of section 987 and definitions.
    (1) Taxpayers subject to section 987.
    (2) Definition of section 987 QBU.
    (3) Definition of an eligible QBU.
    (4) Definition of owner.
    (5) Section 987 aggregate partnership.
    (6) [Reserved]
    (7) Examples illustrating paragraph (b) of this section.
    (c) Exchange rates.
    (1) Spot rate.
    (2) Yearly average exchange rate.
    (3) Historic rate.
    (d) Marked item.

[[Page 646]]

    (e) Historic item.
    (f) [Reserved]
    (g) Elections.
    (1) In general.
    (2) Exceptions to the general rules.
    (3) Manner of making elections.
    (4) No change in method of accounting.
    (5) Revocation of an election.

  Sec. 1.987-2 Attribution of items to eligible QBUs; definition of a 
                       transfer and related rules.

    (a) Scope and general principles.
    (b) Attribution of items to an eligible QBU.
    (1) General rules.
    (2) Exceptions for non-portfolio stock, interests in partnerships, 
and certain acquisition indebtedness.
    (3) Adjustments to items reflected on the books and records.
    (4) Assets and liabilities of a section 987 aggregate partnership or 
DE that are not attributed to an eligible QBU.
    (c) Transfers to and from section 987 QBUs.
    (1) In general.
    (2) Disregarded transactions.
    (3) Transfers of assets to and from section 987 QBUs owned through 
section 987 aggregate partnerships.
    (4) Transfers of liabilities to and from section 987 QBUs owned 
through section 987 aggregate partnerships.
    (5) Acquisitions and dispositions of interests in DEs and section 
987 aggregate partnerships.
    (6) Changes in form of ownership.
    (7) Application of general tax law principles.
    (8) Interaction with Sec. 1.988-1(a)(10).
    (9) Certain disregarded transactions not treated as transfers.
    (10) Examples.
    (d) Translation of items transferred to a section 987 QBU.
    (1) Marked items.
    (2) Historic items.
    (e) Effective/applicability date.
    (1) In general.
    (2) Certain disregarded transactions not treated as transfers.

Sec. 1.987-3 Determination of section 987 taxable income or loss of an 
                       owner of a section 987 QBU.

    (a) In general.
    (b) Determination of each item of income, gain, deduction, or loss 
in the section 987 QBU's functional currency.
    (1) In general.
    (2) Translation of items of income, gain, deduction, or loss that 
are denominated in a nonfunctional currency.
    (3) Determination in the case of a section 987 QBU owned through a 
section 987 aggregate partnership.
    (4) [Reserved]
    (c) Translation of items of income, gain, deduction, or loss of a 
section 987 QBU into the owner's functional currency.
    (1) In general.
    (2) Exceptions.
    (3) Adjustments to COGS required under the simplified inventory 
method.
    (d) [Reserved]
    (e) Examples.

Sec. 1.987-4 Determination of net unrecognized section 987 gain or loss 
                          of a section 987 QBU.

    (a) In general.
    (b) Calculation of net unrecognized section 987 gain or loss.
    (c) Net accumulated unrecognized section 987 gain or loss for all 
prior taxable years.
    (1) In general.
    (2) Coordination with Sec. 1.987-12.
    (d) Calculation of unrecognized section 987 gain or loss for a 
taxable year.
    (1) Step 1: Determine the change in the owner functional currency 
net value of the section 987 QBU for the taxable year.
    (2) Step 2: Increase the amount determined in step 1 by the amount 
of assets transferred from the section 987 QBU to the owner.
    (3) Step 3: Decrease the amount determined in steps 1 and 2 by the 
amount of assets transferred from the owner to the section 987 QBU.
    (4) Step 4: Decrease the amount determined in steps 1 through 3 by 
the amount of liabilities transferred from the section 987 QBU to the 
owner.
    (5) Step 5: Increase the amount determined in steps 1 through 4 by 
the amount of liabilities transferred from the owner to the section 987 
QBU.
    (6) Step 6: Decrease or increase the amount determined in steps 1 
through 5 by the section 987 taxable income or loss, respectively, of 
the section 987 QBU for the taxable year.
    (7) Step 7: Increase the amount determined in steps 1 through 6 by 
any expenses that are not deductible in computing the section 987 
taxable income or loss of the section 987 QBU for the taxable year.
    (8) Step 8: Decrease the amount determined in steps 1 through 7 by 
the amount of any tax-exempt income.
    (e) Determination of the owner functional currency net value of a 
section 987 QBU.
    (1) In general.
    (2) Translation of balance sheet items into the owner's functional 
currency.
    (f) Combinations and separations.
    (1) Combinations.
    (2) Separations.
    (3) Examples.
    (g) Examples.
    (h) Effective/applicability date.
    (1) In general.
    (2) Combinations and separations.

         Sec. 1.987-5 Recognition of section 987 gain or loss.

    (a) Recognition of section 987 gain or loss by the owner of a 
section 987 QBU.

[[Page 647]]

    (b) Remittance proportion.
    (c) Remittance.
    (1) Definition.
    (2) Day when a remittance is determined.
    (3) Termination.
    (d) Aggregate of all amounts transferred from the section 987 QBU to 
the owner for the taxable year.
    (e) Aggregate of all amounts transferred from the owner to the 
section 987 QBU for the taxable year.
    (f) Determination of owner's adjusted basis in transferred assets.
    (1) In general.
    (2) Marked asset.
    (3) Historic asset.
    (g) Example.

     Sec. 1.987-6 Character and source of section 987 gain or loss.

    (a) Ordinary income or loss.
    (b) Character and source of section 987 gain or loss.
    (1) In general.
    (2) Method required to characterize and source section 987 gain or 
loss.
    (3) Coordination with section 954.
    (4) [Reserved]
    (c) Examples.

            Sec. 1.987-7 Section 987 aggregate partnerships.

    (a) In general.
    (b) [Reserved]
    (c) Coordination with subchapter K.

             Sec. 1.987-8 Termination of a section 987 QBU.

    (a) Scope.
    (b) In general.
    (1) Trade or business ceases.
    (2) Substantially all assets transferred.
    (3) Owner no longer a CFC.
    (4) Owner ceases to exist.
    (c) Transactions described in section 381(a).
    (1) Liquidations.
    (2) Reorganizations.
    (d) [Reserved]
    (e) Effect of terminations.
    (f) Examples.

                Sec. 1.987-9 Recordkeeping requirements.

    (a) In general.
    (b) Supplemental information.
    (c) Retention of records.
    (d) Information on a dedicated section 987 form.

                    Sec. 1.987-10 Transition rules.

    (a) Scope.
    (b) Fresh start transition method.
    (1) In general.
    (2) Application of Sec. 1.987-4.
    (3) Determination of historic rate.
    (4) Example.
    (c) Transition of section 987 QBUs that applied the method set forth 
in the 2006 proposed section 987 regulations.
    (1) In general.
    (2) Application of Sec. 1.987-4.
    (3) Use of prior historic rate.
    (4) Example.
    (d) Adjustments to avoid double counting.
    (e) Reporting.
    (1) In general.
    (2) Attachments not required where information is reported on a 
form.

              Sec. 1.987-11 Effective/applicability date.

    (a) In general.
    (b) Application of these regulations to taxable years beginning 
after December 7, 2016.
    (c) Transition date.

          Sec. 1.987-12 Deferral of section 987 gain or loss.

    (a) In general.
    (1) Overview.
    (2) Scope.
    (3) Exceptions.
    (b) Gain and loss recognition in connection with a deferral event.
    (1) In general.
    (2) Deferral event.
    (3) Gain or loss recognized under Sec. 1.987-5 in the taxable year 
of a deferral event.
    (4) Successor QBU.
    (c) Recognition of deferred section 987 gain or loss in the taxable 
year of a deferral event and in subsequent taxable years.
    (1) In general.
    (2) Recognition upon a subsequent remittance.
    (3) Recognition of deferred section 987 loss in certain outbound 
successor QBU terminations.
    (4) Special rules regarding successor QBUs.
    (d) Loss recognition upon an outbound loss event.
    (1) In general.
    (2) Outbound loss event.
    (3) Loss recognized upon an outbound loss event.
    (4) Adjustment of basis of stock received in certain nonrecognition 
transactions.
    (5) Recognition of outbound section 987 loss that is not converted 
into stock basis.
    (e) Source and character.
    (1) Deferred section 987 gain or loss and certain outbound section 
987 loss.
    (2) Outbound section 987 loss reflected in stock basis.
    (f) Definitions.
    (1) Controlled group.
    (2) Qualified successor.
    (g) Anti-abuse.
    (h) Examples.
    (i) Coordination with fresh start transition method.
    (1) In general.
    (2) Adjustment to deferred section 987 gain or loss.
    (3) Adjustments in the case of an outbound loss event.
    (j) Applicability date.

[[Page 648]]

    (1) In general.
    (2) Exceptions.

[T.D. 9794, 81 FR 88821, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88867, Dec. 8, 2016; T.D. 9857, 84 FR 20794, May 13, 2019; 84 FR 31194, 
July 1, 2019]



Sec. 1.987-1  Scope, definitions, and special rules.

    (a) In general. These regulations under section 987 (Sec. Sec. 
1.987-1 through 1.987-11) provide rules for determining the taxable 
income or loss of a taxpayer with respect to a section 987 QBU (as 
defined in paragraph (b)(2) of this section). Further, these regulations 
provide rules for determining the timing, amount, character, and source 
of section 987 gain or loss recognized with respect to a section 987 
QBU. This section addresses the scope of these regulations and provides 
certain definitions, special rules, and the procedures for making the 
elections provided for in the regulations. Section 1.987-2 provides 
rules for attributing assets and liabilities and items of income, gain, 
deduction, and loss to an eligible QBU. It also provides rules regarding 
the translation of items transferred to a section 987 QBU. Section 
1.987-3 provides rules for determining and translating the taxable 
income or loss of a taxpayer with respect to a section 987 QBU. Section 
1.987-4 provides rules for determining net unrecognized section 987 gain 
or loss. Section 1.987-5 provides rules regarding the recognition of 
section 987 gain or loss. It also provides rules for determining an 
owner's basis in assets transferred from a section 987 QBU. Section 
1.987-6 provides rules regarding the character and source of section 987 
gain or loss. Section 1.987-7 provides rules with respect to section 987 
aggregate partnerships. Section 1.987-8 provides rules regarding the 
termination of a section 987 QBU. Section 1.987-9 provides rules 
regarding the recordkeeping required under section 987. Section 1.987-10 
provides transition rules. Section 1.987-11 provides the effective/
applicability date of these regulations.
    (b) Scope of section 987 and definitions--(1) Taxpayers subject to 
section 987--(i) In general. Except as provided in paragraphs (b)(1)(ii) 
and (b)(6) of this section, an individual or corporation is subject to 
these regulations under section 987 if such person is an owner (as 
defined in paragraph (b)(4) of this section) of an eligible QBU (as 
defined in paragraph (b)(3) of this section) that is a section 987 QBU 
(as defined in paragraph (b)(2) of this section).
    (ii) Inapplicability to certain entities. Except as otherwise 
provided in paragraph (b)(1)(iii) of this section, these regulations 
under section 987 do not apply to specified entities described in this 
paragraph (b)(1)(ii), other than specified entities that engage in 
transactions primarily with related persons within the meaning of 
section 267(b) or section 707(b) that are not themselves specified 
entities. For this purpose, specified entities means banks, insurance 
companies, leasing companies, finance coordination centers, regulated 
investment companies, or real estate investment trusts. Further, except 
as otherwise provided in paragraph (b)(1)(iii) of this section, these 
regulations do not apply to trusts, estates, S corporations, and 
partnerships other than section 987 aggregate partnerships (as defined 
in paragraph (b)(5) of this section).
    (iii) [Reserved] For further guidance, see Sec. 1.987-
1T(b)(1)(iii).
    (2) Definition of a section 987 QBU--(i) In general. A section 987 
QBU is an eligible QBU (as defined in paragraph (b)(3) of this section) 
that has a functional currency different from its direct owner. A 
section 987 QBU also includes the assets and liabilities of an eligible 
QBU that are considered under paragraph (b)(5)(ii) of this section to be 
a section 987 QBU of a partner in a section 987 aggregate partnership 
(as defined in paragraph (b)(5) of this section). A section 987 QBU will 
continue to be treated as a section 987 QBU of the owner until a sale or 
other termination of the section 987 QBU as described in Sec. 1.987-
8(b). Except as provided in paragraph (b)(2)(ii) of this section, the 
functional currency of an eligible QBU shall be determined under Sec. 
1.985-1.
    (ii) Section 987 QBU grouping election--(A) In general. Except as 
provided in paragraph (b)(2)(ii)(B) of this section, an owner may elect 
to treat, solely for purposes of section 987, all section 987

[[Page 649]]

QBUs with the same functional currency that it directly owns as a single 
section 987 QBU.
    (B) Special grouping rules for section 987 QBUs owned indirectly 
through a section 987 aggregate partnership. An owner may elect to treat 
all section 987 QBUs with the same functional currency owned indirectly 
through a single section 987 aggregate partnership (as defined in 
paragraph (b)(5) of this section) as a single section 987 QBU. An owner 
may not treat section 987 QBUs as a single section 987 QBU if such QBUs 
are owned indirectly through different section 987 aggregate 
partnerships. Additionally, an owner may not treat section 987 QBUs that 
are owned both directly and indirectly through a section 987 aggregate 
partnership as a single section 987 QBU.
    (3) Definition of an eligible QBU--(i) In general. Eligible QBU 
means a qualified business unit, as defined in Sec. 1.989(a)-1, that is 
not subject to the Dollar Approximate Separate Transactions Method rules 
of Sec. 1.985-3.
    (ii) Exclusion of certain entities. A corporation, partnership, 
trust, estate, or entity disregarded as an entity separate from its 
owner for Federal income tax purposes as described in Sec. 301.7701-
2(c)(2) (hereafter referred to as a ``DE'') is not an eligible QBU (even 
though such an entity may have activities that qualify as an eligible 
QBU).
    (4) Definition of owner. For purposes of these regulations under 
section 987, an owner is any person having direct or indirect ownership 
in an eligible QBU. Only an individual or corporation may be an owner of 
an eligible QBU. The term owner for section 987 purposes does not 
include an eligible QBU. For example, a section 987 QBU (QBU1) is not an 
owner of another section 987 QBU (QBU2) even if QBU1 owns the stock of 
QBU2.
    (i) Direct ownership. An individual or a corporation is a direct 
owner of an eligible QBU if the individual or corporation is the owner 
for Federal income tax purposes of the assets and liabilities of the 
eligible QBU.
    (ii) Indirect ownership. An individual or corporation that is a 
partner in a section 987 aggregate partnership (as defined in paragraph 
(b)(5) of this section) and is allocated, under Sec. 1.987-7, all or a 
portion of the assets and liabilities of an eligible QBU of such 
partnership is an indirect owner of the eligible QBU.
    (5) Section 987 aggregate partnership--(i) In general. A partnership 
is a section 987 aggregate partnership if:
    (A) All of the interests in partnership capital and profits are 
owned, directly or indirectly, by persons related to each other within 
the meaning of sections 267(b) or 707(b). For purposes of this paragraph 
(b)(5), ownership of an interest in partnership capital or profits is 
determined in accordance with the rules for constructive ownership 
provided in section 267(c), other than section 267(c)(3); and
    (B) The partnership has one or more eligible QBUs, at least one of 
which would be a section 987 QBU with respect to a partner if the 
partner owned the eligible QBU directly.
    (ii) Section 987 QBU of a partner. The assets and liabilities of an 
eligible QBU owned through a section 987 aggregate partnership and 
allocated to a partner under the principles of Sec. 1.987-7(b) are 
considered to be a section 987 QBU of such partner if the partner has a 
functional currency different from that of the eligible QBU.
    (iii) Certain unrelated partners disregarded. In determining whether 
a partnership is a section 987 aggregate partnership, the interest of an 
unrelated partner shall be disregarded if the acquisition of such 
interest has as a principal purpose the avoidance of this paragraph 
(b)(5).
    (6) [Reserved] For further guidance, see Sec. 1.987-1T(b)(6).
    (7) Examples illustrating paragraph (b) of this section. The 
following examples illustrate the principles of paragraph (b) of this 
section. U.S. Corp is a domestic corporation, has the U.S. dollar as its 
functional currency, and uses the calendar year as its taxable year. 
Except as otherwise provided, (i) Business A and Business B are eligible 
QBUs and have the euro and the Japanese yen, respectively, as their 
functional currencies and (ii) DE1 and DE2 are DEs, have no assets or 
liabilities, and conduct no activities.

    Example 1. (i) Facts. U.S. Corp owns Business A and all of the 
interests in DE1. DE1 maintains a separate set of books and

[[Page 650]]

records that are kept in British pounds. DE1 owns pounds and all of the 
stock of a foreign corporation, FC. DE1 is liable to a lender on a 
pound-denominated obligation that was incurred to acquire the stock of 
FC. The FC stock, the pounds, and the liability incurred to acquire the 
FC stock are recorded on DE1's separate books and records. DE1 has no 
other assets or liabilities and conducts no activities (other than 
holding the FC stock and servicing its liability).
    (ii) Analysis. (A) Pursuant to paragraph (b)(4)(i) of this section, 
U.S. Corp is the direct owner of Business A because it is the owner of 
the assets and liabilities of Business A. Because Business A is an 
eligible QBU with a functional currency that is different from the 
functional currency of its owner, U.S. Corp, Business A is a section 987 
QBU (as defined in paragraph (b)(2) of this section). As a result, U.S. 
Corp and its section 987 QBU, Business A, are subject to section 987.
    (B) Holding the stock of FC and pounds and servicing a liability 
does not constitute a trade or business within the meaning of Sec. 
1.989(a)-1(c). Because the activities of DE1 do not constitute a trade 
or business within the meaning of Sec. 1.989(a)-1(c), such activities 
are not an eligible QBU. In addition, pursuant to paragraph (b)(3)(ii) 
of this section, DE1 itself is not an eligible QBU. As a result, neither 
DE1 nor its activities qualify as a section 987 QBU of U.S. Corp. 
Therefore, neither the activities of DE1 nor DE1 itself is subject to 
section 987. For the foreign currency treatment of payments on DE1's 
pound-denominated liability, see Sec. 1.988-2(b).
    Example 2. (i) Facts. U.S. Corp owns all of the interests in DE1. 
DE1 owns Business A and all of the interests in DE2. The only activities 
of DE1 are Business A activities and holding the interests in DE2. DE2 
owns Business B and Business C. For purposes of this example, Business B 
does not maintain books and records that are separate from its owner, 
DE2. Instead, the activities of Business B are reflected on the books 
and records of DE2, which are maintained in Japanese yen. In addition, 
Business C has the U.S. dollar as its functional currency, maintains 
books and records that are separate from the books and records of DE2, 
and is an eligible QBU.
    (ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this section, 
DE1 and DE2 are not eligible QBUs. Pursuant to paragraph (b)(3)(i) of 
this section, the Business B and Business C activities of DE2, and the 
Business A activities of DE1, are eligible QBUs. Moreover, pursuant to 
paragraph (b)(4) of this section, DE1 is not the owner of the Business 
A, Business B, or Business C eligible QBUs, and DE2 is not the owner of 
the Business B or Business C eligible QBUs. Instead, pursuant to 
paragraph (b)(4)(i) of this section, U.S. Corp is the direct owner of 
the Business A, Business B, and Business C eligible QBUs.
    (B) Because Business A and Business B are eligible QBUs with 
functional currencies that are different than the functional currency of 
U.S. Corp, Business A and Business B are section 987 QBUs (as defined in 
paragraph (b)(2) of this section).
    (C) The Business C eligible QBU has the same functional currency as 
U.S. Corp. Therefore, the Business C eligible QBU is not a section 987 
QBU.
    Example 3. (i) Facts. U.S. Corp owns all of the interests in DE1. 
DE1 owns Business A and Business B. For purposes of this example, assume 
Business B has the euro as its functional currency.
    (ii) Analysis. (A) Pursuant to paragraph (b)(3)(ii) of this section, 
DE1 is not an eligible QBU. Moreover, pursuant to paragraph (b)(4) of 
this section, DE1 is not the owner of the Business A or Business B 
eligible QBUs. Instead, pursuant to paragraph (b)(4)(i) of this section, 
U.S. Corp is the direct owner of the Business A and Business B eligible 
QBUs.
    (B) Business A and Business B constitute two separate eligible QBUs, 
each with the euro as its functional currency. Accordingly, Business A 
and Business B are section 987 QBUs of U.S. Corp. U.S. Corp may elect to 
treat Business A and Business B as a single section 987 QBU pursuant to 
paragraph (b)(2)(ii)(A) of this section. If such election is made, 
pursuant to paragraph (b)(4)(i) of this section, U.S. Corp would be the 
direct owner of the Business AB section 987 QBU that would include the 
activities of both the Business A section 987 QBU and the Business B 
section 987 QBU. In addition, pursuant to paragraph (b)(4) of this 
section, DE1 would not be treated as the owner of the Business AB 
section 987 QBU.
    Example 4. (i) Facts. U.S. Corp owns all the stock of Y, a U.S. 
corporation that is a member of U.S. Corp's consolidated group. U.S. 
Corp also owns all the stock of CFC, a controlled foreign corporation 
(as defined in section 957(a)) of U.S. Corp with the Japanese yen as its 
functional currency. Y and CFC are the only partners in P, a foreign 
partnership. P owns DE1 and Business A. DE1 owns Business B.
    (ii) Analysis. (A) Under paragraph (b)(5)(i) of this section, P is a 
section 987 aggregate partnership because Y and CFC own all the 
interests in partnership capital and profits, Y and CFC are related 
within the meaning of section 267(b), and the requirements of Sec. 
1.987-1(b)(5)(i)(B) are satisfied. Pursuant to paragraph (b)(3)(ii) of 
this section, P and DE1 are not eligible QBUs. Moreover, pursuant to 
paragraph (b)(4) of this section, for purposes of section 987, neither P 
nor DE1 is the owner of the Business B eligible QBU, and P is not the 
owner of the Business A eligible QBU. Instead, pursuant to paragraph 
(b)(4)(ii) of this section, Y and CFC are indirect owners of

[[Page 651]]

the Business A eligible QBU and the Business B eligible QBU to the 
extent they are allocated the assets and liabilities of such businesses 
under Sec. 1.987-7.
    (B) Because Business A and Business B are eligible QBUs with 
different functional currencies than Y, the portions of Business A and 
Business B allocated to Y under Sec. 1.987-7 are section 987 QBUs of Y.
    (C) Because the Business A eligible QBU has a different functional 
currency than CFC, the portion of Business A that is allocated to CFC 
under Sec. 1.987-7 is a section 987 QBU, and CFC and its section 987 
QBU are subject to section 987. Because the Business B eligible QBU has 
the same functional currency as CFC, the portion of Business B that is 
allocated to CFC under Sec. 1.987-7 is not a section 987 QBU of CFC.
    Example 5. (i) Facts. U.S. Corp owns all of the interests in DE1. 
DE1 owns Business A and all of the interests in DE2. DE2 owns Business B 
and all of the interests in DE3, an entity disregarded as an entity 
separate from its owner. DE3 owns Business C, which is an eligible QBU 
with the Russian ruble as its functional currency.
    (ii) Analysis. Pursuant to paragraph (b)(3)(ii) of this section, 
DE1, DE2, and DE3 are not eligible QBUs, and the Business A, Business B, 
and Business C activities are eligible QBUs. Pursuant to paragraph 
(b)(4) of this section, an eligible QBU is not an owner of another 
eligible QBU. Accordingly, the Business A eligible QBU is not the owner 
of the Business B eligible QBU, and the Business B eligible QBU is not 
the owner of the Business C eligible QBU. Instead, pursuant to paragraph 
(b)(4) of this section, U.S. Corp is the direct owner of the Business A, 
Business B, and Business C eligible QBUs. Because each of the Business 
A, Business B, and Business C eligible QBUs has a different functional 
currency than U.S. Corp, such eligible QBUs are section 987 QBUs of U.S. 
Corp.

    (c) Exchange rates. Solely for purposes of section 987, the 
following definitions shall apply.
    (1) Spot rate--(i) In general. Except as otherwise provided in this 
section, the spot rate means the rate determined under the principles of 
Sec. 1.988-1(d)(1), (2), and (4) on the relevant date.
    (ii) Election to use a spot rate convention--(A) In general--spot 
rate convention. An owner may elect to use a spot rate convention that 
reasonably approximates the spot rate determined in paragraph (c)(1)(i) 
of this section in lieu of such spot rate. A spot rate convention may be 
determined with respect to a spot rate at the beginning of a reasonable 
period, the end of a reasonable period, as an average of spot rates for 
a reasonable period, or by reference to spot and forward rates for a 
reasonable period. For this purpose, a reasonable period shall not 
exceed three months. For example, in lieu of the spot rate determined in 
paragraph (c)(1)(i) of this section, the spot rate for all transactions 
during a monthly period can be determined pursuant to one of the 
following conventions: The spot rate at the beginning of the current 
month or at the end of the preceding month; the monthly average of daily 
spot rates for the current or preceding month; or an average of the 
beginning and ending spot rates for the current or preceding month. 
Similarly, in lieu of the spot rate determined in paragraph (c)(1)(i) of 
this section, the spot rate can be determined pursuant to an average of 
the spot rate and the 30-day forward rate on a day of the preceding 
month. Use of a spot rate convention that is consistent with the 
convention used for financial accounting purposes is presumed to 
reasonably approximate the rate in paragraph (c)(1)(i) of this section. 
The Commissioner can rebut this presumption if the Commissioner 
determines that the use of the convention would not clearly reflect 
income based on the facts and circumstances available at the time of the 
election.
    (B) [Reserved] For further guidance, see Sec. 1.987-
1T(c)(1)(ii)(B).
    (iii) Election to use spot rates in lieu of yearly average exchange 
rates. A taxpayer may elect under this paragraph (c)(1)(iii) to use spot 
rates in lieu of yearly average exchange rates (as defined in paragraph 
(c)(2) of this section) for certain purposes. In particular, a taxpayer 
that makes this election must use the spot rate for purposes of 
determining the historic rate, as provided in paragraph (c)(3)(ii) of 
this section, and for purposes of translating items of income, gain, 
deduction, or loss of a section 987 QBU into the owner's functional 
currency, as described in Sec. 1.987-3(c)(1). Additionally, a taxpayer 
that makes this election will be deemed also to elect to use the 
historic inventory method described in Sec. 1.987-3(c)(2)(iv)(B).
    (2) Yearly average exchange rate. For purposes of section 987, the 
yearly average exchange rate is a rate that represents an average 
exchange rate for

[[Page 652]]

the taxable year (or, if the relevant period is less than a full taxable 
year, such portion of the taxable year) computed under any reasonable 
method. For example, an owner may determine the yearly average exchange 
rate based on a daily, monthly or quarterly averaging convention, 
whether weighted or unweighted, and may take into account forward rates 
for a period not to exceed three months. Use of an averaging convention 
that is consistent with the convention used for financial accounting 
purposes is presumed to be a reasonable method. The Commissioner can 
rebut this presumption if the Commissioner determines that the use of 
the convention would not have been expected to clearly reflect income 
based on the facts and circumstances available at the time of the 
election.
    (3) Historic rate--(i) In general. Except as otherwise provided in 
these regulations, the historic rate is determined as described in 
paragraphs (c)(3)(i)(A) through (E) of this section.
    (A) Assets generally. In the case of an asset other than inventory 
that is acquired by a section 987 QBU (including through a transfer), 
the historic rate is the yearly average exchange rate applicable to the 
year of acquisition.
    (B) Inventory under the simplified inventory method. In the case of 
inventory with respect to which a taxpayer uses the simplified inventory 
method described in Sec. 1.987-3(c)(2)(iv)(A), the historic rate for 
inventory accounted for under the last-in, first-out (LIFO) method of 
accounting is the yearly average exchange rate applicable to the year in 
which the inventory's LIFO layer arose. The historic rate for all other 
inventory of such a taxpayer is the yearly average exchange rate for the 
taxable year for which the determination of the historic rate for such 
inventory is relevant.
    (C) Inventory under the historic inventory method. In the case of 
inventory with respect to which a taxpayer has elected under Sec. 
1.987- 3(c)(2)(iv)(B) to use the historic inventory method, each 
inventoriable cost with respect to such inventory may have a different 
historic rate. The historic rate for each inventoriable cost is the 
exchange rate at which such item would be translated under Sec. 1.987-3 
if it were not an inventoriable cost.
    (D) Liabilities generally. In the case of a liability that is 
incurred or assumed by a section 987 QBU, the historic rate is the 
yearly average exchange rate applicable to the year the liability is 
incurred or assumed.
    (E) [Reserved] For further guidance, see Sec. 1.987-1T(c)(3)(i)(E).
    (ii) Historic rate when an election to use spot rates in lieu of 
yearly average exchange rates is in effect. A taxpayer that has elected 
under paragraph (c)(1)(iii) of this section to use spot rates in lieu of 
yearly average exchange rates must determine historic rates under 
paragraphs (c)(3)(i)(A) and (c)(3)(i)(D) of this section using the spot 
rate (as defined in paragraph (c)(1) of this section) for the date an 
asset is acquired by a section 987 QBU or a liability is assumed or 
incurred by a section 987 QBU in lieu of using the yearly average 
exchange rate.
    (iii) Date placed in service for depreciable or amortizable 
property. In the case of depreciable or amortizable property, an owner 
may determine the historic rate (whether a yearly average exchange rate 
or a spot rate, as applicable) by reference to the date such property is 
placed in service by the section 987 QBU rather than the date the 
property was acquired, provided that this convention is consistently 
applied for all such property attributable to that section 987 QBU.
    (iv) Changed functional currency. In the case of a section 987 QBU 
or an owner of a section 987 QBU that previously changed its functional 
currency, Sec. 1.985-5(d)(1)(ii)(A) and Sec. 1.985-5(e)(4)(i)(A), 
respectively, shall be taken into account in determining the historic 
rate for an item reflected on the balance sheet of the section 987 QBU 
immediately prior to the year of change.
    (d) Marked item. A marked item is an asset (marked asset) or 
liability (marked liability) that is properly reflected on the books and 
records of a section 987 QBU under Sec. 1.987-2(b) and that--
    (1) Is denominated in, or determined by reference to, the functional 
currency of the section 987 QBU, is not a section 988 transaction of the 
section

[[Page 653]]

987 QBU, and would be a section 988 transaction if such item were held 
or entered into directly by the owner of the section 987 QBU;
    (2) Is a prepaid expense or a liability for an advance payment of 
unearned income, in either case having an original term of one year or 
less on the date the prepaid expense or liability for an advance payment 
of unearned income arises; or
    (3) [Reserved] For further guidance, see Sec. 1.987-1T(d)(3).
    (e) Historic item. A historic item is an asset (historic asset) or 
liability (historic liability) that is properly reflected on the books 
and records of a section 987 QBU under Sec. 1.987-2(b) and that is not 
a marked item (as defined in paragraph (d) of this section).
    (f) [Reserved] For further guidance, see Sec. 1.987-1T(f).
    (g) Elections--(1) In general. This paragraph (g) provides rules for 
making elections under section 987. Except as otherwise provided in 
paragraph (g)(2) of this section, such elections--
    (i) May be made separately for each section 987 QBU;
    (ii) Are made by the owner of the section 987 QBU (as defined in 
paragraph (b)(4) of this section); and
    (iii) Must be made for the first taxable year in which the election 
is relevant in determining the section 987 taxable income or loss, or 
section 987 gain or loss, of the section 987 QBU and in which the 
regulations implementing the election are applicable with respect to the 
section 987 QBU.
    (2) Exceptions to the general rules--(i) Consistency and timeliness 
requirements for certain elections. Notwithstanding paragraph (g)(1)(i) 
of this section, the following consistency and timeliness requirements 
apply:
    (A) Section 987 grouping election. Elections made pursuant to 
paragraph (b)(2)(ii) of this section (regarding the grouping of section 
987 QBUs) are binding on all section 987 QBUs that are eligible to be 
grouped under the particular election (for example, election to group 
all euro QBUs owned by the same aggregate partnership), regardless of 
whether the section 987 QBU is established or acquired after the 
election is made and regardless of whether the section 987 QBU is 
identified on the election as required in paragraph (g)(3)(i)(A) of this 
section.
    (B) through (C) [Reserved] For further guidance, see Sec. 1.987-
1T(g)(2)(i)(B) through (C).
    (ii) Persons making elections for QBUs owned by foreign 
corporations. Notwithstanding paragraph (g)(1)(ii) of this section, if a 
section 987 QBU is owned by a foreign corporation, elections shall be 
made in accordance with Sec. 1.964-1(c) by the foreign corporation's 
controlling domestic shareholders, as defined under Sec. 1.964-
1(c)(5)(i) (dealing with controlled foreign corporations) and Sec. 
1.964-1(c)(5)(ii) (dealing with noncontrolled section 902 corporations).
    (3) Manner of making elections--(i) Election made by attaching 
statement to a return. Except as provided in paragraph (g)(3)(ii) of 
this section, elections shall be made under section 987 for each section 
987 QBU by attaching a statement with the information required in this 
paragraph (g)(3)(i) to the timely filed tax return of the owner or, in 
the case of a foreign corporation, other applicable person for the first 
taxable year in which the election is required to be made under 
paragraph (g)(1)(iii) of this section.
    (A) Section 987 grouping election. The election provided in 
paragraph (b)(2)(ii) of this section must be titled ``Section 987 
Grouping Election Under Sec. 1.987-1(b)(2)(ii)'' and provide the 
following information:
    (1) The name, address, and functional currency of each section 987 
QBU that the taxpayer is grouping together; and
    (2) The owner's name and address.
    (B) Election to use a spot rate convention. An election under 
paragraph (c)(1)(ii) of this section to use a spot rate convention must 
be titled ``Section 987 Election to Use a Spot Rate Convention Under 
Sec. 1.987-1(c)(1)(ii)'' and provide the following information:
    (1) A description of the convention; and
    (2) The name and address of each section 987 QBU for which the 
election is being made.
    (C) Election to use spot rates in lieu of yearly average exchange 
rates. An election under paragraph (c)(1)(iii) of this section to use 
spot rates in lieu of yearly average exchange rates must be titled 
``Section 987 Election to Use

[[Page 654]]

Spot Rates in Lieu of Yearly Average Exchange Rates Under Sec. 1.987-
1(c)(1)(iii)'' and provide the following information:
    (1) A description of the convention; and
    (2) The name and address of each section 987 QBU for which the 
election is being made.
    (D) Election to use the historic inventory method. An election under 
Sec. 1.987-3(c)(2)(iv)(B) to use the historic inventory method shall be 
titled ``Section 987 Election to Use the Historic Inventory Method Under 
Sec. 1.987-3(c)(2)(iv)(B)'' and must provide the name and address of 
each section 987 QBU for which the election is being made.
    (E) through (H) [Reserved] For further guidance, see Sec. 1.987-
1T(g)(3)(i)(E) through (H).
    (ii) Election made by filing a dedicated section 987 form. If the 
Commissioner publishes a form that provides the manner in which 
elections are made under section 987, the form shall govern the manner 
in which elections are made under section 987.
    (4) No change in method of accounting. An election under section 987 
is not governed by the general rules concerning changes in methods of 
accounting. See also paragraph (g)(5) of this section.
    (5) Revocation of an election. Elections under section 987 may not 
be revoked without the consent of the Commissioner or his delegate. The 
Commissioner or his delegate will consider allowing a revocation of an 
election if the taxpayer can demonstrate significantly changed 
circumstances or such other circumstances that clearly demonstrate a 
substantial non-tax business reason for revoking the election.

[T.D. 9794, 81 FR 88821, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88867, Dec. 8, 2016]



Sec. 1.987-1T  Scope, definitions, and special rules (temporary).

    (a) through (b)(1)(ii) [Reserved] For further guidance, see Sec. 
1.987-1(a) through (b)(1)(ii).
    (iii) Certain provisions applicable to all taxpayers. 
Notwithstanding Sec. 1.987-1(b)(1)(ii), paragraphs (b)(6) and 
(g)(3)(i)(E) of this section and Sec. 1.987-6T(b)(4) apply to any 
taxpayer that is an owner of a dollar QBU (as defined in paragraph 
(b)(6) of this section), and paragraphs (g)(2)(i)(B) and (g)(3)(i)(H) of 
this section and Sec. Sec. 1.987-8T(d) and 1.987-12T apply to any 
taxpayer that is an owner of an eligible QBU (determined without regard 
to Sec. 1.987-1(b)(3)(ii)) that is subject to section 987.
    (b)(2) through (b)(5) [Reserved] For further guidance, see Sec. 
1.987-1(b)(2) through (b)(5).
    (6) Dollar QBUs--(i) In general. Except as provided in paragraphs 
(b)(1)(iii) and (b)(6)(iii) of this section, section 987 and the 
regulations thereunder do not apply with respect to an eligible QBU 
(determined without regard to Sec. 1.987-1(b)(3)(ii)) that has the U.S. 
dollar as its functional currency and that would be subject to section 
987 if it had a functional currency other than the dollar (dollar QBU). 
This paragraph (b)(6) applies to all taxpayers, including entities 
described in Sec. 1.987-1(b)(1)(ii).
    (ii) Application of section 988 to a dollar QBU--(A) In general. 
Except as provided in paragraphs (b)(6)(ii)(B) and (b)(6)(iii) of this 
section, a controlled foreign corporation (as defined in section 957(a)) 
(CFC) that is the owner of a dollar QBU applies section 988 with respect 
to any item that is properly reflected on the books and records of the 
dollar QBU and that would give rise to a section 988 transaction if such 
item were acquired, accrued, or entered into directly by the owner of 
the dollar QBU. Except as provided in paragraph (b)(6)(ii)(B) of this 
section, for purposes of determining the amount of section 988 gain or 
loss of the CFC, any item that is properly reflected on the books and 
records of the dollar QBU and that would give rise to a section 988 
transaction if such item were acquired, accrued, or entered into 
directly by the owner of the dollar QBU is treated as properly reflected 
on the books and records of the owner of the dollar QBU, such that the 
amount of section 988 gain or loss with respect to such item is 
determined by reference to the owner's functional currency.
    (B) Section 988 gain or loss characterized as effectively connected 
income. Solely for the purpose of determining the amount of section 988 
gain or loss of a CFC described in paragraph

[[Page 655]]

(b)(6)(ii)(A) of this section that is effectively connected with the 
conduct of a trade or business within the United States (ECI), any 
section 988 gain or loss that would be determined under section 988 as a 
result of the acquisition or accrual of any item and treated as ECI 
under Sec. 1.988-4(c) if the item were treated as properly reflected on 
the books and records of the dollar QBU is determined by treating such 
item as properly reflected on the books and records of the dollar QBU. 
Consequently, solely for that purpose, such section 988 gain or loss is 
determined by reference to the U.S. dollar.
    (iii) Election for a CFC to apply section 987 to a dollar QBU--(A) 
In general. A CFC that is the owner of a dollar QBU may elect to apply 
section 987 and the regulations thereunder with respect to the dollar 
QBU in lieu of applying section 988 pursuant to paragraph (b)(6)(ii) of 
this section. If the dollar QBU or CFC is described in Sec. 1.987-
1(b)(1)(ii), however, the CFC must apply section 987 to the dollar QBU 
using the method it applied to the dollar QBU immediately prior to the 
effective date of this paragraph (b)(6) as provided in paragraph (h) of 
this section, provided such method was a reasonable interpretation of 
section 987, or, if no such method exists, a reasonable method.
    (B) Section 988 gain or loss characterized as effectively connected 
income. Solely for the purpose of determining the amount of section 988 
gain or loss of a dollar QBU that is the subject of an election 
described in paragraph (b)(6)(iii)(A) of this section that is ECI, Sec. 
1.987-3T(b)(4)(i) and (ii) do not apply, and any section 988 gain or 
loss that would be determined under section 988 as a result of the 
acquisition or accrual of any item and treated as ECI under Sec. 1.988-
4(c) if the item were treated as properly reflected on the books and 
records of the dollar QBU is determined by treating such item as 
properly reflected on the books and records of the dollar QBU. 
Consequently, solely for that purpose, such section 988 gain or loss is 
determined by reference to the U.S. dollar. See Sec. 1.987-6T(b)(4) for 
rules regarding the source of section 987 gain or loss with respect to a 
dollar QBU for which the CFC owner has made the election described in 
this paragraph.
    (b)(7) through (c)(1)(ii)(A) [Reserved] For further guidance, see 
Sec. 1.987-1(b)(7) through (c)(1)(ii)(A).
    (B) Election inapplicable with respect to certain amounts. Except as 
provided in this paragraph (c)(1)(ii)(B), the election provided in Sec. 
1.987-1(c)(1)(ii)(A) does not apply for purposes of determining section 
987 taxable income or loss (as defined in Sec. 1.987-3(a)) with respect 
to a historic item (as defined in Sec. 1.987-1(e)) if acquiring, 
accruing, or entering into such item gives rise to a section 988 
transaction or specified owner functional currency transaction. However, 
the election provided in Sec. 1.987-1(c)(1)(ii)(A) does apply for 
purposes of determining section 987 taxable income or loss with respect 
to a payable or receivable described in Sec. 1.988-1(d)(3) under the 
circumstances described in Sec. 1.988-1(d)(3).
    (c)(2) through (c)(3)(i)(D) [Reserved] For further guidance, see 
Sec. 1.987-1(c)(2) through (c)(3)(i)(D).
    (E) Section 988 transactions and specified owner functional currency 
transactions. If acquiring, accruing, or entering into a historic item 
gives rise to a section 988 transaction of a section 987 QBU or a 
specified owner functional currency transaction described in Sec. 
1.987-3T(b)(4)(ii), the historic rate is the spot rate (as defined in 
paragraph (c)(1) of this section) on the date such item is acquired, 
accrued, or entered into. For this purpose, use of a spot rate 
convention under Sec. 1.987-1(c)(1)(ii) is permitted only with respect 
to a payable or receivable described in Sec. 1.988-1(d)(3) and only to 
the extent provided therein.
    (c)(3)(ii) through (d)(2) [Reserved] For further guidance, see Sec. 
1.987-1(c)(3)(ii) through (d)(2).
    (3) Gives rise to a qualified short-term section 988 transaction (as 
defined in Sec. 1.987-3T(b)(4)(iii)(B)) of the section 987 QBU, whether 
denominated in the functional currency of the owner or other 
nonfunctional currency with respect to the section 987 QBU, for which 
section 988 gain or loss is determined under Sec. 1.987-
3T(b)(4)(iii)(A) in, and by reference to, the functional currency of the 
section 987 QBU.
    (e) [Reserved] For further guidance, see Sec. 1.987-1(e).

[[Page 656]]

    (f) Examples. The following examples illustrate the application of 
Sec. 1.987-1(d) and (e).

    Example 1. U.S. Corp is a domestic corporation with the U.S. dollar 
as its functional currency and is the owner of Business A, a section 987 
QBU that has the pound as its functional currency. Assume all 
transactions of Business A are entered into in the ordinary course of 
its business. U.S. Corp has not made an election under Sec. 1.987-
3T(b)(4)(iii)(C) to adopt a foreign currency mark-to-market method of 
accounting for qualified short-term section 988 transactions. Items 
reflected on Business A's balance sheet include [pound]10,000, $1,000, a 
building with a basis of [pound]100,000, a light general purpose truck 
with a basis of [pound]30,000, a computer with a basis of [pound]1,000, 
a 60-day receivable for [yen]15,000, an account payable of [pound]5,000, 
and a foreign currency contract within the meaning of section 1256(g)(2) 
that requires Business A to exchange [pound]100 for $125 in 90 days. 
Under paragraph (d) of this section, the [pound]10,000, the [pound]5,000 
account payable and the [pound]/$ section 1256 foreign currency contract 
are marked items. The other items are historic items under this 
paragraph (e) of this section.
    Example 2. The facts are the same as Example 1 except that U.S. Corp 
has elected under Sec. 1.987-3T(b)(4)(iii)(C) to adopt the foreign 
currency mark-to-market method of accounting for qualified short-term 
section 988 transactions of Business A. Under paragraphs (d) and (e) of 
this section, the [pound]10,000, the $1,000, the [yen]15,000 receivable, 
the [pound]5,000 account payable, and the [pound]/$ section 1256 foreign 
currency contract are marked items.

    (g)(1) through (g)(2)(i)(A) [Reserved] For further guidance, see 
Sec. 1.987-1(g)(1) through (g)(2)(i)(A).
    (B) Annual deemed termination election--(1) In general. Except as 
provided in paragraph (g)(2)(i)(B)(2) of this section, an election under 
Sec. 1.987-8T(d) (annual deemed termination election) applies to all 
section 987 QBUs owned by the taxpayer, as well as to all section 987 
QBUs owned by any person that has a relationship to the taxpayer 
described in section 267(b) or section 707(b) (substituting ``and the 
profits interest'' for ``or the profits interest'' in section 
707(b)(1)(A) and substituting ``and profits interests'' for ``or profits 
interests'' in section 707(b)(1)(B)) on the last day of the first 
taxable year for which the election applies (a related person). If a 
taxpayer makes the election under Sec. 1.987-8T(d), the first taxable 
year of a related person for which the election applies is the first 
taxable year that ends with or within a taxable year of the taxpayer for 
which the taxpayer's election applies. An election under Sec. 1.987-
8T(d) may not be revoked.
    (i) Fresh start taxpayers. A taxpayer to which Sec. 1.987-10 
applies that is required under Sec. 1.987-10(a) to apply the fresh 
start transition method described in Sec. 1.987-10(b) (fresh start 
taxpayer) may make the election under Sec. 1.987-8T(d) only if the 
first taxable year for which the election would apply to the taxpayer is 
either the first taxable year beginning on or after the transition date 
(as defined in Sec. 1.987-11(c)) in which the election is relevant or a 
subsequent taxable year in which the taxpayer's controlled group 
aggregate section 987 loss, if any, does not exceed $5 million. For 
purposes of this paragraph (g)(2)(i)(B), a taxpayer's controlled group 
aggregate section 987 loss means the aggregate net amount of section 987 
loss that would be recognized pursuant to the election by the taxpayer 
and all other persons to whom the taxpayer's election would apply in the 
first taxable year of each person for which the election would apply.
    (ii) Other taxpayers. Other taxpayers, including taxpayers described 
in Sec. 1.987-1(b)(1)(ii) and taxpayers described in Sec. 1.987-10(c), 
must follow the election rules provided in paragraph (g)(2)(i)(B)(1)(i) 
of this section if any related party is a fresh start taxpayer. If no 
related party is a fresh start taxpayer, the election under Sec. 1.987-
8T(d) may be made only if the first taxable year for which the election 
would apply to the taxpayer is either the first taxable year beginning 
on or after December 7, 2016, in which the election is relevant or a 
subsequent taxable year in which the taxpayer's controlled group 
aggregate section 987 loss, if any, does not exceed $5 million.
    (2) QBU-by-QBU elections in certain circumstances. Notwithstanding 
paragraph (g)(2)(i)(B)(1) of this section, a taxpayer may make a 
separate election under Sec. 1.987-8T(d) with respect to any section 
987 QBU owned by the taxpayer if the first taxable year for which the 
election would apply to the taxpayer with respect to the section 987 QBU 
is a taxable year in which there is a section 987 gain recognized with 
respect to

[[Page 657]]

the section 987 QBU pursuant to the election, or is a taxable year in 
which there is a section 987 loss of $1 million or less that would be 
recognized with respect to the section 987 QBU pursuant to the election
    (C) Election to translate all items at the yearly average exchange 
rate. An election under Sec. 1.987-3T(d) (election to translate all 
items at the yearly average exchange rate) may be made with respect to a 
section 987 QBU only if the first taxable year for which the election 
would apply is the first taxable year for which an election under Sec. 
1.987-8T(d) (annual deemed termination election) applies with respect to 
the section 987 QBU.
    (g)(2)(ii) through (g)(3)(i)(D) [Reserved] For further guidance, see 
Sec. 1.987-1(g)(2)(ii) through (g)(3)(i)(D).
    (E) Election for a CFC to apply section 987 to a dollar QBU. An 
election under Sec. 1.987-1T(b)(6)(iii) for a CFC to apply section 987 
to a dollar QBU must be titled ``Section 987 Election for a CFC to Apply 
Section 987 to a Dollar QBU Under Sec. 1.987-1T(b)(6)(iii)'' and must 
provide the name and address of each QBU for which the election is being 
made.
    (F) Election to apply the foreign currency mark-to-market method of 
accounting for qualified short-term section 988 transactions. An 
election under Sec. 1.987-3T(b)(4)(iii)(C) to apply the foreign 
currency mark-to-market method of accounting for qualified short-term 
section 988 transactions must be titled ``Section 987 Election to Use 
Foreign Currency Mark-to-Market Method of Accounting for Qualified 
Short-Term Section 988 Transactions Under Sec. 1.987-3(b)T(4)(iii)(C)'' 
and must provide the name and address of each section 987 QBU for which 
the election is being made.
    (G) Election to translate all items at the yearly average exchange 
rate. An election under Sec. 1.987-3T(d) to translate all items at the 
yearly average exchange rate must be titled ``Section 987 Election to 
Translate All Items at the Yearly Average Exchange Rate Under Sec. 
1.987-3T(d)'' and must provide the name and address of each section 987 
QBU for which the election is being made.
    (H) Annual deemed termination election. An election under Sec. 
1.987-8T(d) for an owner to deem all of its section 987 QBUs to 
terminate on the last day of each taxable year must be titled ``Section 
987 Annual Deemed Termination Election Under Sec. 1.987-8T(d)'' and 
must provide the name and address of each section 987 QBU to which the 
election applies, including a section 987 QBU owned by a related person 
(within the meaning of paragraph (g)(2)(i)(B)(1) of this section).
    (g)(4) through (6) [Reserved] For further guidance, see Sec. 1.987-
1(g)(4) through (6).
    (h) Effective/applicability date. Paragraphs (g)(2)(i)(B) and 
(g)(3)(i)(H) of this section apply to the first taxable year beginning 
on or after December 7, 2016. Paragraphs (b)(1)(iii), (b)(6), 
(c)(1)(ii)(B), (c)(3)(i)(E), (d)(3), (f), (g)(2)(i)(C), and (g)(3)(i)(E) 
through (G) of this section apply to taxable years beginning one year 
after the first day of the first taxable year following December 7, 
2016. Notwithstanding the preceding sentence, if a taxpayer makes an 
election under Sec. 1.987-11(b), then paragraphs (b)(1)(iii), (b)(6), 
(c)(1)(ii)(B), (c)(3)(i)(E), (d)(3), (f), (g)(2)(i)(C), and (g)(3)(i)(E) 
through (G) of this section apply to taxable years to which Sec. Sec. 
1.987-1 through 1.987-10 apply as a result of such election.
    (i) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9795, 81 FR 88868, Dec. 8, 2016]



Sec. 1.987-2  Attribution of items to eligible QBUs; definition
of a transfer and related rules.

    (a) Scope and general principles. Paragraph (b) of this section 
provides rules for attributing assets and liabilities, and items of 
income, gain, deduction, and loss, to an eligible QBU. Assets and 
liabilities are attributed to a section 987 QBU for purposes of section 
987. Items of income, gain, deduction, and loss are attributed to a 
section 987 QBU for purposes of computing the section 987 taxable income 
of the section 987 QBU and of its owner. Paragraph (c) of this section 
defines a transfer to or from a section 987 QBU. Paragraph (d) of this 
section provides translation rules for transfers to a section 987 QBU.

[[Page 658]]

    (b) Attribution of items to an eligible QBU--(1) General rules. 
Except as provided in paragraphs (b)(2) and (3) of this section, items 
are attributable to an eligible QBU to the extent they are reflected on 
the separate set of books and records, as defined in Sec. 1.989(a)-
1(d), of the eligible QBU. In the case of a section 987 aggregate 
partnership, items reflected on the books and records of the partnership 
and deemed allocated to an eligible QBU of such partnership are 
considered to be reflected on the books and records of such eligible 
QBU. For purposes of this section, the term ``item'' refers to any asset 
or liability, and any item of income, gain, deduction, or loss. Items 
that are attributed to an eligible QBU pursuant to this section must be 
adjusted to conform to Federal income tax principles. Except as provided 
in Sec. 1.989(a)-1(d)(3), these attribution rules apply solely for 
purposes of section 987. For example, the allocation and apportionment 
of interest expense under section 864(e) is independent of the rules 
under section 987.
    (2) Exceptions for non-portfolio stock, interests in partnerships, 
and certain acquisition indebtedness. The following items shall not be 
considered to be on the books and records of an eligible QBU:
    (i) Stock of a corporation (whether domestic or foreign), other than 
stock of a corporation reflected on the books and records (within the 
meaning of paragraph (b)(1) of this section) of an eligible QBU if the 
owner of the eligible QBU owns less than 10 percent of the total value 
of all classes of stock of such corporation. For this purpose, section 
318(a) applies in determining ownership, except that in applying section 
318(a)(2)(C), the phrase ``10 percent'' is used instead of the phrase 
``50 percent.''
    (ii) An interest in a partnership (whether domestic or foreign).
    (iii) A liability that was incurred to acquire stock described in 
paragraph (b)(2)(i) of this section or that was incurred to acquire a 
partnership interest described in paragraph (b)(2)(ii) of this section.
    (iv) Income, gain, deduction, or loss arising from the items 
described in paragraphs (b)(2)(i) through (iii) of this section. For 
example, a section 951 inclusion with respect to stock of a foreign 
corporation described in paragraph (b)(2)(i) of this section shall not 
be considered to be on the books and records of an eligible QBU.
    (3) Adjustments to items reflected on the books and records--(i) 
General rule. If a principal purpose of recording (or failing to record) 
an item on the books and records of an eligible QBU is the avoidance of 
Federal income tax under, or through the use of, section 987, the item 
must be allocated between or among the eligible QBU, the owner of such 
eligible QBU, and any other persons, entities (including DEs), or other 
QBUs within the meaning of Sec. 1.989(a)-1(b) (including eligible QBUs) 
in a manner that reflects the substance of the transaction. For purposes 
of this paragraph (b)(3)(i), relevant factors for determining whether 
such Federal income tax avoidance is a principal purpose of recording 
(or failing to record) an item on the books and records of an eligible 
QBU shall include, but are not limited to, the factors set forth in 
paragraphs (b)(3)(ii) and (iii) of this section. The presence or absence 
of any factor or factors is not determinative. Moreover, the weight 
given to any factor (whether or not set forth in paragraphs (b)(3)(ii) 
and (iii) of this section) depends on the particular case.
    (ii) Factors indicating no tax avoidance. For purposes of paragraph 
(b)(3)(i) of this section, factors that may indicate that recording (or 
failing to record) an item on the books and records of an eligible QBU 
did not have as a principal purpose the avoidance of Federal income tax 
under, or through the use of, section 987 include the recording (or not 
recording) of an item:
    (A) For a significant and bona fide business purpose;
    (B) In a manner that is consistent with the economics of the 
underlying transaction;
    (C) In accordance with generally accepted accounting principles (or 
similar comprehensive accounting standard);
    (D) In a manner that is consistent with the treatment of similar 
items from year to year;
    (E) In accordance with accepted conditions or practices in the 
particular trade or business of the eligible QBU;

[[Page 659]]

    (F) In a manner that is consistent with an explanation of existing 
internal accounting policies that is evidenced by documentation 
contemporaneous with the timely filing of a Federal income tax return 
for the taxable year; and
    (G) As a result of a transaction between legal entities (for 
example, the transfer of an asset or the assumption of a liability), 
even if such transaction is not regarded for Federal income tax purposes 
(for example, a transaction between a DE and its owner).
    (iii) Factors indicating tax avoidance. For purposes of paragraph 
(b)(3)(i) of this section, factors that may indicate that a principal 
purpose of recording (or failing to record) an item on the books and 
records of an eligible QBU is the avoidance of Federal income tax under, 
or through the use of, section 987 include:
    (A) The presence or absence of an item on the books and records that 
is the result of one or more transactions that are transitory, for 
example, due to a circular flow of cash or other property;
    (B) The presence or absence of an item on the books and records that 
is the result of one or more transactions that do not have substance;
    (C) The presence or absence of an item on the books and records that 
results in the taxpayer (or a person related to the taxpayer within the 
meaning of section 267(b) or section 707(b)) having offsetting positions 
with respect to the functional currency of a section 987 QBU; and
    (D) The absence of any or all of the factors listed in paragraph 
(b)(3)(ii) of this section.
    (4) Assets and liabilities of a section 987 aggregate partnership or 
DE that are not attributed to an eligible QBU. Neither a section 987 
aggregate partnership nor a DE is an eligible QBU and, thus, neither 
entity can be a section 987 QBU. See Sec. 1.987-1(b)(2) and (3). As a 
result, a section 987 aggregate partnership or DE may own assets and 
liabilities that are not attributed to an eligible QBU as provided under 
this paragraph (b) and, therefore, are not subject to section 987. For 
the foreign currency treatment of such assets or liabilities, see Sec. 
1.988-1(a)(4).
    (c) Transfers to and from section 987 QBUs--(1) In general. The 
following rules apply for purposes of determining whether there is a 
transfer of an asset or a liability from an owner to a section 987 QBU, 
or from a section 987 QBU to an owner. These rules apply solely for 
purposes of section 987.
    (2) Disregarded transactions--(i) General rule. An asset or 
liability shall be treated as transferred to a section 987 QBU from its 
owner (whether direct owner or indirect owner, as defined in Sec. 
1.987-1(b)(4)) if, as a result of a disregarded transaction (as defined 
in paragraph (c)(2)(ii) of this section), such asset or liability is 
reflected on the books and records of the section 987 QBU within the 
meaning of paragraph (b) of this section. Similarly, an asset or 
liability shall be treated as transferred from a section 987 QBU to its 
owner if, as a result of a disregarded transaction, such asset or 
liability is no longer reflected on the books and records of the section 
987 QBU within the meaning of paragraph (b) of this section.
    (ii) Definition of a disregarded transaction. For purposes of this 
section, a disregarded transaction means a transaction that is not 
regarded for Federal income tax purposes (for example, any transaction 
between separate section 987 QBUs of the same owner). For purposes of 
this paragraph (c), a disregarded transaction shall be treated as 
including the recording of an asset or liability on the books and 
records of an eligible QBU (as defined in Sec. 1.987-1(b)(3)) of an 
owner, if the recording is the result of such asset or liability being 
removed from the books and records of a separate eligible QBU of the 
same owner, whether such separate eligible QBU is owned directly or is 
owned indirectly through the same entity (including through a DE or a 
section 987 aggregate partnership). Additionally, if an asset or 
liability that is attributable to a section 987 QBU within the meaning 
of paragraph (b) of this section is sold or exchanged (including in a 
nonrecognition transaction, such as an exchange under section 351) for 
an asset or liability that is not attributable to the section 987 QBU 
immediately after the sale or exchange, the sold or exchanged asset or 
liability

[[Page 660]]

that was attributable to the section 987 QBU immediately before the 
transaction shall be treated as transferred from the section 987 QBU to 
its direct or indirect owner in a disregarded transaction immediately 
before the sale or exchange for purposes of section 987 (including for 
purposes of recognizing section 987 gain or loss under Sec. 1.987-5) 
and subsequently sold or exchanged by the owner. The preceding sentence 
shall not apply with respect to an acquisition or disposition of an 
interest in a section 987 aggregate partnership or in a DE, as described 
in paragraph (c)(5) of this section.
    (iii) Items derived from disregarded transactions ignored. For 
purposes of section 987, disregarded transactions shall not give rise to 
items of income, gain, deduction, or loss that are taken into account in 
determining section 987 taxable income or loss under Sec. 1.987-3.
    (3) Transfers of assets to and from section 987 QBUs owned through 
section 987 aggregate partnerships--(i) Contributions to section 987 
aggregate partnerships. Solely for purposes of section 987, an asset 
shall be treated as transferred by an indirect owner (as defined in 
Sec. 1.987-1(b)(4)(ii)) to a section 987 QBU of a partner (as defined 
in Sec. 1.987-1(b)(5)(ii)) to the extent the indirect owner contributes 
the asset to the section 987 aggregate partnership that carries on the 
activities of the section 987 QBU, provided that, immediately prior to 
the contribution, the asset is not reflected on the books and records of 
the section 987 QBU within the meaning of paragraph (b) of this section 
and the asset is reflected on the books and records of the section 987 
QBU immediately following such contribution. For purposes of this 
paragraph (c)(3)(i), deemed contributions of money described under 
section 752 shall be disregarded. See paragraph (c)(4)(ii) of this 
section for rules governing the assumption by a partner of liabilities 
of a section 987 aggregate partnership.
    (ii) Distributions from section 987 aggregate partnerships. Solely 
for purposes of section 987, an asset shall be treated as transferred 
from a section 987 QBU of a partner to its indirect owner to the extent 
the section 987 aggregate partnership that carries on the activities of 
the section 987 QBU distributes the asset to the indirect owner, 
provided that, immediately prior to such distribution, the asset is 
reflected on the books and records of the section 987 QBU within the 
meaning of paragraph (b) of this section, and the asset is not reflected 
on the books and records of the section 987 QBU immediately after such 
distribution. For purposes of this paragraph (c)(3)(ii), deemed 
distributions of money described under section 752 shall be disregarded. 
See paragraph (c)(4)(i) of this section for rules governing the 
assumption by a section 987 aggregate partnership of liabilities of a 
partner.
    (4) Transfers of liabilities to and from section 987 QBUs owned 
through section 987 aggregate partnerships--(i) Assumptions of partner 
liabilities. Solely for purposes of section 987, a liability of the 
owner of a section 987 aggregate partnership shall be treated as 
transferred to a section 987 QBU of a partner if, and to the extent, the 
section 987 aggregate partnership assumes such liability, provided that, 
immediately prior to the transfer, the liability is not reflected on the 
books and records of the section 987 QBU within the meaning of paragraph 
(b) of this section, and the liability is reflected on the books and 
records of the section 987 QBU immediately following the transfer.
    (ii) Assumptions of section 987 aggregate partnership liabilities. 
Solely for purposes of section 987, a liability of a section 987 
aggregate partnership shall be treated as transferred from a section 987 
QBU of a partner to its indirect owner if, and to the extent, the 
indirect owner assumes such liability of the section 987 aggregate 
partnership, provided that, immediately prior to such assumption, the 
liability is reflected on the books and records of the section 987 QBU 
within the meaning of paragraph (b) of this section, and the liability 
is not reflected on the books and records of the section 987 QBU 
immediately following the transfer.
    (5) Acquisitions and dispositions of interests in DEs and section 
987 aggregate partnerships. Solely for purposes of section 987, an asset 
or liability shall be treated as transferred to a section 987 QBU from 
its owner if, as a result of an acquisition (including by contribution)

[[Page 661]]

or disposition of an interest in a section 987 aggregate partnership or 
DE, such asset or liability is reflected on the books and records of the 
section 987 QBU. Similarly, an asset or liability shall be treated as 
transferred from a section 987 QBU to its owner if, as a result of an 
acquisition or disposition of an interest in a section 987 aggregate 
partnership or DE, the asset or liability is not reflected on the books 
and records of the section 987 QBU.
    (6) Changes in form of ownership. For purposes of this paragraph 
(c), mere changes in the form of ownership of an eligible QBU shall not 
result in a transfer to or from a section 987 QBU. Instead, the 
determination of whether a transfer has occurred in such case shall be 
made under paragraph (c)(5) of this section. For example, a transaction 
that causes a direct owner of an eligible QBU to become an indirect 
owner of the eligible QBU shall not, except to the extent provided in 
paragraph (c)(5) of this section, result in a transfer to or from a 
section 987 QBU. See, for example, Rev. Rul. 99-5 (1999-1 CB 434), Rev. 
Rul. 99-6 (1999-1 CB 432), Sec. 601.601(d)(2) of this chapter, and 
section 708 and the applicable regulations.
    (7) Application of general tax law principles. General tax law 
principles, including the circular cash flow, step-transaction, economic 
substance, and substance-over-form doctrines, apply for purposes of 
determining whether there is a transfer of an asset or liability under 
this paragraph (c), including a transfer of an asset or liability 
pursuant to a disregarded transaction (as defined in paragraph 
(c)(2)(ii) of this section).
    (8) Interaction with Sec. 1.988-1(a)(10). See Sec. 1.988-1(a)(10) 
for rules regarding the treatment of an intra-taxpayer transfer of a 
section 988 transaction.
    (9) Certain disregarded transactions not treated as transfers--(i) 
Combinations of section 987 QBUs. The combination of two or more 
separate section 987 QBUs (combining QBUs) that are directly owned by 
the same owner, or that are indirectly owned by the same partner through 
a single section 987 aggregate partnership, into one section 987 QBU 
(combined QBU) does not give rise to a transfer of any combining QBU's 
assets or liabilities to the owner under Sec. 1.987-2(c). In addition, 
transactions between the combining QBUs occurring in the taxable year of 
the combination do not result in a transfer of the combining QBUs' 
assets or liabilities to the owner under Sec. 1.987-2(c). For this 
purpose, a combination occurs when the assets and liabilities that are 
properly reflected on the books and records of two or more combining 
QBUs begin to be properly reflected on the books and records of a 
combined QBU and the separate existence of the combining QBUs ceases. A 
combination may result from any transaction or series of transactions in 
which the combining QBUs become a combined QBU. For rules regarding the 
determination of net unrecognized section 987 gain or loss of a combined 
QBU, see Sec. 1.987-4(f)(1).
    (ii) Change in functional currency from a combination. If, following 
a combination of section 987 QBUs described in paragraph (c)(9)(i) of 
this section, the combined section 987 QBU has a different functional 
currency than one or more of the combining section 987 QBUs, any such 
combining section 987 QBU is treated as changing its functional currency 
and the owner of the combined section 987 QBU must comply with the 
regulations under section 985 regarding the change in functional 
currency. See Sec. Sec. 1.985-1(c)(6) and 1.985-5.
    (iii) Separation of section 987 QBUs. The separation of a section 
987 QBU (separating QBU) into two or more section 987 QBUs (separated 
QBUs) that, after the separation, are directly owned by the same owner, 
or that are indirectly owned by the same partner through a single 
section 987 aggregate partnership, does not result in a transfer of the 
separating QBU's assets or liabilities to the owner under Sec. 1.987-
2(c). Additionally, transactions that occurred between the separating 
QBUs in the taxable year of the separation prior to the completion of 
the separation do not result in transfers for purposes of section 987. 
For this purpose, a separation occurs when the assets and liabilities 
that are properly reflected on the books and records of a separating QBU 
begin to be properly reflected on the books and records of two or more 
separated QBUs. A separation may result

[[Page 662]]

from any transaction or series of transactions in which a separating QBU 
becomes two or more separated QBUs. A separation may also result when a 
section 987 QBU that is subject to a grouping election under Sec. 
1.987-1(b)(2)(ii) changes its functional currency. For rules regarding 
the determination of net unrecognized section 987 gain or loss of a 
separated QBU, see Sec. 1.987-4(f)(2).
    (10) Examples. The following examples illustrate the principles of 
this paragraph (c). For purposes of the examples, X and Y are domestic 
corporations, have the U.S. dollar as their functional currency, and use 
the calendar year as their taxable years. Furthermore, except as 
otherwise provided, Business A and Business B are eligible QBUs that 
have the euro and the Japanese yen, respectively, as their functional 
currencies, and DE1 and DE2 are DEs. For purposes of determining whether 
any of the transfers in these examples result in remittances, see Sec. 
1.987-5.

    Example 1. Transfer to a directly owned section 987 QBU. (i) Facts. 
X owns all of the interests in DE1. DE1 owns Business A, which is a 
section 987 QBU of X. X owns [euro]100 that are not reflected on the 
books and records of Business A. Business A is in need of additional 
capital and, as a result, X lends the [euro]100 to DE1 for use in 
Business A in exchange for a note.
    (ii) Analysis. (A) The loan from X to DE1 is not regarded for 
Federal income tax purposes (because it is an interbranch transaction) 
and therefore is a disregarded transaction (as defined in paragraph 
(c)(2)(ii) of this section). As a result, the DE1 note held by X and the 
liability of DE1 under the note are not taken into account under this 
section.
    (B) As a result of the disregarded transaction, the [euro]100 is 
reflected on the books and records of Business A. Therefore, X is 
treated as transferring [euro]100 to its Business A section 987 QBU for 
purposes of section 987. This transfer is taken into account in 
determining the amount of any remittance for the taxable year under 
Sec. 1.987-5(c). See Sec. 1.988-1(a)(10)(ii) for the application of 
section 988 to X as a result of the transfer of non-functional currency 
to its section 987 QBU.
    Example 2. Transfer to a directly owned section 987 QBU. (i) Facts. 
X owns Business A and Business B, both of which are section 987 QBUs of 
X. X owns equipment that is used in Business A and is reflected on the 
books and records of Business A. Because Business A has excess 
manufacturing capacity and X intends to expand the manufacturing 
capacity of Business B, the equipment formerly used in Business A is 
transferred to Business B for use by Business B. As a result of the 
transfer, the equipment is removed from the books and records of 
Business A and is recorded on the books and records of Business B.
    (ii) Analysis. The transfer of the equipment from the books and 
records of Business A to the books and records of Business B is not 
regarded for Federal income tax purposes (because it is an interbranch 
transaction), and therefore it is a disregarded transaction for purposes 
of this paragraph (c). Therefore, for purposes of section 987, the 
Business A section 987 QBU is treated as transferring the equipment to 
X, and X is subsequently treated as transferring the equipment to the 
Business B section 987 QBU. These transfers are taken into account in 
determining the amount of any remittance for the taxable year under 
Sec. 1.987-5(c).
    Example 3. Intracompany sale of property between two section 987 
QBUs. (i) Facts. X owns all of the interests in DE1 and DE2. DE1 and DE2 
own Business A and Business B, respectively, both of which are section 
987 QBUs of X. DE1 owns equipment that is used in Business A and is 
reflected on the books and records of Business A. For business reasons, 
DE1 sells a portion of the equipment used in Business A to DE2 in 
exchange for a fair market value amount of Japanese yen. The yen used by 
DE2 to acquire the equipment was generated by Business B and was 
reflected on Business B's books and records. Following the sale, the yen 
and the equipment will be used in Business A and Business B, 
respectively. As a result of such sale, the equipment is removed from 
the books and records of Business A and is recorded on the books and 
records of Business B. Similarly, as a result of the sale, the yen is 
removed from the books and records of Business B and is recorded on the 
books and records of Business A.
    (ii) Analysis. (A) The sale of equipment between DE1 and DE2 is a 
transaction that is not regarded for Federal income tax purposes 
(because it is an interbranch transaction). Therefore the transaction is 
a disregarded transaction for purposes of paragraph (c) of this section. 
As a result, the sale is not taken into account under this section and, 
pursuant to paragraph (c)(2)(iii) of this section, the sale does not 
give rise to an item of income, gain, deduction, or loss for purposes of 
determining section 987 taxable income or loss under Sec. 1.987-3. 
However, the yen and equipment exchanged by DE1 and DE2 in connection 
with the sale must be taken into account as a disregarded transaction 
under this paragraph (c).
    (B) As a result of the disregarded transaction, the equipment ceases 
to be reflected on the books and records of Business A and becomes 
reflected on the books and records

[[Page 663]]

of Business B. Therefore, the Business A section 987 QBU is treated as 
transferring the equipment to X, and X is subsequently treated as 
transferring such equipment to the Business B section 987 QBU.
    (C) Additionally, as a result of the disregarded transaction, the 
yen currency ceases to be reflected on the books and records of Business 
B and becomes reflected on the books and records of Business A. 
Therefore, the Business B section 987 QBU is treated as transferring the 
yen to X, and X is subsequently treated as transferring such yen from X 
to the Business A section 987 QBU. The transfers among Business A, 
Business B and X are taken into account in determining the amount of any 
remittance for the taxable year under Sec. 1.987-5(c).
    Example 4. Sale of property by a section 987 QBU to a corporation 
that is a member of the consolidated group. (i) Facts. X owns all of the 
stock of Y and all of the interests in DE1. DE1 owns Business A. X and Y 
file a consolidated return. Business A sells property to Y for 
[euro]100.
    (ii) Analysis. The sale of property by Business A to Y is not 
considered a transfer of property to X (and a corresponding transfer 
from X to Y) under paragraph (c) of this section because the transaction 
is regarded for Federal income tax purposes. Rather, for purposes of 
section 987, the transaction is considered to occur between Business A 
and Y.
    Example 5. Transactions of a section 987 QBU owned through an 
aggregate partnership. (i) Facts. (A) X owns all of the stock of Y and a 
50 percent interest in the capital and profits of P, a partnership. Y 
owns the other 50 percent interest in P. P owns 100 percent of the 
interests in DE1 and DE2. DE1 owns Business A and DE2 owns Business B.
    (B) In connection with Business A, DE1 licenses intangible property 
to both DE2 and X. X enters into the license agreement in a transaction 
other than in its capacity as a partner of P and, therefore, the license 
is considered as occurring between P and one who is not a partner within 
the meaning of section 707(a). X uses the intangible property in its own 
trade or business in the U.S. DE2 uses the intangible property in 
Business B. Pursuant to the license agreement, X and DE2 pay a [euro]30 
and a [euro]50 royalty, respectively, to DE1.
    (ii) Analysis. (A) Under Sec. 1.987-1(b)(5)(i), P is a section 987 
aggregate partnership because X and Y own all the interests in 
partnership capital and profits, X and Y are related within the meaning 
of section 267(b), and the requirements of Sec. 1.987-1(b)(5)(i)(B) are 
satisfied. X and Y each have a 50 percent allocable share of the assets 
and liabilities of Business A and Business B, as determined under Sec. 
1.987-7. Under Sec. 1.987-1(b)(5)(ii), the assets and liabilities of 
Business A allocated to X are a section 987 QBU of X, and the assets and 
liabilities of Business A allocated to Y are a section 987 QBU of Y. 
Likewise, the assets and liabilities of Business B allocated to X are a 
section 987 QBU of X, and the assets and liabilities of Business B 
allocated to Y are a section 987 QBU of Y.
    (B) The license from DE1 to DE2 is not regarded for Federal income 
tax purposes (because it is an interbranch agreement) and, as a result, 
royalty payments under the license are disregarded transactions. Thus, 
pursuant to paragraph (c)(2)(iii) of this section, DE1's receipt of the 
royalty pursuant to the license agreement does not give rise to an item 
of income, gain, deduction, or loss for purposes of determining section 
987 taxable income or loss under Sec. 1.987-3. However, the [euro]50 
that is paid from DE2 to DE1 pursuant to the license agreement must be 
taken into account under paragraph (c) of this section. Accordingly, 
[euro]50 ceases to be reflected on the books and records of Business B 
and becomes reflected on the books and records of Business A. As a 
result, a 50 percent allocable share of the [euro]50 royalty payment 
([euro]25) is treated as transferred from each of the Business B section 
987 QBUs of X and Y, to X and Y, respectively. And subsequently, X and Y 
are treated as transferring their respective receipts of [euro]25 to 
their respective Business A section 987 QBUs. These transfers are taken 
into account in determining the amount of any remittance to either of X 
or Y for the taxable year under Sec. 1.987-5(c).
    (C) The [euro]30 royalty payment from X to DE1 is regarded for 
Federal income tax purposes (because it is a payment from a partnership 
to a separate entity). Accordingly, the royalty payment is not a 
disregarded transaction for purposes of this paragraph (c) and is 
therefore not treated as a transfer of an asset from an owner to a 
section 987 QBU. As a result, the payment is not taken into account in 
determining the amount of any remittance for the taxable year under 
Sec. 1.987-5(c). Instead, the payment gives rise to an item of income 
and deduction that must be taken into account in computing section 987 
taxable income or loss of Business A pursuant to Sec. 1.987-3.
    Example 6. Acquisition of an interest in a partnership. (i) Facts. 
(A) X owns all of the stock of Z, a domestic corporation with the dollar 
as its functional currency. X also owns all of the stock of Y and a 50 
percent interest in the capital and profits of P, a partnership. Y owns 
the other 50 percent interest in P. P owns Business A, and P owns no 
other assets or liabilities other than those of Business A.
    (B) Z contributes cash to P in exchange for a 20 percent interest in 
the capital and profits of P. The cash Z contributes to P is used in 
Business A and is reflected on Business A's books and records.
    (ii) Analysis. (A) Under Sec. 1.987-1(b)(5)(i), P is a section 987 
aggregate partnership because

[[Page 664]]

X and Y own all the interests in partnership capital and profits, X and 
Y are related within the meaning of section 267(b), and the requirements 
of Sec. 1.987-1(b)(5)(i)(B) are satisfied. Prior to the contribution to 
P by Z, X and Y each have a 50 percent allocable share of the assets and 
liabilities of Business A, as determined under Sec. 1.987-7. Under 
Sec. 1.987-1(b)(5)(ii), the assets and liabilities of Business A 
allocated to X are a section 987 QBU of X, and the assets and 
liabilities of Business A allocated to Y are a section 987 QBU of Y.
    (B) Following Z's acquisition of a 20 percent interest in P, P 
remains a section 987 aggregate partnership because X, Y and Z own all 
the interests in partnership capital and profits; X, Y, and Z are 
related within the meaning of section 267(b); and the requirements of 
Sec. 1.987-1(b)(5)(i)(B) are satisfied. Z acquires a 20 percent 
allocable share of the assets and liabilities of Business A, as 
determined under Sec. 1.987-7. Under Sec. 1.987-1(b)(5)(ii), the 
assets and liabilities of Business A allocated to Z are a section 987 
QBU of Z (because Z becomes an indirect owner of Business A and Z and 
Business A have different functional currencies).
    (C) As a result of Z's contribution of cash to Business A, through 
its contribution to P, each of X, Y, and Z are allocated a share of that 
Business A asset. Accordingly, under Sec. 1.987-2(c)(5), Z is treated 
as contributing its allocable share of the cash to its Business A 
section 987 QBU. In addition, Z is treated as transferring X's and Y's 
respective allocable shares of the cash to X and Y, and X and Y are 
subsequently treated as transferring that cash to their respective 
Business A section 987 QBUs.
    (D) In addition, as a result of Z's acquisition of its interest in P 
and Z's consequent acquisition of a Business A section 987 QBU, Z's 
allocable portion of the assets and liabilities of Business A (other 
than the cash) cease being reflected on the books and records of the 
respective Business A section 987 QBUs of each of X and Y. Those 
allocable portions of assets and liabilities from the Business A section 
987 QBUs of X and Y are treated as if they are transferred from such 
section 987 QBUs to their respective owners, X and Y. These assets and 
liabilities are consequently recorded on the books and records of Z's 
Business A section 987 QBU. Accordingly, X and Y are treated as 
transferring those assets and liabilities to Z, and Z is treated as 
contributing those assets and liabilities to its new Business A section 
987 QBU.
    Example 7. Acquisition of an interest in a partnership. (i) Facts. 
The facts are the same as in Example 6, except that the cash that Z 
contributes to P in exchange for a 20 percent interest in P is not used 
in Business A and is not reflected on Business A's books and records. 
Instead, the cash is reflected on P's books and records.
    (ii) Analysis. (A) Following Z's acquisition of a 20 percent 
interest in P, P remains a section 987 aggregate partnership because X, 
Y and Z own all the interests in partnership capital and profits; X, Y, 
and Z are related within the meaning of section 267(b); and the 
requirements of Sec. 1.987-1(b)(5)(i)(B) are satisfied. Z acquires a 20 
percent allocable share of the assets and liabilities of Business A, as 
determined under Sec. 1.987-7. Under Sec. 1.987-1(b)(5)(ii), the 
assets and liabilities of Business A allocated to Z are a section 987 
QBU of Z (because Z becomes an indirect owner of Business A and Z and 
Business A have different functional currencies).
    (B) As a result of Z's acquisition of its interest in P and Z's 
consequent acquisition of a Business A section 987 QBU, Z's allocable 
portion of the assets and liabilities of Business A cease being 
reflected on the books and records of the respective Business A section 
987 QBUs of each of X and Y. Those allocable portions of assets and 
liabilities from the Business A section 987 QBUs of X and Y are treated 
as if they are transferred from such section 987 QBUs to their 
respective owners, X and Y. These assets and liabilities are 
consequently recorded on the books and records of Z's Business A section 
987 QBU. Accordingly, X and Y are treated as transferring those assets 
and liabilities to Z, and Z is treated as contributing those assets and 
liabilities to its new Business A section 987 QBU.
    Example 8. Conversion of a DE to a partnership through a sale of an 
interest. (i) Facts. X owns all of the stock of Y and all of the 
interests in DE1. DE1 owns Business A. Y acquires 50 percent of the DE1 
interests from X for cash.
    (ii) Analysis. (A) DE1 is converted to a partnership when Y 
purchases the 50 percent interest in DE1. For Federal income tax 
purposes, Y's purchase of 50 percent of X's interest in DE1 is treated 
as the direct purchase of 50 percent of the assets of Business A because 
DE1 is disregarded and Business A is treated as held directly by X. 
Immediately after the sale of 50 percent of Business A to Y, X and Y are 
treated as contributing their respective interests in the assets of 
Business A to a partnership. See Rev. Rul. 99-5 (1999-1 CB 434) 
(situation 1) and Sec. 601.601(d)(2) of this chapter.
    (B) For purposes of this paragraph (c), these deemed transactions 
are disregarded transactions. Under Sec. 1.987-1(b)(5)(i), the newly 
formed partnership is a section 987 aggregate partnership because X and 
Y own all the interests in partnership capital and profits, X and Y are 
related within the meaning of section 267(b), and the requirements of 
Sec. 1.987-1(b)(5)(i)(B) are satisfied. Because Y is a partner in a 
section 987 aggregate partnership that owns Business A and because Y and

[[Page 665]]

Business A have different functional currencies, Y's portion of the 
Business A assets and liabilities constitutes a section 987 QBU of Y.
    (C) As a result of the conversion of DE1 to a partnership, Y 
acquires an allocable share of 50 percent of the assets and liabilities 
of Business A, as determined under Sec. 1.987-7. Accordingly, 50 
percent of the assets and liabilities of Business A cease being 
reflected on the books and records of X's section 987 QBU. Under Sec. 
1.987-2(b)(5), these amounts are treated as if they are transferred from 
X's section 987 QBU to X, and X is treated as transferring these assets 
and liabilities to Y. Accordingly, the assets and liabilities of 
Business A allocated to Y are treated as transferred by Y to Y's newly 
formed Business A section 987 QBU.
    Example 9. Conversion of a DE to a partnership through a 
contribution. (i) Facts. X owns all of the stock of Y and all of the 
interests in DE1. DE1 owns Business A. Y contributes property (that is 
not then attributed to a section 987 QBU of Y) to DE1 in exchange for an 
interest in DE1. The property transferred by Y to DE1 is used in 
Business A and is reflected on the books and records of Business A.
    (ii) Analysis. (A) DE1 is converted to a partnership when Y 
contributes property to DE1 in exchange for a 50 percent interest in 
DE1. For Federal income tax purposes, Y's contribution is treated as a 
contribution to a partnership in exchange for an ownership interest in 
the partnership. X is treated as contributing all of Business A to the 
partnership in exchange for a partnership interest. See Rev. Rul. 99-5 
(situation 2), (1999-1 CB 434) and Sec. 601.601(d)(2) of this chapter.
    (B) For purposes of this paragraph (c), these deemed transactions 
are disregarded transactions. Under Sec. 1.987-1(b)(5)(i), the newly 
formed partnership is a section 987 aggregate partnership because X and 
Y own all the interests in partnership capital and profits, X and Y are 
related within the meaning of section 267(b), and the requirements of 
Sec. 1.987-1(b)(5)(i)(B) are satisfied. Because Y is a partner in a 
section 987 aggregate partnership that owns Business A and because Y and 
Business A have different functional currencies, Y's portion of the 
Business A assets and liabilities constitutes a section 987 QBU of Y.
    (C) As a result of the conversion of DE1 to a partnership, Y 
acquires an allocable share of 50 percent of the assets and liabilities 
of Business A, as determined under Sec. 1.987-7. Accordingly, under 
Sec. 1.987-2(c)(5), Y is treated as contributing its allocable share of 
its contributed property to its Business A section 987 QBU. In addition, 
Y is treated as transferring X's allocable share of the contributed 
property to X, and X is subsequently treated as transferring that 
property to its Business A section 987 QBUs. In addition, Y's allocable 
share of the original (pre-conversion) assets and liabilities of 
Business A cease being reflected on the books and records of X's section 
987 QBU. Under Sec. 1.987-2(b)(5), these amounts are treated as if they 
are transferred from X's section 987 QBU to X, and X is treated as 
transferring these assets and liabilities to Y. Y is subsequently 
treated as transferring these assets and liabilities to Y's Business A 
section 987 QBU.
    Example 10. Contribution of assets to a corporation. (i) Facts. X 
owns Business A. X forms Z, a domestic corporation, contributing 50 
percent of its Business A assets and liabilities to Z in exchange for 
all of the stock of Z. X and Z do not file a consolidated tax return.
    (ii) Analysis. Pursuant to paragraph (b)(2) of this section, the Z 
stock received in exchange for 50 percent of Business A's assets and 
liabilities is not reflected on the books and records of, and therefore 
is not attributable to, Business A for purposes of section 987 
immediately after the exchange. As a result, pursuant to paragraph 
(c)(2)(i) and (ii) of this section, 50 percent of the assets and 
liabilities of Business A are treated as transferred from Business A to 
X in a disregarded transaction immediately before the exchange. The 
result would be the same even if X and Z filed a consolidated return.
    Example 11. Circular transfers. (i) Facts. X owns Business A. On 
December 30, 2021, Business A purports to transfer [euro]100 to X. On 
January 2, 2022, X purports to transfer [euro]50 to Business A. On 
January 4, 2022, X purports to transfer another [euro]50 to Business A. 
As of the end of 2021, X has an unrecognized section 987 loss with 
respect to Business A, such that a remittance, if respected, would 
result in recognition of a foreign currency loss under section 987.
    (ii) Analysis. Because the transfer by Business A to X is offset by 
the transfers from X to Business A that occurred in close temporal 
proximity, the Internal Revenue Service (IRS) may disregard the 
purported transfers to and from Business A for purposes of section 987 
pursuant to general tax principles under paragraph (c)(7) of this 
section.
    Example 12. Transfers without substance. (i) Facts. X owns Business 
A and Business B. On January 1, 2021, Business A purports to transfer 
[euro]100 to X. On January 4, 2021, X purports to transfer [euro]100 to 
Business B. The account in which Business B deposited the [euro]100 is 
used to pay the operating expenses and other costs of Business A. As of 
the end of 2021, X has an unrecognized section 987 loss with respect to 
Business A, such that a remittance, if respected, would result in 
recognition of a foreign currency loss under section 987.
    (ii) Analysis. Because Business A continues to have use of the 
transferred property, the

[[Page 666]]

IRS may disregard the [euro]100 purported transfer from Business A to X 
for purposes of section 987 pursuant to general tax principles under 
paragraph (c)(7) of this section.
    Example 13. Offsetting positions in section 987 QBUs. (i) Facts. X 
owns Business A and Business B. Each of Business A and Business B has 
the euro as its functional currency. X has not made a grouping election 
under Sec. 1.987-1(b)(2)(ii). On January 1, 2021, X borrows [euro]1,000 
from a third party lender, records the liability with respect to the 
borrowing on the books and records of Business A, and records the 
borrowed [euro]1,000 on the books and records of Business B. On December 
31, 2022, when Business A has $100 of net unrecognized section 987 loss 
and Business B has $100 of net unrecognized section 987 gain resulting 
from the change in exchange rates with respect to the liability and the 
[euro]1,000, X terminates the Business A section 987 QBU.
    (ii) Analysis. Because Business A and Business B have offsetting 
positions in the euro, the IRS will scrutinize the transaction under 
paragraph (b)(3) of this section to determine if a principal purpose of 
recording the euro-denominated liability on the books and records of 
Business A and the borrowed euros on the books and records of Business B 
was the avoidance of tax under section 987. If such a principal purpose 
is present, the IRS may reallocate the items (that is, the euros and the 
euro-denominated liability) between Business A, Business B, and X, under 
paragraph (c)(7) of this section to reflect the substance of the 
transaction.
    Example 14. Offsetting positions with respect to a section 987 QBU 
and a section 988 transaction. (i) Facts. X owns all of the interests in 
DE1, and DE1 owns Business A. On January 1, 2021, X borrows [euro]1,000 
from a third party lender and records the liability with respect to the 
borrowing on its books and records. X contributes the [euro]1,000 loan 
proceeds to DE1 and the [euro]1,000 are reflected on the books and 
records of Business A. On December 31, 2022, when Business A has $100 of 
net unrecognized section 987 loss resulting from the change in exchange 
rates with respect to the [euro]1,000 received from the borrowing, and 
when the euro-denominated borrowing, if repaid, would result in $100 of 
gain under section 988, X terminates the Business A section 987 QBU.
    (ii) Analysis. Because X and Business A have offsetting positions in 
the euro, the IRS will scrutinize the transaction under paragraph (b)(3) 
of this section to determine whether a principal purpose of recording 
the borrowed euros on the books and records of Business A, or not 
recording the corresponding euro-denominated liability on the books and 
records of Business A, was the avoidance of tax under section 987. If 
such a principal purpose is present, the Commissioner may reallocate the 
items (that is, the euros and the euro-denominated liability) between 
Business A and X under paragraph (c)(7) of this section to reflect the 
substance of the transaction.
    Example 15. Offsetting positions with respect to a section 987 QBU 
and a section 988 transaction. (i) Facts. X owns all of the stock of Y 
and all of the interests in DE1. DE1 owns Business A. X and Y file a 
consolidated return. On January 1, 2021, DE1 lends [euro]1,000 to Y. X 
records the receivable with respect to the loan on Business A's books 
and records. On December 31, 2022, when Business A has $100 of net 
unrecognized section 987 gain resulting from the loan, Y repays the 
[euro]1,000 liability. The repayment of the euro-denominated borrowing 
results in $100 of loss to Y under section 988. X claims a $100 loss on 
its consolidated return under section 988. Business A does not make any 
remittances to X in 2022, so the offsetting gain with respect to the 
loan receivable has not been recognized by X.
    (ii) Analysis. Y, a related party to X, and Business A have 
offsetting positions in the euro. The IRS will scrutinize the 
transaction under paragraph (b)(3) of this section to determine whether 
a principal purpose of recording the euro-denominated receivable on the 
books and records of Business A, rather than on the books and records of 
X, was to avoid tax through the use of section 987. If such a principal 
purpose is present, the IRS may reallocate the euro-denominated 
receivable between Business A and X under paragraph (c)(7) of this 
section to reflect the substance of the transaction. Other provisions 
may also apply to defer or disallow the loss.
    Example 16. Loan by section 987 QBU followed by immediate 
distribution to owner. (i) Facts. X owns all of the interests in DE1. 
DE1 owns Business A. On January 1, 2021, Business A borrows [euro]1,000 
from a bank. On January 2, 2021, Business A distributes the [euro]1,000 
it received from the bank to X. There are no other transfers between X 
and Business A during the year. At the end of the year, X has net 
unrecognized section 987 loss with respect to Business A such that a 
remittance would result in the recognition of foreign currency loss 
under section 987.
    (ii) Analysis. Because the proceeds from the loan to Business A are 
immediately transferred to X and the distribution from Business A to X 
could result in the recognition of section 987 loss, the IRS may 
scrutinize the recording of the loan on the books of Business A and move 
the loan onto the books of X, resulting in the transfer not being taken 
into account for purposes of section 987 under paragraph (b)(3) of this 
section.
    Example 17. Payment of interest by section 987 QBU on obligation of 
owner. (i) Facts. X owns all of the interests in DE1. DE1 owns business 
A. On January 1, X borrows [euro]1,000 from a bank. On July 1, Business 
A pays [euro]20 in interest on X's [euro]1,000 obligation to the bank.

[[Page 667]]

    (ii) Analysis. Under general tax law principles as provided in 
paragraph (c)(7) of this section, on July 1, 2021, Business A is treated 
for purposes of section 987 as making a transfer of [euro]20 to X, and X 
is treated as making a [euro]20 interest payment to the bank.

    (d) Translation of items transferred to a section 987 QBU--(1) 
Marked items. The adjusted basis of a marked asset, or the amount of a 
marked liability, transferred to a section 987 QBU shall be translated 
into the section 987 QBU's functional currency at the spot rate (as 
defined in Sec. 1.987-1(c)(1)) applicable to the date of transfer. If 
the asset or liability transferred is denominated in (or determined by 
reference to) the functional currency of the section 987 QBU (for 
example, cash or a note denominated in the functional currency of the 
section 987 QBU), no translation is required. See Sec. 1.988-
1(a)(10)(ii) for special rules regarding intra-taxpayer transfers.
    (2) Historic items. The adjusted basis of a historic asset, or the 
amount of a historic liability, transferred to a section 987 QBU shall 
be translated into the section 987 QBU's functional currency at the rate 
provided in Sec. 1.987-1(c)(3).
    (e) Effective/applicability date--(1) In general. Except as set 
forth in paragraph (e)(2) of this section, this section is applicable as 
specified in Sec. 1.987-11.
    (2) Certain disregarded transactions not treated as transfers. 
Paragraph (c)(9) of this section applies to taxable years beginning on 
or after the day that is three years after the first day of the first 
taxable year following December 7, 2016. Notwithstanding the preceding 
sentence, if a taxpayer makes an election under Sec. 1.987-11(b), then 
paragraph (c)(9) of this section applies to taxable years to which 
Sec. Sec. 1.987-1 through 1.987-10 apply as a result of such election.

[T.D. 9794, 81 FR 88821, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88870, Dec. 8, 2016; T.D. 9857, 84 FR 20795, May 13, 2019; 84 FR 31194, 
July 1, 2019]



Sec. 1.987-3  Determination of section 987 taxable income or loss
of an owner of a section 987 QBU.

    (a) In general. This section provides rules for determining the 
taxable income or loss, or the earnings and profits, of an owner of a 
section 987 QBU (hereafter, section 987 taxable income or loss). 
Paragraph (b) of this section provides rules for determining items of 
income, gain, deduction, and loss, which generally must be determined in 
the section 987 QBU's functional currency. Paragraph (c) of this section 
provides rules for translating each item determined under paragraph (b) 
of this section into the functional currency of the owner of the section 
987 QBU, if necessary. Paragraph (e) of this section provides examples 
illustrating the application of the rules of this section.
    (b) Determination of each item of income, gain, deduction, or loss 
in the section 987 QBU's functional currency--(1) In general. Except as 
otherwise provided in this section, a section 987 QBU shall determine 
each item of income, gain, deduction, or loss of such section 987 QBU in 
its functional currency under Federal income tax principles.
    (2) Translation of items of income, gain, deduction, or loss that 
are denominated in a nonfunctional currency--(i) In general. Except as 
otherwise provided in paragraphs (b)(2)(ii) and (b)(4) of this section, 
an item of income, gain, deduction, or loss that is denominated in (or 
determined by reference to) a nonfunctional currency (including the 
functional currency of the owner) shall be translated into the section 
987 QBU's functional currency at the spot rate (as defined in Sec. 
1.987-1(c)(1)) on the date such item is properly taken into account, 
subject to the limitation under Sec. 1.987-1(c)(1)(ii)(B) regarding the 
use of a spot rate convention. Examples 1, 2 and 6 of paragraph (e) of 
this section illustrate the application of this paragraph (b)(2)(i).
    (ii) [Reserved] For further guidance, see Sec. 1.987-3T(b)(2)(ii).
    (3) Determination in the case of a section 987 QBU owned through a 
section 987 aggregate partnership--(i) In general. Except as otherwise 
provided in this paragraph (b)(3), the taxable income or loss of a 
section 987 aggregate partnership, and the distributive share of any 
owner that is a partner in such partnership, shall be determined in 
accordance with the provisions of subchapter K of the Internal Revenue 
Code.

[[Page 668]]

    (ii) Determination of each item of income, gain, deduction, or loss 
in the eligible QBU's functional currency. A section 987 aggregate 
partnership generally shall determine each item of income, gain, 
deduction, or loss reflected on the books and records of each of its 
eligible QBUs under Sec. 1.987-2(b) in the functional currency of each 
such QBU.
    (iii) Allocation of items of income, gain, deduction, or loss of an 
eligible QBU. A section 987 aggregate partnership shall allocate the 
items of income, gain, deduction, or loss of each eligible QBU among its 
partners in accordance with each partner's distributive share of such 
income, gain, deduction, or loss as determined under subchapter K of the 
Internal Revenue Code.
    (iv) Translation of items into the owner's functional currency. To 
the extent the items referred to in paragraph (b)(3)(iii) of this 
section are allocated to a partner, the partner shall adjust the items 
to conform to Federal income tax principles and translate the items into 
the partner's functional currency as provided in paragraph (c) of this 
section.
    (4) [Reserved] For further guidance, see Sec. 1.987-3T(b)(4).
    (c) Translation of items of income, gain, deduction, or loss of a 
section 987 QBU into the owner's functional currency--(1) In general. 
Except as otherwise provided in this section, the exchange rate to be 
used by an owner in translating an item of income, gain, deduction, or 
loss attributable to a section 987 QBU into the owner's functional 
currency, if necessary, shall be the yearly average exchange rate (as 
defined in Sec. 1.987-1(c)(2)) for the taxable year. However, an owner 
of a section 987 QBU that has elected under Sec. 1.987-1(c)(1)(iii) to 
use spot rates in lieu of yearly average exchange rates must use the 
spot rate (as defined in Sec. 1.987-1(c)(1)) for the date each item is 
properly taken into account.
    (2) Exceptions--(i) Recovery of basis with respect to historic 
assets. Except as otherwise provided in this section, the exchange rate 
to be used by the owner in translating any recovery of basis (whether 
through a sale or exchange; deemed sale or exchange; cost recovery 
deduction such as depreciation, depletion or amortization; or otherwise) 
with respect to a historic asset (as defined in Sec. 1.987-1(e)) shall 
be the historic rate as determined under Sec. 1.987-1(c)(3) for the 
property to which such recovery of basis is attributable.
    (ii) [Reserved] For further guidance, see Sec. 1.987-3T(c)(2)(ii).
    (iii) Gain or loss on the sale, exchange or other disposition of an 
interest in a section 987 aggregate partnership. [Reserved]
    (iv) Cost of goods sold computation--(A) General rule--simplified 
inventory method. Cost of goods sold (COGS) for a taxable year shall be 
translated into the functional currency of the owner at the yearly 
average exchange rate (as defined in Sec. 1.987-1(c)(2)) for the 
taxable year and adjusted as provided in paragraph (c)(3) of this 
section.
    (B) Election to use the historic inventory method. In lieu of using 
the simplified inventory method described in paragraph (c)(2)(iv)(A) of 
this section, the owner of a section 987 QBU may elect under this 
paragraph (c)(2)(iv)(B) to translate inventoriable costs (including 
current-year inventoriable costs and costs that were capitalized into 
inventory in prior years) that are included in COGS at the historic rate 
as determined under Sec. 1.987-1(c)(3) for each such cost. As described 
in Sec. 1.987-1(c)(1)(iii), a taxpayer that elects to use spot rates in 
lieu of yearly average exchange rates as provided in that section will 
be deemed to have made the election described in this paragraph 
(c)(2)(iv)(B).
    (v) [Reserved] For further guidance, see Sec. 1.987-3T(c)(2)(v) 
through (d).
    (3) Adjustments to COGS required under the simplified inventory 
method--(i) In general. An owner of a section 987 QBU that uses the 
simplified inventory method described in paragraph (c)(2)(iv)(A) of this 
section must make the adjustment described in paragraph (c)(3)(ii) of 
this section. In addition, the owner must make the adjustment described 
in paragraph (c)(3)(iii) of this section with respect to any inventory 
for which the section 987 QBU does not use the LIFO inventory method (as 
described in section 472) and must make the adjustment described in 
paragraph (c)(3)(iv) of this section with respect to any inventory for 
which the section 987 QBU uses the LIFO inventory method.

[[Page 669]]

An owner of a section 987 QBU that uses the simplified inventory method 
must make all of the applicable adjustments described in paragraphs 
(c)(3)(ii) through (iv) with respect to the section 987 QBU even in 
taxable years in which the amount of COGS is zero.
    (ii) Adjustment for cost recovery deductions included in 
inventoriable costs. The translated COGS amount computed under paragraph 
(c)(2)(iv)(A) of this section must be increased or decreased (as 
appropriate) to reflect the difference between the historic rates 
appropriate for translating cost recovery deductions attributable to 
other historic assets and the exchange rate used to translate COGS under 
paragraph (c)(2)(iv)(A) of this section, to the extent any such cost 
recovery deductions are included in inventoriable costs for the taxable 
year. The adjustment shall be included as an adjustment to translated 
COGS computed under paragraph (c)(2)(iv)(A) of this section in full in 
the year to which the adjustment relates and shall not be allocated 
between COGS and ending inventory. The adjustment for each cost recovery 
deduction shall be computed as the product of:
    (A) The cost recovery deduction, expressed in the functional 
currency of the section 987 QBU; and
    (B) The exchange rate specified in paragraph (c)(2)(i) of this 
section for translating the cost recovery deduction (that is, the 
historic rate for the property to which such deduction is attributable) 
less the exchange rate used to translate COGS under the simplified 
inventory method described in paragraph (c)(2)(iv)(A) of this section 
(that is, the yearly average exchange rate for the taxable year).
    (iii) Adjustment to beginning inventory for non-LIFO inventory. In 
the case of inventory with respect to which a section 987 QBU does not 
use the LIFO inventory method (non-LIFO inventory), the translated COGS 
amount computed under paragraph (c)(2)(iv)(A) of this section must be 
increased or decreased (as appropriate) by the product of:
    (A) The ending non-LIFO inventory included on the closing balance 
sheet for the preceding year, expressed in the functional currency of 
the section 987 QBU; and
    (B) The exchange rate described in Sec. Sec. 1.987-4(e)(2)(ii) and 
1.987-1(c)(3)(i)(C) that is used for translating ending inventory on the 
closing balance sheet for the preceding year (that is, the yearly 
average exchange rate for the preceding year) less the exchange rate 
used to translate COGS under paragraph (c)(2)(iv)(A) of this section 
(that is, the yearly average exchange rate for the taxable year).
    (iv) Adjustment for year of LIFO liquidation. In the case of 
inventory with respect to which a section 987 QBU uses the LIFO 
inventory method, for each LIFO layer liquidated in whole or in part 
during the taxable year, the translated COGS amount computed under 
paragraph (c)(2)(iv)(A) of this section must be increased or decreased 
(as appropriate) by the product of:
    (A) The amount of the LIFO layer liquidated during the taxable year, 
expressed in the functional currency of the section 987 QBU; and
    (B) The exchange rate described in Sec. Sec. 1.987-4(e)(2)(ii) and 
1.987-1(c)(3)(i)(C) that is used for translating such LIFO layer (that 
is, the yearly average exchange rate for the year such LIFO layer arose) 
less the exchange rate used to translate COGS under paragraph 
(c)(2)(iv)(A) of this section (that is, the yearly average exchange rate 
for the taxable year).
    (d) [Reserved] For further guidance, see Sec. 1.987-3T(c)(2)(v) 
through (d).
    (e) Examples. The following examples illustrate the application of 
this section. For purposes of the examples, U.S. Corp is a domestic 
corporation that uses the calendar year as its taxable year and has the 
U.S. dollar as its functional currency. Except as otherwise indicated, 
U.S. Corp is the owner of Business A, a section 987 QBU with the euro as 
its functional currency, and elects under paragraph (c)(2)(iv)(B) of 
this section to use the historic inventory method with respect to 
Business A but does not make any other elections under section 987. 
However, where it is specified that U.S. Corp elects to use spot rates 
in lieu of yearly average exchange rates under Sec. 1.987-1(c)(1)(iii), 
U.S. Corp also elects under Sec. 1.987-1(c)(1)(ii) to use a spot rate 
convention. Under this convention, sales booked

[[Page 670]]

during a particular month are translated at the average of the spot 
rates on the first and last day of the preceding month (the ``convention 
rate''). Exchange rates used in these examples are selected for the 
purpose of illustrating the principles of this section. No inference 
(for example, whether a currency is hyperinflationary or not) is 
intended by their use. See Sec. 1.987-4(g) for an illustration of the 
simplified inventory method described in paragraphs (c)(2)(iv)(A) and 
(c)(3) of this section.

    Example 1. Business A properly accrues [pound]100 of income from the 
provision of services. Under paragraph (b)(2)(i) of this section, the 
[pound]100 is translated into [euro]90 at the spot rate (as defined in 
Sec. 1.987-1(c)(1)) on the date of accrual, without the use of a spot 
rate convention. In determining U.S. Corp's taxable income, the [euro]90 
of income is translated into dollars at the rate provided in paragraph 
(c)(1) of this section.
    Example 2. Business A sells a historic asset consisting of non-
inventory property for [pound]100. Under paragraph (b)(2)(i) of this 
section, the [pound]100 amount realized is translated into [euro]85 at 
the spot rate (as defined in Sec. 1.987-1(c)(1)) on the sale date 
without the use of a spot rate convention. In determining U.S. Corp's 
taxable income, the [euro]85 is translated into dollars at the rate 
provided in paragraph (c)(1) of this section. The euro basis of the 
property is translated into dollars at the rate provided in paragraph 
(c)(2)(i) of this section (that is, the historic rate as determined 
under Sec. 1.987-1(c)(3)).
    Example 3. (i) Business A uses a first-in, first-out (FIFO) method 
of accounting for inventory. Business A sells 1,200 units of inventory 
in 2021 for [euro]3 per unit. Business A's gross sales are translated 
under paragraph (c)(1) of this section at the yearly average exchange 
rate for the year of the sale. The yearly average exchange rate is 
[euro]1 = $1.02 for 2020 and [euro]1 = $1.05 for 2021. Thus, Business 
A's dollar gross sales will be computed as follows:

                                                   Gross Sales
                                                     [2021]
----------------------------------------------------------------------------------------------------------------
                                                                                     [euro]/$
                      Month                          Number of       Amount in    yearly average    Amount in $
                                                       units          [euro]           rate
----------------------------------------------------------------------------------------------------------------
Jan.............................................             100             300       [euro]1 =          315.00
                                                                                           $1.05
Feb.............................................             200             600       [euro]1 =          630.00
                                                                                           $1.05
March...........................................               0               0       [euro]1 =               0
                                                                                           $1.05
April...........................................             200             600       [euro]1 =          630.00
                                                                                           $1.05
May.............................................             100             300       [euro]1 =          315.00
                                                                                           $1.05
June............................................               0               0       [euro]1 =               0
                                                                                           $1.05
July............................................             100             300       [euro]1 =          315.00
                                                                                           $1.05
Aug.............................................             100             300       [euro]1 =          315.00
                                                                                           $1.05
Sept............................................               0               0       [euro]1 =               0
                                                                                           $1.05
Oct.............................................               0               0       [euro]1 =               0
                                                                                           $1.05
Nov.............................................             100             300       [euro]1 =          315.00
                                                                                           $1.05
Dec.............................................             300             900       [euro]1 =          945.00
                                                                                           $1.05
                                                 ---------------------------------------------------------------
                                                           1,200  ..............  ..............        3,780.00
----------------------------------------------------------------------------------------------------------------

    (ii) The purchase price for each inventory unit was [euro]1.50. 
Under Sec. 1.987-1(c)(3)(i) and paragraph (c)(2)(iv)(B) of this 
section, the basis of each item of inventory is translated into dollars 
at the yearly average exchange rate for the year the inventory was 
acquired.

                                         Opening Inventory and Purchases
                                                     [2021]
----------------------------------------------------------------------------------------------------------------
                                                                                     [euro]/$
                      Month                          Number of       Amount in    yearly average    Amount in $
                                                       units          [euro]           rate
----------------------------------------------------------------------------------------------------------------
Opening inventory (purchased in December 2020)               100             150       [euro]1 =          153.00
                                                                                           $1.02
Purchases in 2021:
    Jan.........................................             300             450       [euro]1 =          472.50
                                                                                           $1.05
    Feb.........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    March.......................................               0               0       [euro]1 =               0
                                                                                           $1.05
    April.......................................             300             450       [euro]1 =          472.50
                                                                                           $1.05
    May.........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    June........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    July........................................             300             450       [euro]1 =          472.50
                                                                                           $1.05
    Aug.........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    Sept........................................               0               0       [euro]1 =               0
                                                                                           $1.05

[[Page 671]]

 
    Oct.........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    Nov.........................................             300             450       [euro]1 =          472.50
                                                                                           $1.05
    Dec.........................................               0               0       [euro]1 =               0
                                                                                           $1.05
                                                 ---------------------------------------------------------------
                                                           1,200  ..............  ..............        1,890.00
----------------------------------------------------------------------------------------------------------------

    (iii) Because Business A uses a FIFO method for inventory, Business 
A is considered to have sold in 2021 the 100 units of opening inventory 
purchased in 2020 ($153.00), the 300 units purchased in January 2021 
($472.50), the 300 units purchased in April 2021 ($472.50), the 300 
units purchased in July 2021 ($472.50), and 200 of the 300 units 
purchased in November 2021 ($315.00). Accordingly, Business A's 
translated dollar COGS for 2021 is $1,885.50. Business A's opening 
inventory for 2022 is 100 units of inventory with a translated dollar 
basis of $157.50.
    (iv) Accordingly, for purposes of section 987 Business A has gross 
income in dollars of $1,894.50 ($3,780.00--$1,885.50).
    Example 4. (i) The facts are the same as in Example 3 except that 
U.S. Corp properly elects under paragraph Sec. 1.987-1(c)(1)(iii) to 
use spot rates in lieu of yearly average exchange rates. As a result, 
under paragraph (c)(3) of this section, U.S. Corp uses the convention 
rate to translate items of income, gain, deduction, or loss where such 
rate is appropriate. Thus, Business A's dollar gross sales will be 
computed as follows:

                                                   Gross Sales
                                                     [2021]
----------------------------------------------------------------------------------------------------------------
                                                                                     [euro]/$
                      Sales                          Number of       Amount in      convention      Amount in $
                                                       units          [euro]           rate
----------------------------------------------------------------------------------------------------------------
Jan.............................................             100             300       [euro]1 =             300
                                                                                           $1.00
Feb.............................................             200             600       [euro]1 =             630
                                                                                           $1.05
March...........................................               0               0       [euro]1 =               0
                                                                                           $1.03
April...........................................             200             600       [euro]1 =             612
                                                                                           $1.02
May.............................................             100             300       [euro]1 =             312
                                                                                           $1.04
June............................................               0               0       [euro]1 =               0
                                                                                           $1.05
July............................................             100             300       [euro]1 =             318
                                                                                           $1.06
Aug.............................................             100             300       [euro]1 =             315
                                                                                           $1.05
Sept............................................               0               0       [euro]1 =               0
                                                                                           $1.06
Oct.............................................               0               0       [euro]1 =               0
                                                                                           $1.07
Nov.............................................             100             300       [euro]1 =             324
                                                                                           $1.08
Dec.............................................             300             900       [euro]1 =             972
                                                                                           $1.08
                                                 ---------------------------------------------------------------
                                                           1,200  ..............  ..............           3,783
----------------------------------------------------------------------------------------------------------------

    (ii) As in Example 3, the purchase price for each inventory unit was 
[euro]1.50. Under Sec. 1.987-3(c)(2)(iv)(B), U.S. Corp uses the 
convention rate as the historic rate in determining COGS.

                                         Opening Inventory and Purchases
                                                     [2021]
----------------------------------------------------------------------------------------------------------------
                                                                                     [euro]/$
                      Month                          Number of       Amount in      convention      Amount in $
                                                       units          [euro]           rate
----------------------------------------------------------------------------------------------------------------
Opening inventory (purchased in December 2020)               100             150       [euro]1 =             153
                                                                                           $1.02
Purchases in 2021:
    Jan.........................................             300             450       [euro]1 =             450
                                                                                           $1.00
    Feb.........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    March.......................................               0               0       [euro]1 =               0
                                                                                           $1.03
    April.......................................             300             450       [euro]1 =             459
                                                                                           $1.02
    May.........................................               0               0       [euro]1 =               0
                                                                                           $1.04
    June........................................               0               0       [euro]1 =               0
                                                                                           $1.05
    July........................................             300             450       [euro]1 =             477
                                                                                           $1.06
    Aug.........................................               0               0       [euro]1 =               0
                                                                                           $1.05

[[Page 672]]

 
    Sept........................................               0               0       [euro]1 =               0
                                                                                           $1.06
    Oct.........................................               0               0       [euro]1 =               0
                                                                                           $1.07
    Nov.........................................             300             450       [euro]1 =             486
                                                                                           $1.08
    Dec.........................................               0               0       [euro]1 =             486
                                                                                           $1.08
                                                 ---------------------------------------------------------------
                                                           1,200  ..............  ..............           1,872
----------------------------------------------------------------------------------------------------------------

    (iii) As set forth in (i), Business A's gross sales are $3,783.
    (iv) Because Business A uses a FIFO method for inventory, Business A 
is considered to have sold in 2021 the 100 units of opening inventory 
purchased in December 2020 ($150), the 300 units purchased in January 
2021 ($450), the 300 units purchased in April 2021 ($459), the 300 units 
purchased in July 2021 ($477), and 200 of the 300 units purchased in 
November 2021 ($324). Thus, Business A's COGS is $1,860.
    (v) Accordingly, Business A has gross income in dollars of $1,923 
($3,783 - $1,860).
    Example 5. The facts are the same as in Example 3 except that during 
2021, Business A incurred [euro]100 of depreciation expense with respect 
to a truck. No portion of the depreciation expense is an inventoriable 
cost. The truck was purchased on January 15, 2020. The yearly average 
exchange rate for 2020 was [euro]1 = $1.02. Under paragraph (c)(2)(i) of 
this section, the [euro]100 of depreciation is translated into dollars 
at the historic rate. Under Sec. 1.987-1(c)(3)(i), the historic rate is 
the yearly average rate for 2020. Accordingly, U.S. Corp takes into 
account depreciation of $102 with respect to Business A in 2021.
    Example 6. The facts are the same as in Example 5 except that the 
[euro]100 of depreciation expense incurred during 2021 with respect to 
the truck is an inventoriable cost. As a result, the depreciation 
expense is capitalized into the 1,200 units of inventory purchased by 
Business A in 2021. Of those 1,200 units, 1,100 units are sold during 
the year, and 100 units become ending inventory. The portion of 
depreciation expense capitalized into inventory that is sold during 2021 
is reflected in Business A's euro COGS and is translated at the [euro]1 
= $1.02 yearly average exchange rate for 2020, the year in which the 
truck was purchased. The portion of the depreciation expense capitalized 
into the 100 units of ending inventory is not taken into account in 2021 
but, rather, will be taken into account in the year the ending inventory 
is sold, translated at the [euro]1 = $1.02 yearly average exchange rate 
for 2020.
    Example 7. Business A purchased raw land on October 16, 2020, for 
[euro]8,000 and sold the land on November 1, 2021, for [euro]10,000. The 
yearly average exchange rate was [euro]1 = $1.02 for 2020 and [euro]1 = 
$1.05 for 2021. Under paragraph (c)(1) of this section, the amount 
realized is translated into dollars at the yearly average exchange rate 
for 2021 ([euro]10,000 x $1.05 = $10,500). Under paragraph (c)(2)(i) of 
this section, the basis is determined at the historic rate for 2020, 
which is the yearly average rate under section Sec. 1.987-1(c)(3)(i) 
for such year ([euro]8,000 x $1.02 = $8,160). Accordingly, the amount of 
gain reported by U.S. Corp on the sale of the land is $2,340 ($10,500 - 
$8,160).
    Example 8. The facts are the same as in Example 7 except that 
Business A properly elects under paragraph Sec. 1.987-1(c)(1)(iii) to 
use spot rates in lieu of yearly average rates. Accordingly, the amount 
realized will be translated at the convention rate for the date of sale, 
and the basis will be translated at the convention rate for the date of 
purchase. The convention rate is [euro]1 = $1.01 for October 2020 and is 
[euro]1 = $1.08 for November 2021. Under these facts, the amount 
realized, translated into dollars at the convention rate for November 
2021, is $10,800 ([euro]10,000 x $1.08), and the basis, translated at 
the convention rate for October 2020, is $8,080 ([euro]8,000 x $1.01). 
The amount of gain reported by U.S. Corp on the sale of the land is 
$2,720 ($10,800 - $8,080).
    Example 9 through Example 14 [Reserved] For further guidance, see 
Sec. 1.987-3T(e), Example 9 through Example 14.

[T.D. 9794, 81 FR 88821, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88870, Dec. 8, 2016]



Sec. 1.987-3T  Determination of section 987 taxable income or loss
of an owner of a section 987 QBU (temporary).

    (a) through (b)(2)(i) [Reserved] For further guidance, see Sec. 
1.987-3(a) through (b)(2)(i).
    (ii) No translation of basis or amount realized with respect to a 
specified owner functional currency transaction treated as a historic 
asset. If the acquisition of a historic asset gives rise to a specified 
owner functional currency transaction

[[Page 673]]

described in paragraph (b)(4)(ii) of this section, the basis of the 
historic asset, and any amount realized on a disposition of the historic 
asset, is not translated if the amount is denominated in the owner's 
functional currency.
    (3) [Reserved] For further guidance, see Sec. 1.987-3(b)(3).
    (4) Special rule for section 988 transactions--(i) In general. 
Section 988 and the regulations thereunder apply to section 988 
transactions of a section 987 QBU. For this purpose, whether a 
transaction is a section 988 transaction is determined by reference to 
the functional currency of the section 987 QBU. (But see paragraph 
(b)(4)(ii) of this section, providing that specified owner functional 
currency transactions are not treated as section 988 transactions.) 
However, except as provided in paragraph (b)(4)(iii)(A) of this section, 
section 988 gain or loss is determined in, and by reference to, the 
functional currency of the owner of the section 987 QBU rather than the 
functional currency of the section 987 QBU. Accordingly, in determining 
section 988 gain or loss of a section 987 QBU with respect to a section 
988 transaction of the section 987 QBU, the amounts required under 
section 988 and the regulations thereunder to be translated on the 
applicable booking date or payment date with respect to the section 988 
transaction are translated into the owner's functional currency at the 
rate required under section 988 and the regulations thereunder.
    (ii) Specified owner functional currency transactions not treated as 
section 988 transactions. Transactions of a section 987 QBU described in 
sections 988(c)(1)(B)(i), 988(c)(1)(B)(ii), and 988(c)(1)(C) (including 
the acquisition of nonfunctional currency as described in Sec. 1.988-
1(a)(1)), other than transactions described in paragraph (b)(4)(iii)(A) 
of this section, that are denominated in (or determined by reference to) 
the owner's functional currency (specified owner functional currency 
transactions) are not treated as section 988 transactions. Thus, no 
currency gain or loss is recognized by a section 987 QBU under section 
988 with respect to such transactions.
    (iii) Determination of section 988 gain or loss for qualified short-
term section 988 transactions--(A) Determination by reference to the 
section 987 QBU's functional currency for certain transactions subject 
to a mark-to-market method of accounting. Section 988 gain or loss with 
respect to section 988 transactions described in paragraph 
(b)(4)(iii)(B) of this section that are accounted for under a mark-to-
market method of accounting for Federal income tax purposes or under the 
foreign currency mark-to-market method of accounting described in 
paragraph (b)(4)(iii)(C) of this section, and any hedges entered into to 
manage risk with respect to such transactions within the meaning of 
Sec. 1.1221-2(c)(4) (related hedges), must be determined in, and by 
reference to, the functional currency of the section 987 QBU (rather 
than the functional currency of its owner).
    (B) Qualified short-term section 988 transaction. A qualified short-
term section 988 transaction is a section 988 transaction that occurs in 
the ordinary course of a section 987 QBU's business and has an original 
term of one year or less on the date the transaction is entered into by 
the section 987 QBU. The holding of currency that is nonfunctional 
currency (within the meaning of section 988(c)(1)(C)(ii)) to the section 
987 QBU in the ordinary course of a section 987 QBU's trade or business 
also is treated as a qualified short-term section 988 transaction. Any 
transaction that is denominated in, or determined by reference to, a 
hyperinflationary currency, including the holding of hyperinflationary 
currency, is not considered a qualified short-term section 988 
transaction. See Sec. Sec. 1.988-2(b)(15), 1.988-2(d)(5), and 1.988-
2(e)(7) for rules relating to transactions denominated in, or determined 
by reference to, a hyperinflationary currency.
    (C) Election to use a foreign currency mark-to-market method of 
accounting. A taxpayer may elect under this paragraph (b)(4)(iii)(C) to 
apply the foreign currency mark-to-market method of accounting described 
in this paragraph for all qualified short-term section 988 transactions 
described in paragraph (b)(4)(iii)(B) of this section, and any related 
hedges, that are properly attributable to a section 987 QBU on or after 
the effective date of the election and that are not otherwise accounted 
for

[[Page 674]]

under a mark-to-market method of accounting under section 475 or section 
1256. Under the foreign currency mark-to-market method of accounting, 
the timing of section 988 gain or loss on section 988 transactions is 
determined under the principles of section 1256(a)(1). Thus, only 
section 988 gain or loss is taken into account under the foreign 
currency mark-to-market method of accounting. Appropriate adjustments 
must be made to prevent the section 988 gain or loss from being taken 
into account again under section 988 or another provision of the Code or 
regulations. A section 988 transaction subject to this election is not 
subject to the ``netting rule'' of section 988(b) and Sec. 1.988-
2(b)(8), under which exchange gain or loss is limited to overall gain or 
loss realized in a transaction, in taxable years prior to the taxable 
year in which section 988 gain or loss would be recognized with respect 
to such section 988 transaction but for this election.
    (iv) Examples. Examples 10 through 13 of paragraph (e) of this 
section illustrate the application of this paragraph (b)(4).
    (c)(1) through (c)(2)(i) [Reserved] For further guidance, see Sec. 
1.987-3(c)(1) through (c)(2)(i).
    (ii) Amount realized with respect to historic assets that are 
section 988 transactions. If the acquisition of a historic asset gave 
rise to a section 988 transaction described in paragraph (b)(4)(i) of 
this section, then in computing the total gain or loss on a disposition 
of the historic asset (some or all of which total gain or loss may be 
section 988 gain or loss described in section 988(b) and paragraph 
(b)(4)(i) of this section), the amount realized (determined, if 
necessary, under Sec. 1.987-3(b)(2)(i)) is translated into the owner's 
functional currency using the spot rate on the date such item is 
properly taken into account, subject to the limitation under Sec. 
1.987-1T(c)(1)(ii)(B) regarding the use of a spot rate convention.
    (iii) through (iv) [Reserved] For further guidance, see Sec. 1.987-
3(c)(2)(iii) through (iv).
    (v) Translation of income to account for certain foreign income tax 
claimed as a credit. The owner of a section 987 QBU claiming a credit 
under section 901 for foreign income taxes, other than foreign income 
taxes deemed paid under section 902 or section 960, that are properly 
reflected on the books and records of the section 987 QBU (the 
creditable tax amount) must determine section 987 taxable income or loss 
attributable to the section 987 QBU by reducing the amount of section 
987 taxable income or loss that otherwise would be determined under this 
section by an amount equal to the creditable tax amount, translated into 
U.S. dollars using the yearly average exchange rate for the taxable year 
in which the creditable tax is accrued, and by increasing the resulting 
amount by an amount equal to the creditable tax amount, translated using 
the same exchange rate that is used to translate the creditable taxes 
into U.S. dollars under section 986(a). See Example 14 of paragraph (e) 
of this section,, for an illustration of this rule.
    (d) Election to translate all items at the yearly average exchange 
rate. Notwithstanding Sec. 1.987-3(c), a taxpayer that has made the 
annual deemed termination election described in Sec. 1.987-8T(d) may 
elect under this paragraph (d) to translate all items of income, gain, 
deduction, and loss with respect to a section 987 QBU determined under 
Sec. 1.987-3(b) in the functional currency of the section 987 QBU into 
the owner's functional currency, if necessary, at the yearly average 
exchange rate for the taxable year. Example 9 of paragraph (e) of this 
section illustrates the application of this election.
    (e) Example 1 through Example 8 [Reserved] For further guidance, see 
Sec. 1.987-3(e), Example 1 through Example 8.

    Example 9. The facts are the same as in Example 7, except that U.S. 
Corp properly elects under paragraph (d) of this section to translate 
all items of income, gain, deduction, and loss with respect to Business 
A at the yearly average exchange rate. Accordingly, Business A's 
[euro]2,000 gain on the sale of the land is translated at the yearly 
average exchange rate for 2021 of [euro]1 = $1.05, and the amount of 
gain reported by U.S. Corp on the sale of the land is $2,100.
    Example 10. Business A acquires [pound]100 on August 27, 2021, for 
[euro]120 and sells the pounds on November 17, 2021, for [euro]125. The 
dollar-pound spot rate (without the use of a spot rate convention) is 
[pound]1 = $1 on August 27, 2021, and [pound]1 = $1.10 on November 17, 
2021. The disposition

[[Page 675]]

of the pounds is a section 988 transaction of Business A under paragraph 
(b)(4)(i) of this section, and the pounds are a historic asset under 
Sec. 1.987-1(e). Section 988 gain or loss with respect to the 
disposition of the pounds is determined under paragraph (b)(4)(i) of 
this section and Sec. 1.988-2(a)(2) by reference to the dollar 
functional currency of Business A's owner. The dollar amount realized 
for the pounds is determined under paragraph (c)(2)(ii) of this section 
by translating [pound]100 into $110 using the dollar-pound spot rate on 
November 17, 2021, without the use of a spot rate convention. The dollar 
basis in the pounds is determined under Sec. 1.987-3(c)(2)(i) by 
translating [pound]100 into $100 using the historic rate described in 
Sec. 1.987-1T(c)(3)(i)(E), which is the dollar-pound spot rate on 
August 27, 2021, without the use of a spot rate convention. Thus, U.S. 
Corp takes into account $10 of section 988 gain with respect to Business 
A's disposition of [pound]100.
    Example 11. (i) Business A purchases a [pound]100 2-year note for 
[euro]75 on October 1, 2021, and receives a [pound]100 repayment of 
principal with respect to the note on December 31, 2021. At the spot 
rates on October 1, 2021 (as defined in Sec. 1.987-1(c)(1)), without 
the use of a spot rate convention, Business A's [euro]75 purchase price 
translates into [pound]80 and $95. At the spot rates on December 31, 
2021, without the use of a spot rate convention, the [pound]100 
principal amount on the note translates into [euro]90 and $130, and 
[pound]80 translates into $104.
    (ii) The acquisition of the note is a section 988 transaction of 
Business A under paragraph (b)(4)(i) of this section, and the note is a 
historic asset under Sec. 1.987-1(e). To determine its section 987 
taxable income or loss with respect to Business A, U.S. Corp must 
determine Business A's total gain or loss on the disposition of the note 
in U.S. Corp's dollar functional currency. Consistent with Sec. 1.988-
2(b)(8), U.S. Corp also must determine whether some or all of that gain 
or loss constitutes section 987 gain or loss described in section 
988(b).
    (iii) To determine Business A's total gain or loss on the 
disposition of the note, Business A's basis and amount realized on the 
note must be determined in euros under Sec. 1.987-3(b), if necessary, 
and translated into dollars under Sec. 1.987-3(c). Business A has a 
[euro]75 basis in the note that is translated into $95 under Sec. 
1.987-3(c)(2)(i) at the historic rate described in Sec. 1.987-
1T(c)(3)(i)(E), which is the spot rate on the date the note was acquired 
without the use of a spot rate convention. Business A's [pound]100 
amount realized on the note is translated into [euro]90 under Sec. 
1.987-3(b)(2)(i) using the spot rate on December 31, 2021, without the 
use of a spot rate convention. That [euro]90 amount realized is then 
translated into $130 under paragraph (c)(2)(ii) of this section using 
the spot rate on December 31, 2021, without the use of a spot rate 
convention. Accordingly, the total gain with respect to the disposition 
of the note that is included in section 987 taxable income is $35 ($130 
less $95).
    (iv) U.S. Corp must determine whether some or all of the $35 total 
gain with respect to the note constitutes section 988 gain. The amount 
of section 988 gain realized with respect to the note is determined 
under Sec. 1.988-2(b)(5), which requires a comparison of the functional 
currency value of the principal amount of the note on the booking date 
and payment date spot rates, respectively, and defines the principal 
amount of the note as Business A's purchase price in units of 
nonfunctional currency, which is [pound]80. Under paragraph (b)(4)(i) of 
this section, section 988 gain or loss with respect to the note is 
determined by reference to U.S. Corp's dollar functional currency, such 
that the amounts required under section 988 to be translated on the 
booking date and payment date are translated into the dollars at the 
booking date and payment date spot rates. Accordingly, Business A's 
[pound]80 principal amount with respect to the note is translated at the 
booking date and payment date spots rates into $95 and $104, 
respectively. Thus, $9 ($104 less $95) of the $35 total gain taken into 
account by U.S. Corp as section 987 taxable income with respect to the 
note is section 988 gain. The remaining $26 of gain, which may be 
attributable to credit risk or another factor unrelated to currency 
fluctuations, is sourced and characterized without regard to section 
988.
    Example 12. The facts are the same as in Example 11, except that 
Business A is owned by a foreign corporation with a pound functional 
currency. Under paragraph (b)(4)(ii) of this section, the acquisition of 
the [pound]100 2-year note is a specified owner functional currency 
transaction that is not treated as a section 988 transaction of Business 
A. Because the note is a historic asset under Sec. 1.987-1(e), Business 
A's [euro]75 basis in the note translates into [pound]80 at the historic 
rate described in Sec. 1.987-1T(c)(3)(i)(E), which provides that the 
historic rate is the spot rate for the date the note was acquired 
without the use of a spot rate convention. (If, instead, Business A had 
purchased the 5-year note for [pound]80 rather than [euro]75, then 
pursuant to paragraph (b)(2)(ii) of this section, Business A's basis in 
the note would have been determined without translating the [pound]80 
purchase price because it is denominated in the owner's functional 
currency.) Under paragraph (b)(2)(ii) of this section, the [pound]100 
amount realized with respect to the note is not translated because it is 
denominated in the owner's functional currency. Thus, the owner takes 
into account [pound]20 ([pound]100 less [pound]80) of section 987 
taxable income in 2021 with respect to the note.
    Example 13. (i) Business A receives and accrues $100 of income from 
the provision of

[[Page 676]]

services on January 1, 2021. Business A continues to hold the $100 as a 
U.S. dollar-denominated demand deposit at a bank on December 31, 2021. 
U.S. Corp has elected under paragraph (b)(4)(iii)(C) of this section to 
use the foreign currency mark-to-market method of accounting for 
qualified short-term section 988 transactions entered into by Business 
A. The euro-dollar spot rate without the use of a spot rate convention 
is [euro]1 = $1 on January 1, 2021, and [euro]1 = $2 on December 31, 
2021, and the yearly average exchange rate for 2021 is [euro]1 = $1.50.
    (ii) Under Sec. 1.987-3(b)(2)(i), the $100 earned by Business A is 
translated into [euro]100 at the spot rate on January 1, 2021, as 
defined in Sec. 1.987-1(c)(1) without the use of a spot rate 
convention. In determining U.S. Corp's taxable income, the [euro]100 of 
service income is translated into $150 at the yearly average exchange 
rate for 2021, as provided in Sec. 1.987-3(c)(1).
    (iii) The $100 demand deposit constitutes a qualified short-term 
section 988 transaction under paragraph (b)(4)(iii)(B) of this section 
because the demand deposit is treated as nonfunctional currency within 
the meaning of section 988(c)(1)(C)(ii). Because Business A uses the 
foreign currency mark-to-market method of accounting for qualified 
short-term section 988 transactions, under paragraph (b)(4)(iii)(A) of 
this section, section 988 gain or loss for such transactions is 
determined in, and by reference to, euros, the functional currency of 
Business A. Accordingly, section 988 gain or loss must be determined on 
Business A's holding of the $100 demand deposit in, and by reference to, 
the euro. Under Sec. 1.988-2(a)(2), Business A is treated as having an 
amount realized of [euro]50 when the $100 is marked to market at the end 
of 2021 under paragraph (b)(4)(iii)(C) of this section. Marking the 
dollars to market gives rise to a section 988 loss of [euro]50 ([euro]50 
amount realized, less Business A's [euro]100 basis in the $100). In 
determining U.S. Corp's taxable income, that [euro]50 loss is translated 
into a $75 loss at the yearly average exchange rate for 2021, as 
provided in Sec. 1.987-3(c)(1).
    Example 14. (i) Facts. Business A earns [euro]100 of revenue from 
the provision of services and incurs [euro]30 of general expenses and 
[euro]10 of depreciation expense during 2021. Except as otherwise 
provided, U.S. Corp uses the yearly average exchange rate described in 
Sec. 1.987-1(c)(2) to translate items of income, gain, deduction, and 
loss of Business A. Business A is subject to income tax in Country X at 
a 25 percent rate. U.S. Corp claims a credit with respect to Business 
A's foreign income taxes and elects under section 986(a)(1)(D) to 
translate the foreign income taxes at the spot rate on the date the 
taxes were paid. The yearly average exchange rate for 2021 is [euro]1 = 
$1.50. The historic rate used to translate the depreciation expense is 
[euro]1 = $1.00. The spot rate on the date that Business A paid its 
foreign income taxes was [euro]1 = $1.60.
    (ii) Analysis. Because U.S. Corp has elected to translate foreign 
income taxes at the spot rate on the date such taxes were paid rather 
than at the yearly average exchange rate, U.S. Corp must make the 
adjustments described in paragraph (c)(2)(v) of this section. 
Accordingly, U.S. Corp determines its section 987 taxable income by 
reducing the section 987 taxable income or loss that otherwise would be 
determined under this section by [euro]15, translated into U.S. dollars 
at the yearly average exchange rate ([euro]1 = $1.50), and increasing 
the resulting amount by [euro]15, translated using the same exchange 
rate that is used to translate the creditable taxes into U.S. dollars 
under section 986(a) ([euro]1 = $1.60). Following these adjustments, 
Business A's section 987 taxable income for 2021 is $96.50, computed as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Amount in      Translation
                                                                      [euro]           rate         Amount in $
----------------------------------------------------------------------------------------------------------------
Revenue.........................................................       [euro]100       [euro]1 =         $150.00
                                                                                           $1.50
General Expenses................................................            (30)       [euro]1 =         (45.00)
                                                                                           $1.50
Depreciation....................................................            (10)       [euro]1 =         (10.00)
                                                                                           $1.00
                                                                 -----------------------------------------------
Tentative section 987 taxable income............................        [euro]60  ..............          $95.00
Adjustments under paragraph (c)(2)(v) of this section:
    Decrease by [euro]15 tax translated at yearly average         ..............  ..............        ($22.50)
     exchange rate ([euro]1 = $1.50)............................
    Increase by [euro]15 tax translated at spot rate on payment   ..............  ..............           24.00
     date ([euro]1 = $1.60).....................................
                                                                 -----------------------------------------------
Section 987 taxable income......................................  ..............  ..............          $96.50
----------------------------------------------------------------------------------------------------------------

    (f) Effective/applicability date. This section applies to taxable 
years beginning on or after one year after the first day of the first 
taxable year following December 7, 2016. Notwithstanding the preceding 
sentence, if a taxpayer makes an election under Sec. 1.987-11(b), then 
this section applies to taxable years to which Sec. Sec. 1.987-1 
through 1.987-10 apply as a result of such election.

[[Page 677]]

    (g) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9795, 81 FR 88870, Dec. 8, 2016]



Sec. 1.987-4  Determination of net unrecognized section 987 gain or 
loss of a section 987 QBU.

    (a) In general. The net unrecognized section 987 gain or loss of a 
section 987 QBU shall be determined by the owner annually as provided in 
paragraph (b) of this section in the owner's functional currency. Only 
assets and liabilities reflected on the books and records of the section 
987 QBU under Sec. 1.987-2(b) shall be taken into account.
    (b) Calculation of net unrecognized section 987 gain or loss. Net 
unrecognized section 987 gain or loss of a section 987 QBU for a taxable 
year shall equal the sum of:
    (1) The section 987 QBU's net accumulated unrecognized section 987 
gain or loss for all prior taxable years to which these regulations 
apply as determined in paragraph (c) of this section, and
    (2) The section 987 QBU's unrecognized section 987 gain or loss for 
the current taxable year as determined in paragraph (d) of this section.
    (c) Net accumulated unrecognized section 987 gain or loss for all 
prior taxable years--(1) In general. A section 987 QBU's net accumulated 
unrecognized section 987 gain or loss for all prior taxable years is the 
aggregate of the amounts determined under Sec. 1.987-4(d) for all prior 
taxable years to which these regulations apply, reduced by the amounts 
taken into account under Sec. 1.987-5 upon remittances for all such 
prior taxable years.
    (2) Coordination with Sec. 1.987-12. For purposes of paragraph 
(c)(1) of this section, amounts taken into account under Sec. 1.987-5 
are determined without regard to Sec. 1.987-12.
    (d) Calculation of unrecognized section 987 gain or loss for a 
taxable year. The unrecognized section 987 gain or loss of a section 987 
QBU for a taxable year shall be determined under paragraphs (d)(1) 
through (8) of this section.
    (1) Step 1: Determine the change in the owner functional currency 
net value of the section 987 QBU for the taxable year--(i) In general. 
The change in the owner functional currency net value of the section 987 
QBU for the taxable year shall equal--
    (A) The owner functional currency net value of the section 987 QBU, 
determined in the functional currency of the owner under paragraph (e) 
of this section, on the last day of the taxable year; less
    (B) The owner functional currency net value of the section 987 QBU, 
determined in the functional currency of the owner under paragraph (e) 
of this section, on the last day of the preceding taxable year. This 
amount shall be zero in the case of the section 987 QBU's first taxable 
year.
    (ii) Year section 987 QBU is terminated. If a section 987 QBU is 
terminated within the meaning of Sec. 1.987-8 during an owner's taxable 
year, the owner functional currency net value of the section 987 QBU as 
provided in paragraph (d)(1)(i)(A) of this section shall be determined 
on the date the section 987 QBU is terminated.
    (2) Step 2: Increase the amount determined in step 1 by the amount 
of assets transferred from the section 987 QBU to the owner--(i) In 
general. The amount determined in paragraph (d)(1) of this section shall 
be increased by the total amount of assets described in paragraph 
(d)(2)(ii) of this section transferred from the section 987 QBU to the 
owner during the taxable year translated into the owner's functional 
currency as provided in paragraph (d)(2)(ii) of this section.
    (ii) Assets transferred from the section 987 QBU to the owner during 
the taxable year. The assets transferred from the section 987 QBU to the 
owner for the taxable year shall equal the sum of:
    (A) The amount of the section 987 QBU's functional currency and the 
aggregate adjusted basis of all marked assets (as defined in Sec. 
1.987-1(d)), after taking into account Sec. 1.988-1(a)(10), transferred 
to the owner during the taxable year determined in the functional 
currency of the section 987 QBU and translated into the owner's 
functional currency at the spot rate (as defined in Sec. 1.987-1(c)(1)) 
applicable to the date of transfer; and
    (B) The aggregate adjusted basis of all historic assets (as defined 
in Sec. 1.987-1(e)), after taking into account Sec. 1.988-

[[Page 678]]

1(a)(10), transferred to the owner during the taxable year determined in 
the functional currency of the section 987 QBU and translated into the 
owner's functional currency at the historic rate for each such asset (as 
defined in Sec. 1.987-1(c)(3)).
    (3) Step 3: Decrease the amount determined in steps 1 and 2 by the 
amount of assets transferred from the owner to the section 987 QBU--(i) 
In general. The aggregate amount determined in paragraphs (d)(1) and 
(d)(2) of this section shall be decreased by the total amount of assets 
transferred from the owner to the section 987 QBU during the taxable 
year determined in the functional currency of the owner as provided in 
paragraph (d)(3)(ii) of this section.
    (ii) Total of all amounts transferred from the owner to the section 
987 QBU during the taxable year. The total amount of assets transferred 
from the owner to the section 987 QBU for the taxable year shall equal 
the aggregate of:
    (A) The total amount of functional currency of the owner transferred 
to the section 987 QBU during the taxable year; and
    (B) The adjusted basis, determined in the functional currency of the 
owner, of any asset transferred to the section 987 QBU during the 
taxable year (after taking into account Sec. 1.988-1(a)(10)).
    (4) Step 4: Decrease the amount determined in steps 1 through 3 by 
the amount of liabilities transferred from the section 987 QBU to the 
owner. The aggregate amount determined in paragraphs (d)(1) through (3) 
of this section shall be decreased by the aggregate amount of 
liabilities transferred from the section 987 QBU to the owner during the 
taxable year. The amount of such liabilities shall be translated into 
the functional currency of the owner at the spot rate (as defined in 
Sec. 1.987-1(c)(1)) applicable on the date of transfer.
    (5) Step 5: Increase the amount determined in steps 1 through 4 by 
the amount of liabilities transferred from the owner to the section 987 
QBU. The aggregate amount determined in paragraphs (d)(1) through (4) of 
this section shall be increased by the aggregate amount of liabilities 
transferred by the owner to the section 987 QBU during the taxable year. 
The amount of such liabilities shall be translated into the functional 
currency of the owner at the spot rate (as defined in Sec. 1.987-
1(c)(1)) applicable on the date of transfer.
    (6) Step 6: Decrease or increase the amount determined in steps 1 
through 5 by the section 987 taxable income or loss, respectively, of 
the section 987 QBU for the taxable year. The aggregate amount 
determined in paragraphs (d)(1) through (5) of this section shall be 
decreased or increased by the section 987 taxable income or loss, 
respectively, computed under Sec. 1.987-3 for the taxable year.
    (7) Step 7: Increase the amount determined in steps 1 through 6 by 
any expenses that are not deductible in computing the section 987 
taxable income or loss of the section 987 QBU for the taxable year. The 
aggregate amount determined under paragraphs (d)(1) through (6) shall be 
increased by the amount of any expense or loss attributable to a section 
987 QBU for the taxable year that is not deductible in computing the 
section 987 QBU's taxable income or loss for the year, including any 
foreign income taxes incurred by the section 987 QBU with respect to 
which the owner claims a credit (translated at the same rate at which 
such taxes were translated under section 986(a)).
    (8) Step 8: Decrease the amount determined in steps 1 through 7 by 
the amount of any tax-exempt income. The aggregate amount determined 
under paragraphs (d)(1) through (7) shall be decreased by the amount of 
any income or gain attributable to a section 987 QBU for the taxable 
year that is not included in computing the section 987 QBU's taxable 
income or loss for the year.
    (e) Determination of the owner functional currency net value of a 
section 987 QBU--(1) In general. The owner functional currency net value 
of a section 987 QBU on the last day of a taxable year shall equal the 
aggregate amount of functional currency and the adjusted basis of each 
asset on the section 987 QBU's balance sheet on that day, less the 
aggregate amount of each liability on the section 987 QBU's balance 
sheet on that day, in each case translated into the owner's functional 
currency as provided in paragraph (e)(2) of this section. Such amount 
shall be determined by:

[[Page 679]]

    (i) Preparing a balance sheet for the relevant date from the section 
987 QBU's books and records (within the meaning of Sec. 1.989(a)-1(d)), 
as recorded in the section 987 QBU's functional currency and showing all 
assets and liabilities reflected on such books and records as provided 
in Sec. 1.987-2(b);
    (ii) Making adjustments necessary to conform the items reflected on 
the balance sheet described in paragraph (e)(1)(i) of this section to 
United States tax accounting principles; and
    (iii) Translating the asset and liability amounts on the adjusted 
balance sheet described in paragraph (e)(1)(ii) of this section into the 
functional currency of the owner in accordance with paragraph (e)(2) of 
this section.
    (2) Translation of balance sheet items into the owner's functional 
currency. The amount of the section 987 QBU's functional currency, the 
basis of an asset, or the amount of a liability shall be translated as 
follows:
    (i) Marked item. A marked item (as defined in Sec. 1.987-1(d)) 
shall be translated into the owner's functional currency at the spot 
rate (as defined in Sec. 1.987-1(c)(1)) applicable to the last day of 
the relevant taxable year.
    (ii) Historic item. A historic item (as defined in Sec. 1.987-1(e)) 
shall be translated into the owner's functional currency at the historic 
rate (as defined in Sec. 1.987-1(c)(3)).
    (f) Combinations and separations--(1) Combinations. The net 
unrecognized section 987 gain or loss of a combined QBU (as defined in 
Sec. 1.987-2(c)(9)(i)) for a taxable year is determined under paragraph 
(b) of this section by taking into account the net accumulated 
unrecognized section 987 gain or loss of each combining QBU (as defined 
in Sec. 1.987-2(c)(9)(i)) for all prior taxable years to which the 
regulations under section 987 apply, as determined under paragraph (c) 
of this section, and by treating the combining QBUs as having combined 
immediately prior to the beginning of the taxable year of combination. 
See paragraph (f)(3) of this section, Example 1, for an illustration of 
this rule.
    (2) Separations. The net unrecognized section 987 gain or loss of a 
separated QBU (as defined in Sec. 1.987-2(c)(9)(iii)) for a taxable 
year is determined under paragraph (b) of this section by taking into 
account the separated QBU's share of the net accumulated unrecognized 
section 987 gain or loss of the separating QBU (as defined in Sec. 
1.987-2(c)(9)(iii)) for all prior taxable years to which the regulations 
under section 987 apply, as determined under paragraph (c) of this 
section, and by treating the separating QBU as having separated 
immediately prior to the beginning of the taxable year of separation. A 
separated QBU's share of the separating QBU's net accumulated 
unrecognized section 987 gain or loss for all such prior taxable years 
is determined by apportioning the separating QBU's net accumulated 
unrecognized section 987 gain or loss for all such prior taxable years 
to each separated QBU in proportion to the aggregate adjusted basis of 
the gross assets properly reflected on the books and records of each 
separated QBU immediately after the separation. For purposes of 
determining the owner functional currency net value of the separated 
QBUs on the last day of the taxable year preceding the taxable year of 
separation under paragraphs (d)(1)(B) and (e) of this section, the 
balance sheets of the separated QBUs on that day will be deemed to 
reflect the assets and liabilities reflected on the balance sheet of the 
separating QBU on that day, apportioned between the separated QBUs in a 
reasonable manner that takes into account the assets and liabilities 
reflected on the balance sheets of the separated QBUs immediately after 
the separation. See paragraph (f)(3) of this section, Example 2, for an 
illustration of this rule.
    (3) Examples. The following examples illustrate the rules of 
paragraphs (f)(1) and (2) of this section.
    (i) Example 1. Combination of two section 987 QBUs that have the 
same owner--(A) Facts. DC1, a domestic corporation, owns Entity A, a DE. 
Entity A conducts a business in France that constitutes a section 987 
QBU (French QBU) that has the euro as its functional currency. French 
QBU has a net accumulated unrecognized section 987 loss from all prior 
taxable years to which the regulations under section 987 apply of $100. 
DC1 also owns Entity B, a DE. Entity B conducts a business in Germany 
that constitutes a section 987

[[Page 680]]

QBU (German QBU) that has the euro as its functional currency. German 
QBU has a net accumulated unrecognized section 987 gain from all prior 
taxable years to which the regulations under section 987 apply of $110. 
During the taxable year, Entity A and Entity B merge under local law. As 
a result, the books and records of French QBU and German QBU are 
combined into a new single set of books and records. The combined entity 
has the euro as its functional currency.
    (B) Analysis. Pursuant to Sec. 1.987-2(c)(9)(i), French QBU and 
German QBU are combining QBUs, and their combination does not give rise 
to a transfer that is taken into account in determining the amount of a 
remittance (as defined in Sec. 1.987-5(c)). For purposes of computing 
net unrecognized section 987 gain or loss under this section for the 
year of the combination, the combination is deemed to have occurred on 
the last day of the owner's prior taxable year, such that the owner 
functional currency net value of the combined section 987 QBU at the end 
of that taxable year described under paragraph (d)(1)(B) of this section 
takes into account items reflected on the balance sheets of both French 
QBU and German QBU at that time. Additionally, any transactions between 
French QBU and German QBU occurring during the year of the merger will 
not result in transfers to or from a section 987 QBU. Pursuant to 
paragraph (f)(1) of this section, the combined QBU will have a net 
accumulated unrecognized section 987 gain from all prior taxable years 
of $10 (the $100 loss from French QBU plus the $110 gain from German 
QBU).
    (ii) Example 2. Separation of two section 987 QBUs that have the 
same owner--(A) Facts. DC1, a domestic corporation, owns Entity A, a DE. 
Entity A conducts a business in the Netherlands that constitutes a 
section 987 QBU (Dutch QBU) that has the euro as its functional 
currency. The business of Dutch QBU consists of manufacturing and 
selling bicycles and scooters and is recorded on a single set of books 
and records. On the last day of Year 1, the adjusted basis of the gross 
assets of Dutch QBU is [euro]1,000. In Year 2, the net accumulated 
unrecognized section 987 loss of Dutch QBU from all prior taxable years 
is $200. During Year 2, Entity A separates the bicycle and scooter 
business such that each business begins to have its own books and 
records and to meet the definition of a section 987 QBU under Sec. 
1.987-1(b)(2) (hereafter, ``bicycle QBU'' and ``scooter QBU''). There 
are no transfers between DC1 and Dutch QBU before the separation. After 
the separation, the aggregate adjusted basis of bicycle QBU's assets is 
[euro]600 and the aggregate adjusted basis of scooter QBU's assets is 
[euro]400. Each section 987 QBU continues to have the euro as its 
functional currency.
    (B) Analysis. Pursuant to Sec. 1.987-2(c)(9)(iii), bicycle QBU and 
scooter QBU are separated QBUs, and the separation of Dutch QBU, a 
separating QBU, does not give rise to a transfer taken into account in 
determining the amount of a remittance (as defined in Sec. 1.987-5(c)). 
For purposes of computing net unrecognized section 987 gain or loss 
under this section for Year 2, the separation will be deemed to have 
occurred on the last day of the owner's prior taxable year, Year 1. 
Pursuant to paragraph (f)(2) of this section, bicycle QBU will have a 
net accumulated unrecognized section 987 loss of $120 ([euro]600/
[euro]1,000 x $200), and scooter QBU will have a net accumulated 
unrecognized section 987 loss of $80 ([euro]400/[euro]1,000 x $200).
    (g) Examples. The following examples illustrate the provisions of 
this section. For purposes of the examples, U.S. Corp is a domestic 
corporation that uses the calendar year as its taxable year and has the 
dollar as its functional currency. Except as otherwise indicated, U.S. 
Corp elects under Sec. 1.987-3(c)(2)(iv)(B) to use the historic 
inventory method with respect to all of its section 987 QBUs but does 
not make other elections under section 987. Exchange rate and tax 
accounting (for example, depreciation rate) assumptions used in these 
examples are selected for the purpose of illustrating the principles of 
this section, and no inference is intended by their use. Additionally, 
the examples are not intended to demonstrate when activities constitute 
a trade or business within the meaning of Sec. 1.989(a)-1(b)(2)(ii)(A) 
and Sec. 1.989(a)-1(c) and therefore whether a section 987 QBU is 
onsidered to exist.


[[Page 681]]


    Example 1. (i) On July 1, 2021, U.S. Corp establishes Japan Branch, 
a section 987 QBU of U.S. Corp that has the yen as its functional 
currency, and transfers to Japan Branch $1,000 and raw land with a basis 
of $500. Japan Branch immediately exchanges the $1,000 for [yen]100,000. 
On the same day, Japan Branch borrows [yen]10,000. For the taxable year 
2021, Japan Branch earns [yen]2,000 per month (total of [yen]12,000 for 
the six-month period from July 1, 2021, through December 31, 2021) for 
providing services and incurs [yen]333.33 per month (total of [yen]2,000 
when rounded for the six-month period from July 1, 2021, through 
December 31, 2021) of related expenses. Assume that the spot rate on 
July 1, 2021, is $1 = [yen]100; the spot rate on December 31, 2021, is 
$1 = [yen]120; and the average rate for the period of July 1, 2021, to 
December 31, 2021, is $1 = [yen]110. Thus, the [yen]12,000 of services 
revenue when properly translated under Sec. 1.987-3(c)(1) at the yearly 
average exchange rate equals $109.09 ([yen]12,000 x ($1/[yen]110)) = 
$109.09). The [yen]2,000 of expenses translated at the same yearly 
average exchange rate equals $18.18 ([yen]2,000 x ($1/[yen]110) = 
$18.18). Thus, Japan Branch's net income translated into dollars equals 
$90.91 ($109.09 - $18.18 = $90.91).
    (ii) Under paragraph (a) of this section, U.S. Corp must compute the 
net unrecognized section 987 gain or loss of Japan Branch for 2021. 
Because this is Japan Branch's first taxable year, the net unrecognized 
section 987 gain or loss (as defined under paragraph (b) of this 
section) is the branch's unrecognized section 987 gain or loss for 2021 
as determined in paragraph (d) of this section. The calculation under 
paragraph (d) of this section is made as follows:
    (iii) Step 1. Under paragraph (d)(1) of this section, U.S. Corp must 
determine the change in the owner functional currency net value (OFCNV) 
of Japan Branch for 2021 in dollars. The change in the OFCNV of Japan 
Branch for 2021 is equal to the OFCNV of Japan Branch determined in 
dollars on the last day of 2021, less the OFCNV of Japan Branch 
determined in dollars on the last day of the preceding taxable year.
    (A) The OFCNV of Japan Branch determined in dollars on the last day 
of the current taxable year is determined under paragraph (e) of this 
section as the sum of the basis of each asset on Japan Branch's balance 
sheet on December 31, 2021, less the sum of each liability on Japan 
Branch's balance sheet on that date, translated into dollars as provided 
in paragraph (e)(2) of this section.
    (B) For this purpose, Japan Branch will show the following assets 
and liabilities on its balance sheet for December 31, 2021:
    (1) [yen]120,000;
    (2) Raw land with a basis of [yen]55,000 ($500 translated under 
Sec. 1.987-2(d)(2) at the historic rate of $1 = [yen]110); and
    (3) Liabilities of [yen]10,000.
    (C) Under paragraph (e)(2) of this section, U.S. Corp will translate 
these items as follows. The [yen]120,000 is a marked asset and the 
[yen]10,000 liability is a marked liability (as each is defined in Sec. 
1.987-1(d)). These items are translated into dollars on December 31, 
2021, using the spot rate on December 31, 2021, of $1 = [yen]120. The 
raw land is a historic asset (as defined in Sec. 1.987-1(e)) and is 
translated into dollars under paragraph (e)(2)(ii) of this section at 
the historic rate, which under Sec. 1.987-1(c)(3)(1)(A) is the yearly 
average exchange rate of $1 = [yen]110 applicable to the year the land 
was transferred to the QBU. Thus, the OFCNV of Japan Branch on December 
31, 2021, in dollars is $1,416.67 determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                         [yen]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Yen....................................         120,000  $1 = [yen]120 (spot rate--12/31/21)       $1,000.00
    Land...................................          55,000  1 = [yen]110 (yearly average rate--          500.00
                                                              2021).
                                            --------------------------------------------------------------------
        Total assets.......................  ..............  ...................................        1,500.00
Liabilities:
    Bank Loan..............................          10,000  1 = [yen]120 (spot rate--12/31/21).           83.33
                                            --------------------------------------------------------------------
        Total liabilities..................  ..............  ...................................           83.33
2021 ending OFCNV..........................  ..............  ...................................        1,416.67
----------------------------------------------------------------------------------------------------------------

    (D) Under paragraph (d)(1) of this section, the change in OFCNV of 
Japan Branch for 2021 is equal to the OFCNV of the branch determined in 
dollars on December 31, 2021, ($1,416.67) less the OFCNV of the branch 
determined in dollars on the last day of the preceding taxable year. 
Because this is the first taxable year of Japan Branch, the OFCNV of 
Japan Branch determined in dollars on the last day of the preceding 
taxable year is zero under paragraph (d)(1)(i)(B) of this section. 
Accordingly, the change in OFCNV of Japan Branch for 2021 is $1,416.67.
    (iv) Step 2. Under paragraph (d)(2) of this section, the aggregate 
amount determined in paragraph (d)(1) of this section (step 1) is 
increased by the total amount of assets described in paragraph 
(d)(2)(ii) of this section transferred from the section 987 QBU to the 
owner during the taxable year translated into the owner's functional 
currency as provided in paragraph (d)(2)(ii) of this section. Because no 
such amounts were transferred,

[[Page 682]]

there is no change in the $1,416.67 determined in step 1.
    (v) Step 3. Under paragraph (d)(3) of this section, the aggregate 
amount determined in paragraphs (d)(1) and (d)(2) of this section (steps 
1 and 2) is decreased by the total amount of assets transferred from the 
owner to the section 987 QBU during the taxable year as determined in 
paragraph (d)(3)(ii) of this section in dollars. On July 1, 2021, U.S. 
Corp transferred to Japan Branch $1,000.00 (which Japan Branch 
immediately converted into [yen]100,000) and raw land with a basis of 
$500.00 (equal to [yen]55,000, translated under Sec. 1.987-2(d)(2) at 
the historic rate of $1 = [yen]110). Thus, the $1,416.67 determined 
under steps 1 and 2 is reduced by $1,500.00, resulting in ($83.33).
    (vi) Steps 4 and 5. Because no liabilities were transferred by U.S. 
Corp to Japan Branch or by Japan Branch to U.S. Corp during the taxable 
year, the aggregate amount determined in paragraph (d)(3) of this 
section (Step 3) is not increased or decreased.
    (vii) Step 6. Under paragraph (d)(6) of this section, the aggregate 
amount determined after applying paragraphs (d)(1) through (5) of this 
section (steps 1 through 5) is decreased by the section 987 taxable 
income of Japan Branch of $90.91 from ($83.33) to ($174.24).
    (viii) Steps 7 and 8. Paragraphs (d)(7) and (d)(8) do not apply 
because Japan Branch does not have any tax-exempt or nondeductible 
items. Accordingly, the unrecognized section 987 loss of Japan Branch 
for 2021 is ($174.24), the amount determined after applying step 6.
    Example 2. (i) U.S. Corp operates in the United Kingdom through U.K. 
Branch, a section 987 QBU of U.S. Corp that has the pound as its 
functional currency. U.S. Corp properly elects under Sec. 1.987-
1(c)(1)(ii) for U.K. Branch to use a spot rate convention (when 
permitted). Under the chosen convention, the spot rate (the ``convention 
rate'') for any transaction occurring during a month is the average of 
the pound spot rate and the 30-day forward rate for pounds on the next-
to-last Thursday of the preceding month. The yearly average exchange 
rate was [pound]1 = $0.90 for 2020, [pound]1 = $1.00 for 2021, and 
[pound]1 = $1.10 for 2022. The closing balance sheet of U.K. Branch in 
2021 reflected the following assets:
    (A) [pound]100;
    (B) A sales office purchased in 2020 with an adjusted basis of 
[pound]1,000;
    (C) A delivery truck purchased in 2020 with an adjusted basis of 
[pound]200;
    (D) Inventory of 100 units purchased in 2021 with a basis of 
[pound]100; and
    (E) Stock in ABC Corporation purchased in 2021 with a basis of 
[pound]150, representing less than 10 percent of the total voting power 
and value of all classes of stock of ABC Corporation.
    The closing balance sheet of U.K. Branch for 2021 reflected one 
liability, [pound]50 of long-term debt entered into in 2020 with F Bank, 
an unrelated bank.
    The office, truck, stock, and inventory are historic assets (as 
defined in Sec. 1.987-1(e)). The [pound]100 and long-term debt are 
marked items (as defined in Sec. 1.987-1(d)). Assume that U.S. Corp 
translated U.K. Branch's 2021 closing balance sheet as follows:

----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [pound]               Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Pounds.................................          100.00  [pound]1 = $1.05 (convention rate--          105.00
                                                              Dec. 2021).
    Office.................................        1,000.00  [pound]1 = $0.90 (historic rate--            900.00
                                                              2020).
    Truck..................................          200.00  [pound]1 = $0.90 (historic rate--            180.00
                                                              2020).
    Stock..................................           50.00  [pound]1 = $1.00 (historic rate--            150.00
                                                              2021).
    Inventory..............................          100.00  [pound]1 = $1.00 (historic rate--            100.00
                                                              2021).
                                            --------------------------------------------------------------------
        Total assets.......................  ..............  ...................................        1,435.00
Liabilities:
    Bank Loan..............................           50.00  [pound]1 = $1.05 (convention rate--           52.50
                                                              Dec. 2021).
                                            --------------------------------------------------------------------
        Total liabilities..................  ..............  ...................................           52.50
2021 ending OFCNV..........................  ..............  ...................................        1,382.50
----------------------------------------------------------------------------------------------------------------

    (ii) U.K. Branch uses the first-in, first-out (FIFO) method of 
accounting for inventory. In 2022, U.K. Branch sold 100 units of 
inventory for a total of [pound]300 and purchased another 100 units of 
inventory for [pound]100. There is depreciation of [pound]33 with 
respect to the office and [pound]40 with respect to the truck, and U.K. 
Branch incurred [pound]30 of business expenses during 2022. Neither the 
depreciation nor the business expenses are inventoriable costs. All 
items of income earned and expenses incurred during 2022 are received 
and paid, respectively, in pounds. Under Sec. 1.987-3, U.K. Branch's 
section 987 taxable income or loss is determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                Amount in
                    Item                         [pound]               Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
Gross receipts.............................          300.00  [pound]1 = $1.10 (yearly average             330.00
                                                              rate--2022).
Less:

[[Page 683]]

 
    COGS...................................        (100.00)  [pound]1 = $1.00 (historic rate--          (100.00)
                                                              2021).
                                            --------------------------------------------------------------------
        Gross income.......................  ..............  ...................................          230.00
Dep:
    Office.................................         (33.00)  [pound]1 = $0.90 (historic rate--           (29.70)
                                                              2020).
    Truck..................................         (40.00)  [pound]1 = $0.90 (historic rate--           (36.00)
                                                              2020).
Other expenses.............................         (30.00)  [pound]1 = $1.10 (yearly average            (33.00)
                                                              rate--2022).
                                            --------------------------------------------------------------------
        Total expenses.....................  ..............  ...................................         (98.70)
Section 987 taxable income.................  ..............  ...................................          131.30
----------------------------------------------------------------------------------------------------------------

    Accordingly, U.K. Branch has $131.30 of section 987 taxable income 
in 2022.
    (iii) In December 2022, U.K. Branch transferred [pound]30 to U.S. 
Corp, and U.S. Corp transferred a computer with a basis of $10 to U.K. 
Branch. U.S. Corp's net accumulated unrecognized section 987 gain or 
loss for all prior taxable years as determined in paragraph (c) of this 
section is $30.
    (iv) The unrecognized section 987 gain or loss of U.K. Branch for 
2022 is determined as follows:
    (A) Step 1. Under paragraph (d)(1) of this section, the change in 
OFCNV for the taxable year must be determined. This amount is equal to 
the OFCNV of U.K. Branch determined under paragraph (e) of this section 
on the last day of 2022, less the OFCNV of U.K. Branch determined on the 
last day of 2021. The OFCNV of U.K. Branch on December 31, 2022, and the 
change in OFCNV for 2022, are determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [pound]               Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Pounds.................................          240.00  [pound]1 = $1.15 (convention rate--          276.00
                                                              Dec. 2022).
    Office.................................          967.00  1 = $0.90 (historic rate--2020)....          870.30
    Truck..................................          160.00  [pound]1 = $0.90 (historic rate--            144.00
                                                              2020).
    Inventory..............................          100.00  [pound]1 = $1.10 (historic rate--            110.00
                                                              2022).
    Computer...............................            9.09  [pound]1 = $1.10 (historic rate--             10.00
                                                              2022).
    Stock..................................          150.00  [pound]1 = $1.00 (historic rate--            150.00
                                                              2021).
                                            --------------------------------------------------------------------
        Total assets.......................  ..............  ...................................        1,560.30
Liabilities:
    Bank Loan..............................           50.00  [pound]1 = $1.15 (convention rate--           57.50
                                                              Dec. 2022).
                                            --------------------------------------------------------------------
        Total liabilities..................  ..............  ...................................           57.50
2022 ending OFCNV..........................  ..............  ...................................        1,502.80
Less:
    2021 ending OFCNV......................  ..............  ...................................      (1,382.50)
                                            --------------------------------------------------------------------
        Change in OFCNV....................  ..............  ...................................          120.30
----------------------------------------------------------------------------------------------------------------

    (B) Step 2. Under paragraph (d)(2) of this section, the aggregate 
amount determined in step 1 must be increased by the total amount of 
assets described in paragraph (d)(2)(ii) of this section transferred 
from U.K. Branch to U.S. Corp during the taxable year, translated into 
U.S. Corp's functional currency as provided in paragraph (d)(2)(ii) of 
this section. The amount of assets transferred from U.K. Branch to U.S. 
Corp during 2022 is determined as follows:

----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Asset                         [pound]               Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
[pound]30..................................           30.00  [pound]1 = $1.15 (convention rate--           34.50
                                                              Dec. 2022).
----------------------------------------------------------------------------------------------------------------

    (C) Step 3: Decrease the aggregate amount described in steps 1 and 2 
by the owner's transfers to the section 987 QBU. Under paragraph (d)(3) 
of this section, the aggregate amount determined in steps 1 and 2 must 
be decreased by the total amount of all assets transferred from U.S. 
Corp to U.K. Branch during the taxable year as determined in paragraph 
(d)(3)(ii) of this section. The amount of assets transferred from U.S. 
Corp to U.K. Branch during 2022 is determined as follows:

[[Page 684]]



----------------------------------------------------------------------------------------------------------------
                   Asset                                                                            Amount in $
----------------------------------------------------------------------------------------------------------------
Computer...................................  ..............  ...................................           10.00
----------------------------------------------------------------------------------------------------------------

    (D) Step 4. Under paragraph (d)(4) of this section, the aggregate 
amount determined in steps 1 through 3 must be decreased by the 
aggregate amount of liabilities transferred by U.K. Branch to U.S. Corp. 
Under these facts, such amount is $0.
    (E) Step 5. Under paragraph (d)(5) of this section, the aggregate 
amount determined in steps 1 through 4 must be increased by the 
aggregate amount of liabilities transferred by U.S. Corp to U.K. Branch. 
Under these facts, such amount is $0.
    (F) Step 6. Under paragraph (d)(6) of this section, the aggregate 
amount determined in steps 1 through 5 is decreased or increased, 
respectively, by any section 987 taxable income or loss of U.K. Branch 
computed under Sec. 1.987-3 for the taxable year. The amount of U.K. 
Branch's taxable income, as determined above, is $131.30.
    (G) [Reserved]
    (H) Steps 7 and 8: Paragraphs (d)(7) and (d)(8) do not apply because 
U.K. Branch does not have any tax-exempt income or nondeductible 
expense.
    (v) Summary. Taking steps 1 through 8 into account, the amount of 
U.S. Corp's unrecognized section 987 gain or loss with respect to U.K. 
Branch in 2022 is computed as follows:

------------------------------------------------------------------------
                  Step                      Amount in $       Balance
------------------------------------------------------------------------
1.......................................        + 120.30         $120.30
2.......................................         + 34.50          154.80
3.......................................         - 10.00          144.80
4.......................................             - 0          144.80
5.......................................             + 0          144.80
6.......................................        - 131.30           13.50
7.......................................             + 0           13.50
8.......................................             - 0           13.50
------------------------------------------------------------------------

    Thus, U.S. Corp's unrecognized section 987 gain for 2022 with 
respect to U.K. Branch is $13.50. As of the end of 2022, before taking 
into account the recognition of any section 987 gain or loss under Sec. 
1.987-5, U.S. Corp's net unrecognized section 987 gain is $43.50 (that 
is, $30.00 accumulated from prior years, plus $13.50 in 2022).
    Example 3. (i) Background. U.S. Corp is the owner of Business A, a 
section 987 QBU that has the euro as its functional currency. Business A 
uses the FIFO method to account for inventory and uses the simplified 
inventory method described in Sec. 1.987-3(c)(2)(iv)(A). On the last 
day of 2020, U.S. Corp begins Business A by contributing to Business A a 
building with a basis of $780, a machine with a basis of $300, and $100. 
On January 1, 2021, Business A converts the $100 into [euro]100. The tax 
basis of the building and machine is translated into euros using the 
historic rate, which is the yearly average exchange rate for 2020, the 
year of the transfer. Accordingly, the building and the machine have a 
tax basis of [euro]780 and [euro]300, respectively, on December 31, 
2020. The building and machine have annual depreciation of [euro]20 and 
[euro]30, respectively. Business A determines that 50 percent of the 
building depreciation should be allocated to the cost of goods 
manufactured (that is, treated as an inventoriable cost) and 50 percent 
should be allocated to selling, general and administrative (SG&A) 
expenses. The machine is used exclusively to manufacture inventory. 
Relevant exchange rates for purposes of this example are as follows:

------------------------------------------------------------------------
                                          Yearly average    December 31
                  Year                     exchange rate     spot rate
------------------------------------------------------------------------
2020....................................       [euro]1 =       [euro]1 =
                                                   $1.00           $1.00
2021....................................       [euro]1 =       [euro]1 =
                                                   $1.50           $2.00
2022....................................       [euro]1 =       [euro]1 =
                                                   $2.50           $3.00
------------------------------------------------------------------------

    (ii) Operations in 2021. During 2021, Business A recognizes 
[euro]140 of revenue from sales of finished goods. The related COGS is 
[euro]70. Business A pays [euro]10 in salaries allocable to SG&A. 
Inventoriable costs in 2021 include [euro]10 of depreciation on the 
building and [euro]30 of depreciation on the machine. Business A's 
balance sheet on December 31, 2021, shows no liabilities and the 
following assets: currency of [euro]160, the building with an adjusted 
basis of [euro]760, the machine with an adjusted basis of [euro]270, and 
ending inventory with a FIFO cost basis of [euro]40, comprising raw 
materials and finished goods.
    (A) Determination of income. Under the simplified inventory method, 
Business A's income for 2021 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Amount in
                     Item                           [euro]              Translation rate            Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue.................................             140  [euro]1 = $1.50 (yearly avg.                 210
                                                                 rate--2021).
COGS before adjustments.......................              70  [euro]1 = $1.50 (yearly avg.                 105
                                                                 rate--2021).
    Adjustment for cost recovery deductions     ..............  ................................            (20)
     (see calculation below).
    Adjustment for beginning inventory (none).  ..............  ................................               0
                                               -----------------------------------------------------------------
        Adjusted COGS.........................  ..............  ................................              85

[[Page 685]]

 
SG&A:
    Depreciation on building (50%)............              10  [euro]1 = $1.00 (historic rate--              10
                                                                 2020).
    Salaries..................................              10  [euro]1 = $1.50 (yearly avg.                  15
                                                                 rate--2021).
                                               -----------------------------------------------------------------
        Total SG&A............................  ..............  ................................              25
Section 987 net income (revenue less COGS and   ..............  ................................             100
 SG&A).
----------------------------------------------------------------------------------------------------------------

    COGS Adjustments.
    Adjustment for cost recovery deductions included in inventoriable 
costs.

----------------------------------------------------------------------------------------------------------------
                                                                                                    Adjustment
                                                                    2021 yearly    Difference in   (depreciation
               Depreciation amount                 Historic rate     avg. rate      translation     x change in
                                                                                       rates          rates)
----------------------------------------------------------------------------------------------------------------
[euro]10 (building).............................            1.00            1.50          (0.50)            ($5)
[euro]30 (machine)..............................            1.00            1.50          (0.50)            (15)
                                                 ---------------------------------------------------------------
    Total adjustment for cost recovery            ..............  ..............  ..............            (20)
     deductions.................................
----------------------------------------------------------------------------------------------------------------

    (B) Determination of OFCNV for 2020 and 2021.
    Under the simplified inventory method, the OFCNV of Business A for 
2020 and 2021 is determined under paragraph (e) of this section as 
follows:

                                               OFCNV--End of 2021
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Euros..................................             160  [euro]1 = $2.00 (year-end spot                  320
                                                              rate--2021).
    Building...............................             760  [euro]1 = $1.00 (historic rate--                760
                                                              2020).
    Machine................................             270  [euro]1 = $1.00 (historic rate--                270
                                                              2020).
    Inventory..............................              40  [euro]1 = $1.50 (yearly average                  60
                                                              rate--2021).
                                            --------------------------------------------------------------------
        Total assets.......................  ..............  ...................................           1,410
Liabilities:
        Total liabilities..................  ..............  ...................................               0
2021 ending OFCNV..........................  ..............  ...................................           1,410
----------------------------------------------------------------------------------------------------------------


                                               OFCNV--End of 2020
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Euros..................................             100  [euro]1 = $1.00 (year-end spot                  100
                                                              rate--2020).
    Building...............................             780  [euro]1 = $1.00 (historic rate--                780
                                                              2020).
    Machine................................             300  [euro]1 = $1.00 (historic rate--                300
                                                              2020).
                                            --------------------------------------------------------------------
        Total assets.......................  ..............  ...................................           1,180
Liabilities:
        Total liabilities..................  ..............  ...................................               0
2020 ending OFCNV..........................  ..............  ...................................           1,180
----------------------------------------------------------------------------------------------------------------

    (C) Determination of net unrecognized section 987 gain or loss. The 
net unrecognized section 987 gain or loss of Business A is determined 
under paragraph (d) of this section as follows (relevant steps only):
    (1) Step 1. Under paragraph (d)(1) of this section, the change in 
OFCNV for the taxable year must be determined. This amount is equal to 
the OFCNV of Business A determined under paragraph (e) of this section 
on the last day of 2021, less the OFCNV of Business A determined on the 
last day of 2020.

2021 ending OFCNV.......................................          $1,410
Less: 2020 ending OFCNV.................................         (1,180)
                                                         ---------------
    Change in OFCNV.....................................             230
 

    (2) Step 6. Under paragraph (d)(6) of this section, the aggregate 
amount determined in steps 1 through 5 must be decreased by the

[[Page 686]]

section 987 taxable income of Business A. The amount of Business A's 
taxable income for 2021, as determined above, is $100.

Change in OFCNV.........................................            $230
Less: section 987 taxable income........................           (100)
                                                         ---------------
    Unrecognized section 987 gain.......................             130
Plus: Net accumulated unrecognized section 987 gain or                 0
 loss from prior years..................................
                                                         ---------------
    Net unrecognized section 987 gain...................             130
 

    (iii) Operations in 2022. During 2022, Business A recognizes 
[euro]180 of revenue from sales of finished goods. The related COGS is 
[euro]96. Business A pays [euro]10 in salaries allocable to SG&A. 
Inventoriable costs in 2022 include [euro]30 of depreciation on the 
machine and [euro]10 of depreciation on the building. Business A's 
balance sheet on December 31, 2022, shows no liabilities and the 
following assets: currency of [euro]260, the building with an adjusted 
basis of [euro]740, the machine with an adjusted basis of [euro]240, and 
ending inventory with a FIFO cost basis of [euro]54, comprising raw 
materials and finished goods.
    (A) Determination of income. Under the simplified inventory method, 
Business A's income for 2022 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Amount in
                     Item                           [euro]              Translation rate            Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue.................................             180  [euro]1 = $2.50 (yearly avg.                 450
                                                                 rate--2022).
COGS before adjustments.......................              96  [euro]1 = $2.50 (yearly avg.                 240
                                                                 rate--2022).
    Adjustment for cost recovery deductions     ..............  ................................            (60)
     (see calculation below).
    Adjustment for beginning inventory (see     ..............  ................................            (40)
     calculation below).
                                               -----------------------------------------------------------------
        Adjusted COGS.........................  ..............  ................................             140
SG&A:
    Depreciation on building (50%)............              10  [euro]1 = $1.00 (historic rate--              10
                                                                 2020).
    Salaries..................................              10  [euro]1 = $2.50 (yearly avg.                  25
                                                                 rate--2022).
                                               -----------------------------------------------------------------
        Total SG&A............................  ..............  ................................              35
Section 987 net income (revenue less COGS and   ..............  ................................             275
 SG&A).
----------------------------------------------------------------------------------------------------------------

    COGS Adjustments.
    Adjustment for cost recovery deductions.

----------------------------------------------------------------------------------------------------------------
                                                                                                    Adjustment
                                                                    2022 yearly    Difference in   (depreciation
               Depreciation amount                 Historic rate     avg. rate      translation     x change in
                                                                                       rates          rates)
----------------------------------------------------------------------------------------------------------------
[euro]10 (building).............................            1.00            2.50          (1.50)           ($15)
[euro]30 (machine)..............................            1.00            2.50          (1.50)            (45)
                                                 ---------------------------------------------------------------
    Total adjustment for cost recovery            ..............  ..............  ..............            (60)
     deductions.................................
----------------------------------------------------------------------------------------------------------------

    Adjustment for beginning inventory.

----------------------------------------------------------------------------------------------------------------
                                                                                                    Adjustment
                                                    2021 yearly     2022 yearly    Difference in   (inventory x
           Prior year ending inventory               avg. rate       avg. rate      translation      change in
                                                                                       rates          rates)
----------------------------------------------------------------------------------------------------------------
[euro]40........................................            1.50            2.50          (1.00)           ($40)
                                                 ---------------------------------------------------------------
    Total adjustment for beginning inventory....  ..............  ..............  ..............            (40)
----------------------------------------------------------------------------------------------------------------

    (B) Determination of OFCNV. Under the simplified inventory method, 
the OFCNV of Business A for 2022 is determined under paragraph (e) of 
this section as follows:

[[Page 687]]



                                               OFCNV--End of 2022
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
    Euros..................................             260  [euro]1 = $3.00 (year-end spot                  780
                                                              rate--2022).
    Building...............................             740  [euro]1 = $1.00 (historic rate--                740
                                                              2020).
    Machine................................             240  [euro]1 = $1.00 (historic rate--                240
                                                              2020).
    Inventory..............................              54  [euro]1 = $2.50 (yearly average                 135
                                                              rate--2022).
                                            --------------------------------------------------------------------
        Total assets.......................  ..............  ...................................           1,895
Liabilities:
        Total liabilities..................  ..............  ...................................               0
2022 ending OFCNV..........................  ..............  ...................................           1,895
----------------------------------------------------------------------------------------------------------------

    (C) Determination of net unrecognized section 987 gain or loss. The 
net unrecognized section 987 gain of Business A is determined under 
paragraph (d) of this section as follows (relevant steps only):
    (1) Step 1. Under paragraph (d)(1) of this section, the change in 
OFCNV for the taxable year must be determined. This amount is equal to 
the OFCNV of Business A determined under paragraph (e) of this section 
on the last day of 2022, less the OFCNV of Business A determined on the 
last day of 2021.

2022 ending OFCNV.......................................          $1,895
Less: 2021 ending OFCNV.................................         (1,410)
                                                         ---------------
    Change in OFCNV.....................................             485
 

    (2) Step 6. Under paragraph (d)(6) of this section, the aggregate 
amount determined in steps 1 through 5 must be decreased by the section 
987 taxable income of Business A. The amount of Business A's taxable 
income for 2022, as determined above, is $275.

Change in OFCNV.........................................            $485
Less: Section 987 taxable income........................           (275)
                                                         ---------------
    Unrecognized section 987 gain 2022..................             210
Plus: Net accumulated unrecognized section 987 gain from             130
 prior year.............................................
                                                         ---------------
    Net unrecognized section 987 gain...................             340
 

    Example 4. (i) Background. The background facts about Business A are 
the same as in Example 3, except that Business A uses the dollar-value 
LIFO method to account for inventory.
    (ii) Operations in 2021. The facts about Business A's operations in 
2021 are the same as in Example 3.
    (A) Determination of income. Under the simplified inventory method, 
Business A's income for 2021 is computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Amount in
                     Item                           [euro]              Translation rate            Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue.................................             140  [euro]1 = $1.50 (yearly avg.                 210
                                                                 rate--2021).
COGS before adjustments.......................              70  [euro]1 = $1.50 (yearly avg.                 105
                                                                 rate--2021).
    Adjustment for cost recovery deductions     ..............  ................................            (20)
     (same as Example 1).
    Adjustment for LIFO liquidation (none)....  ..............  ................................               0
                                               -----------------------------------------------------------------
        Adjusted COGS.........................  ..............  ................................              85
SG&A:
    Depreciation on building (50%)............              10  [euro]1 = $1.00 (historic rate--              10
                                                                 2020).
    Salaries..................................              10  [euro]1 = $1.50 (yearly avg.                  15
                                                                 rate--2021).
                                               -----------------------------------------------------------------
        Total SG&A............................  ..............  ................................              25
Section 987 net income (revenue less COGS and   ..............  ................................             100
 SG&A).
----------------------------------------------------------------------------------------------------------------

    (B) Determination of OFCNV for 2020 and 2021. Under the simplified 
inventory method, the OFCNV of Business A for 2020 and 2021 is 
determined under paragraph (e) of this section as follows:

                                               OFCNV--End of 2021
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
Euros......................................             160  [euro]1 = $2.00 (year-end spot                  320
                                                              rate--2021).
Building...................................             760  [euro]1 = $1.00 (historic rate--                760
                                                              2020).

[[Page 688]]

 
Machine....................................             270  [euro]1 = $1.00 (historic rate--                270
                                                              2020).
Inventory..................................              40  [euro]1 = $1.50 (historic rate--                 60
                                                              2021).
                                            --------------------------------------------------------------------
    Total assets...........................  ..............  ...................................           1,410
Liabilities:
    Total liabilities......................  ..............  ...................................               0
2021 ending OFCNV..........................  ..............  ...................................           1,410
----------------------------------------------------------------------------------------------------------------


                                               OFCNV--End of 2020
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
Euros......................................             100  [euro]1 = $1.00 (year-end spot                  100
                                                              rate--2020).
Building...................................             780  [euro]1 = $1.00 (historic rate--                780
                                                              2020).
Machine....................................             300  [euro]1 = $1.00 (historic rate--                300
                                                              2020).
                                            --------------------------------------------------------------------
    Total assets...........................  ..............  ...................................           1,180
Liabilities:
    Total liabilities......................  ..............  ...................................               0
2020 ending OFCNV..........................  ..............  ...................................           1,180
----------------------------------------------------------------------------------------------------------------

    (C) Determination of net unrecognized section 987 gain or loss. The 
net unrecognized section 987 gain or loss of Business A for 2021 is 
determined under paragraph (d) of this section as follows (relevant 
steps only):
    (1) Step 1. Under paragraph (d)(1) of this section, the change in 
OFCNV for the taxable year must be determined. This amount is equal to 
the OFCNV of Business A determined under paragraph (e) of this section 
on the last day of 2021, less the OFCNV of Business A determined on the 
last day of 2020.

2021 ending OFCNV.......................................          $1,410
Less: 2020 ending OFCNV.................................         (1,180)
                                                         ---------------
    Change in OFCNV.....................................           (230)
 

    (2) Step 6. Under paragraph (d)(6) of this section, the aggregate 
amount determined in steps 1 through 5 must be decreased by the section 
987 taxable income of Business A. The amount of Business A's taxable 
income for 2021, as determined above, is $100.

Change in OFCNV.........................................            $230
Less: section 987 taxable income........................           (100)
                                                         ---------------
    Unrecognized section 987 gain.......................             130
Plus: Net accumulated unrecognized section 987 gain or                 0
 loss from prior years..................................
                                                         ---------------
    Net unrecognized section 987 gain...................             130
 

    (iii) Operations in 2022. The facts about Business A's operations in 
2022 are the same as in Example 3, except that due to Business A's 
dollar-value LIFO method of inventory accounting, Business A's balance 
sheet on December 31, 2022, reflects a 2021 layer of inventory with a 
LIFO cost basis of [euro]40 and a 2022 layer of inventory with a LIFO 
cost basis of [euro]10.80, and Business A's COGS is [euro]99.20.
    (A) Determination of income. Business A's income for 2022 is 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Amount in
                     Item                           [euro]              Translation rate            Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue.................................             180  [euro]1 = $2.50 (yearly avg.                 450
                                                                 rate--2022).
COGS before adjustments.......................           99.20  [euro]1 = $2.50 (yearly avg.                 248
                                                                 rate--2022).
    Adjustment for cost recovery deductions     ..............  ................................            (60)
     (same as Example 3).
    Adjustment for LIFO liquidation (none)....  ..............  ................................               0
                                               -----------------------------------------------------------------
        Adjusted COGS.........................  ..............  ................................             188
SG&A:
    Depreciation on building (50%)............              10  [euro]1 = $1.00 (historic rate--              10
                                                                 2020).
    Salaries..................................              10  [euro]1 = $2.50 (yearly avg.                  25
                                                                 rate--2022).
                                               -----------------------------------------------------------------
        Total SG&A............................  ..............  ................................              35
Section 987 net income (revenue less COGS and   ..............  ................................             227
 SG&A).
----------------------------------------------------------------------------------------------------------------


[[Page 689]]


                                               OFCNV--End of 2022
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
Euros......................................          260.00  [euro]1 = $3.00 (year-end spot                  780
                                                              rate--2022).
Building...................................          740.00  [euro]1 = $1.00 (historic rate--                740
                                                              2020).
Machine....................................          240.00  [euro]1 = $1.00 (historic rate--                240
                                                              2020).
Inventory..................................           10.80  [euro]1 = $2.50 (historic rate--                 27
                                                              2022).
                                                      40.00  [euro]1 = $1.50 (historic rate--                 60
                                                              2021).
                                            --------------------------------------------------------------------
    Total assets...........................  ..............  ...................................           1,847
Liabilities:
    Total liabilities......................  ..............  ...................................               0
2022 ending OFCNV..........................  ..............  ...................................           1,847
----------------------------------------------------------------------------------------------------------------

    (B) Determination of net unrecognized section 987 gain or loss. The 
net unrecognized section 987 gain of Business A for 2022 is determined 
under paragraph (d) of this section as follows (relevant steps only):
    (1) Step 1. Under paragraph (d)(1) of this section, the change in 
OFCNV for the taxable year must be determined. This amount is equal to 
the OFCNV of Business A determined under paragraph (e) of this section 
on the last day of 2022, less the OFCNV of Business A determined on the 
last day of 2021.

2022 ending OFCNV.......................................          $1,847
Less: 2021 ending OFCNV.................................         (1,410)
                                                         ---------------
    Change in OFCNV.....................................             437
 

    (2) Step 6--Decrease the aggregate amount determined in steps 1 
through 5 by the section 987 taxable income of the section 987 QBU for 
the taxable year. Under paragraph (d)(6) of this section, the aggregate 
amount determined in steps 1 through 5 must be decreased by the section 
987 taxable income of Business A. The amount of Business A's taxable 
income for 2022, as determined above, is $227.

Change in OFCNV.........................................            $437
Less: section 987 taxable income........................           (227)
                                                         ---------------
    Unrecognized section 987 gain 2022..................             210
Plus: net accumulated unrecognized section 987 gain from             130
 prior years............................................
                                                         ---------------
    Net unrecognized section 987 gain...................             340
 

    (iv) Operations in 2023. During 2023, Business A recognizes revenue 
of [euro]252 from sales of finished goods. The related COGS is 
[euro]140.80, reflecting a full liquidation of the 2022 inventory layer 
with a LIFO cost basis of $10.80 and a partial liquidation of inventory 
from the 2021 layer with a LIFO cost basis of $10.00. Business A pays 
[euro]10 in salaries allocable to SG&A. Inventoriable costs in 2023 
include [euro]10 of depreciation on the building and [euro]30 of 
depreciation on the machine. Business A's balance sheet on December 31, 
2023, shows no liabilities and the following assets: currency of 
[euro]422, the building with an adjusted basis of [euro]720, the machine 
with an adjusted basis of [euro]210, and a 2021 layer of ending 
inventory with a LIFO cost basis of [euro]30, comprising raw materials 
and finished goods. The yearly average exchange rate for 2023 is [euro]1 
= $3.50, and the spot rate on December 31, 2023 is [euro]1 = $4.00.
    (A) Determination of income. Business A's income for 2023 is 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Amount in
                     Item                           [euro]              Translation rate            Amount in $
----------------------------------------------------------------------------------------------------------------
Sales revenue.................................             252  [euro]1 = $3.50 (yearly avg.                 882
                                                                 rate--2023).
COGS before adjustments.......................          140.80  [euro]1 = $3.50 (yearly avg.              492.80
                                                                 rate--2023).
    Adjustment for cost recovery deductions     ..............  ................................        (100.00)
     (see calculation below).
    Adjustment for LIFO liquidation (see        ..............  ................................         (30.80)
     calculation below).
                                               -----------------------------------------------------------------
        Adjusted COGS.........................  ..............  ................................          362.00
SG&A:
    Depreciation on building (50%)............              10  [euro]1 = $1.00 (historic rate--              10
                                                                 2020).
    Salaries..................................              10  [euro]1 = $3.50 (yearly avg.                  35
                                                                 rate--2023).
                                               -----------------------------------------------------------------
        Total SG&A............................  ..............  ................................              45
Section 987 net income........................  ..............  ................................             475
----------------------------------------------------------------------------------------------------------------


[[Page 690]]

    COGS Adjustments.
    Adjustment for cost recovery deductions.

----------------------------------------------------------------------------------------------------------------
                                                                                                    Adjustment
                                                                    2023 yearly    Difference in   (depreciation
               Depreciation amount                 Historic rate     avg. rate      translation     x change in
                                                                                       rates          rates)
----------------------------------------------------------------------------------------------------------------
[euro]10 (building).............................            1.00            3.50          (2.50)           ($25)
[euro]30 (machine)..............................            1.00            3.50          (2.50)            (75)
                                                 ---------------------------------------------------------------
    Total adjustment for cost recovery            ..............  ..............  ..............           (100)
     deductions.................................
----------------------------------------------------------------------------------------------------------------

    Adjustment for LIFO liquidation.

----------------------------------------------------------------------------------------------------------------
                                                                                                    Adjustment
                                                                    2023 yearly    Difference in    (liquidated
             LIFO liquidation layer                Historic rate     avg. rate      translation   layer x change
                                                                                       rates         in rates)
----------------------------------------------------------------------------------------------------------------
[euro]10.80 (2022)..............................            2.50            3.50          (1.00)        ($10.80)
[euro]10 (2021).................................            1.50            3.50          (2.00)         (20.00)
                                                 ---------------------------------------------------------------
    Total adjustment for liquidation of LIFO      ..............  ..............  ..............         (30.80)
     layers.....................................
----------------------------------------------------------------------------------------------------------------

    (B) Determination of OFCNV. The OFCNV of Business A for 2023 is 
determined under paragraph (e) of this section as follows:

                                               OFCNV--End of 2023
----------------------------------------------------------------------------------------------------------------
                                                Amount in
                   Assets                        [euro]                Translation rate             Amount in $
----------------------------------------------------------------------------------------------------------------
Euros......................................             422  [euro]1 = $4.00 (year-end spot                1,688
                                                              rate--2023).
Building...................................             720  [euro]1 = $1.00 (historic rate--                720
                                                              2020).
Machine....................................             210  [euro]1 = $1.00 (historic rate--                210
                                                              2020).
Inventory..................................              30  [euro]1 = $1.50 (historic rate--                 45
                                                              2021).
                                            --------------------------------------------------------------------
    Total assets...........................  ..............  ...................................           2,663
Liabilities:
    Total liabilities......................  ..............  ...................................               0
2023 ending OFCNV..........................  ..............  ...................................           2,663
----------------------------------------------------------------------------------------------------------------

    (C) Determination of net unrecognized section 987 gain or loss. The 
net unrecognized section 987 gain of Business A is determined under 
paragraph (d) of this section as follows (relevant steps only):
    (1) Step 1. Under paragraph (d)(1) of this section, the change in 
OFCNV for the taxable year must be determined. This amount is equal to 
the OFCNV of Business A determined under paragraph (e) of this section 
on the last day of 2023, less the OFCNV of Business A determined on the 
last day of 2022.

2023 ending OFCNV.......................................          $2,663
Less: 2022 ending OFCNV.................................         (1,847)
                                                         ---------------
Change in OFCNV.........................................             816
 

    (2) Step 6--Decrease the aggregate amount determined in steps 1 
through 5 by the section 987 taxable income of the section 987 QBU for 
the taxable year. Under paragraph (d)(6) of this section, the aggregate 
amount determined in steps 1 through 5 must be decreased by the section 
987 taxable income of Business A. The amount of Business A's taxable 
income for 2023, as determined above, is $475.

Change in OFCNV.........................................            $816
Less: section 987 taxable income........................           (475)
                                                         ---------------
    Unrecognized section 987 gain 2023..................             341
Plus: net accumulated unrecognized section 987 gain from             340
 prior years............................................
                                                         ---------------
    Net unrecognized section 987 gain...................             681
 

    (h) Effective/applicability date--(1) In general. Except as set 
forth in paragraph (h)(2) of this section, this section is applicable as 
specified in Sec. 1.987-11.

[[Page 691]]

    (2) Combinations and separations. Paragraphs (c)(2) and (f) of this 
section apply to taxable years beginning on or after the day that is 
three years after the first day of the first taxable year following 
December 7, 2016. Notwithstanding the preceding sentence, if a taxpayer 
makes an election under Sec. 1.987-11(b), then paragraphs (c)(2) and 
(f) of this section applies to taxable years to which Sec. Sec. 1.987-1 
through 1.987-10 apply as a result of such election.

[T.D. 9794, 81 FR 88821, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88873, Dec. 8, 2016; T.D. 9857, 84 FR 20795, May 13, 2019; 84 FR 31194, 
July 1, 2019]



Sec. 1.987-5  Recognition of section 987 gain or loss.

    (a) Recognition of section 987 gain or loss by the owner of a 
section 987 QBU. The taxable income of an owner of a section 987 QBU 
shall include the owner's section 987 gain or loss recognized with 
respect to the section 987 QBU for the taxable year. Except as otherwise 
provided, for any taxable year the owner's section 987 gain or loss 
recognized with respect to a section 987 QBU shall equal:
    (1) The owner's net unrecognized section 987 gain or loss with 
respect to the section 987 QBU determined under Sec. 1.987-4 on the 
last day of such taxable year (or, if earlier, on the day the section 
987 QBU is terminated under Sec. 1.987-8); multiplied by
    (2) The owner's remittance proportion for the taxable year, as 
determined under paragraph (b) of this section.
    (b) Remittance proportion. The owner's remittance proportion with 
respect to a section 987 QBU for a taxable year shall equal:
    (1) The remittance, as determined under paragraph (c) of this 
section, to the owner from the section 987 QBU for such taxable year; 
divided by
    (2) The sum of
    (A) The aggregate adjusted basis of the gross assets of the section 
987 QBU as of the end of the taxable year that are reflected on its 
year-end balance sheet translated into the owner's functional currency 
as provided in Sec. 1.987-4(e)(2) and
    (B) The amount of the remittance as determined under paragraph (c) 
of this section.
    (c) Remittance--(1) Definition. A remittance shall be determined in 
the owner's functional currency and shall equal the excess, if any, of:
    (i) The aggregate of all amounts transferred from the section 987 
QBU to the owner during the taxable year, as determined in paragraph (d) 
of this section; over
    (ii) The aggregate of all amounts transferred from the owner to the 
section 987 QBU during the taxable year, as determined in paragraph (e) 
of this section.
    (2) Day when a remittance is determined. An owner's remittance from 
a section 987 QBU shall be determined on the last day of the owner's 
taxable year (or, if earlier, on the day the section 987 QBU is 
terminated under Sec. 1.987-8).
    (3) Termination. A termination of a section 987 QBU as determined 
under Sec. 1.987-8 is treated as a remittance of all the gross assets 
of the section 987 QBU to the owner on the date of such termination. See 
Sec. 1.987-8(e). Accordingly, the remittance proportion in the case of 
a termination is 1.
    (d) Aggregate of all amounts transferred from the section 987 QBU to 
the owner for the taxable year. For purposes of paragraph (c)(1)(i) of 
this section, the aggregate amount transferred from the section 987 QBU 
to the owner for the taxable year shall be the aggregate amount of 
functional currency and the aggregate adjusted basis of the assets 
transferred, as determined in the owner's functional currency under 
Sec. 1.987-4(d)(2). Solely for this purpose, the amount of liabilities 
transferred from the owner to the section 987 QBU, as determined in the 
owner's functional currency under Sec. 1.987-4(d)(5), shall be treated 
as a transfer of assets from the section 987 QBU to the owner in an 
amount equal to the amount of such liabilities.
    (e) Aggregate of all amounts transferred from the owner to the 
section 987 QBU for the taxable year. For purposes of paragraph 
(c)(1)(ii) of this section, the aggregate of all amounts transferred 
from the owner to the section 987 QBU for the taxable year shall be the 
aggregate amount of functional currency

[[Page 692]]

and the aggregate adjusted basis of the assets transferred, as 
determined in the owner's functional currency under Sec. 1.987-4(d)(3). 
Solely for this purpose, the amount of liabilities transferred from the 
section 987 QBU to the owner determined under Sec. 1.987-4(d)(4) shall 
be treated as a transfer of assets from the owner to the section 987 QBU 
in an amount equal to the amount of such liabilities.
    (f) Determination of owner's adjusted basis in transferred assets--
(1) In general. The owner's adjusted basis in an asset received in a 
transfer from a section 987 QBU (whether or not such transfer is made in 
connection with a remittance, as defined in paragraph (c) of this 
section) shall be determined in the owner's functional currency under 
the rules prescribed in paragraphs (f)(2) and (f)(3) of this section.
    (2) Marked asset. The basis of a marked asset shall be the amount 
determined by translating the section 987 QBU's functional currency 
basis of the asset, after taking into account Sec. 1.988-1(a)(10), into 
the owner's functional currency at the spot rate (as defined in Sec. 
1.987-1(c)(1)) applicable to the date of transfer.
    (3) Historic asset. The basis of a historic asset shall be the 
amount determined by translating the section 987 QBU's functional 
currency basis of the asset, after taking into account Sec. 1.988-
1(a)(10), into the owner's functional currency at the historic rate for 
the asset (as defined in Sec. 1.987-1(c)(3)).
    (g) Example. The following example illustrates the calculation of 
section 987 gain or loss under this section:

    Example. (i) U.S. Corp, a domestic corporation with the dollar as 
its functional currency, operates in the United Kingdom through Business 
A, a section 987 QBU with the pound as its functional currency. During 
2021, the following transfers took place between U.S. Corp and Business 
A. On January 5, 2021, U.S. Corp transferred to Business A $300, which 
Business A used during the year to purchase services. On March 5, 2021, 
Business A transferred a machine to U.S. Corp. The pound adjusted basis 
of the machine when properly translated into dollars as described under 
Sec. 1.987-4(d)(2)(ii)(B) and paragraph (d) of this section is $500. On 
November 1, 2021, Business A transferred pounds to U.S. Corp. The dollar 
amount of the pounds when properly translated as described under Sec. 
1.987-4(d)(2)(ii)(A) and paragraph (d) of this section is $2,300. On 
December 7, 2021, U.S. Corp transferred a truck to Business A with an 
adjusted basis of $2,000.
    (ii) At the end of 2021, Business A holds assets, properly 
translated into the owner's functional currency pursuant to Sec. 1.987-
4(e)(2), consisting of a computer with a pound adjusted basis equivalent 
to $500, a truck with a pound adjusted basis equivalent to $2,000, and 
pounds equivalent to $2,850. In addition, Business A has a pound 
liability entered into in 2020 with Bank A. All such assets and 
liabilities are reflected on the books and records of Business A. Assume 
that the net unrecognized section 987 gain for Business A as determined 
under Sec. 1.987-4 as of the last day of 2021 is $80.
    (iii) U.S. Corp's section 987 gain with respect to Business A is 
determined as follows:
    (A) Computation of amount of remittance. Under paragraphs (c)(1) and 
(c)(2) of this section, U.S. Corp must determine the amount of the 
remittance for 2021 in the owner's functional currency (dollars) on the 
last day of 2021. The amount of the remittance for 2021 is $500, 
determined as follows:
    Transfers from Business A to U.S. Corp in dollars:

Machine.................................................            $500
Pounds..................................................           2,300
                                                         ---------------
    Aggregate transfers from Business A to U.S. Corp....           2,800
 

    Transfers from U.S. Corp to Business A in dollars:

U.S. dollars............................................            $300
Truck...................................................           2,000
                                                         ---------------
    Aggregate transfers from U.S. Corp to Business A....           2,300
 

    Computation of amount of remittance:

Aggregate transfers from Business A to U.S. Corp........          $2,800
Less: aggregate transfers from U.S. Corp to Business A..         (2,300)
                                                         ---------------
    Total remittance....................................             500
 

    (B) Computation of section 987 QBU gross assets plus remittance. 
Under paragraph (b)(2) of this section, Business A must determine the 
aggregate basis of its gross assets that are reflected on its year-end 
balance sheet translated into the owner's functional currency and must 
increase this amount by the amount of the remittance.

Computer................................................            $500
Pounds..................................................           2,850

[[Page 693]]

 
Truck...................................................           2,000
                                                         ---------------
    Aggregate gross assets..............................           5,350
    Remittance..........................................             500
    Aggregate basis of Business A's gross assets at end            5,850
     of 2021, increased by amount of remittance.........
 

    (C) Computation of remittance proportion. Under paragraph (b) of 
this section, Business A must compute the remittance proportion by 
dividing the $500 remittance amount by the $5,850 sum of the aggregate 
basis of Business A's gross assets and the amount of the remittance. The 
resulting remittance proportion is 0.085.
    (D) Computation of section 987 gain or loss. The amount of U.S. 
Corp's section 987 gain or loss that must be recognized with respect to 
Business A is determined under paragraph (a) of this section by 
multiplying the 0.085 remittance proportion by the $80 of net 
unrecognized section 987 gain. U.S. Corp's resulting recognized section 
987 gain for 2021 is $6.80.

[T.D. 9794, 81 FR 88821, Dec. 8, 2016]



Sec. 1.987-6  Character and source of section 987 gain or loss.

    (a) Ordinary income or loss. Section 987 gain or loss is ordinary 
income or loss for Federal income tax purposes.
    (b) Character and source of section 987 gain or loss--(1) In 
general. With respect to each section 987 QBU, the owner must determine 
the character and source of section 987 gain or loss in the year of a 
remittance under the rules of this paragraph (b) for all purposes of the 
Internal Revenue Code, including sections 904(d), 907, and 954.
    (2) Method required to characterize and source section 987 gain or 
loss. The owner must use the asset method set forth in Sec. 1.861-9T(g) 
to characterize and source section 987 gain or loss. In applying the 
asset method, the owner must take into account only the assets of the 
section 987 QBU and must consistently determine the value of the assets 
on the basis of either the tax book value or the fair market value of 
the assets. The modified gross income method described in Sec. 1.861-
9T(j) cannot be used.
    (3) Coordination with section 954. Solely for purposes of 
determining the excess of foreign currency gains over foreign currency 
losses characterized as foreign personal holding company income under 
section 954(c)(1)(D), section 987 gain or loss that is characterized 
pursuant to paragraph (b)(2) of this section by reference to assets that 
give rise to subpart F income shall be treated as foreign currency gain 
or foreign currency loss attributable to section 988 transactions not 
directly related to the business needs of the controlled foreign 
corporation.
    (4) [Reserved] For further guidance, see Sec. 1.987-6T(b)(4).
    (c) Examples. The following examples illustrate the application of 
this section.

    Example 1. CFC is a controlled foreign corporation as defined in 
section 957 with the Swiss franc (Sf) as its functional currency. CFC is 
the owner of Business A, a section 987 QBU that has the euro as its 
functional currency. For the year 2021, CFC recognizes section 987 gain 
of Sf10,000 under Sec. 1.987-5. Applying the rules of this section, 
Business A has average total assets of Sf1,000,000, which generate 
income as follows: Sf750,000 of assets that generate foreign source 
general limitation income under section 904(d)(1)(A), none of which is 
subpart F income under section 952; and Sf250,000 of assets that 
generate foreign source passive income under section 904(d)(1)(B), all 
of which is subpart F income. Under paragraph (b) of this section, 
Sf7,500 (Sf750,000/Sf1,000,000 x Sf10,000) of the section 987 gain will 
be characterized as foreign source general limitation income that is not 
subpart F income under section 952, and Sf2,500 (Sf250,000/Sf1,000,000 x 
Sf10,000) will be characterized as foreign source passive income that is 
characterized as foreign personal holding company income under section 
954(c)(1)(D). All of the section 987 gain is treated as ordinary income.
    Example 2. The facts are the same as in Example 1 except that: (a) 
CFC recognizes section 987 loss of Sf40,000, Sf10,000 of which is 
characterized under paragraph (b) of this section by reference to assets 
that give rise to subpart F income; and (b) CFC otherwise has Sf12,000 
of net foreign currency gain determined under Sec. 1.954-2(g) that is 
taken into account in determining the excess of foreign currency gain 
over foreign currency losses characterized as foreign personal holding 
company income under section 954(c)(1)(D). Under paragraph (b)(3) of 
this section, the Sf10,000 section 987 loss characterized by reference 
to assets that give rise to subpart F income is treated as foreign 
currency loss attributable to section 988 transactions not directly 
related to the business needs of the controlled foreign corporation for 
purposes of determining the excess of foreign currency

[[Page 694]]

gains over foreign currency losses characterized as foreign personal 
holding company income under section 954(c)(1)(D). Accordingly, CFC will 
aggregate the Sf10,000 section 987 loss with the Sf12,000 net foreign 
currency gain and will have Sf2,000 of net foreign currency gain 
characterized as foreign personal holding company income under section 
954(c)(1)(D).

[T.D. 9794, 81 FR 88845, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88874, Dec. 8, 2016]



Sec. 1.987-6T  Character and source of section 987 gain or loss 
(temporary).

    (a) through (b)(3) [Reserved] For further guidance, see Sec. 1.987-
6(a) through (b)(3).
    (4) Source of section 987 gain or loss with respect to a dollar QBU. 
The source of section 987 gain or loss with respect to a dollar QBU (as 
defined in Sec. 1.987-1T(b)(6)(i)) for which the CFC owner has elected 
under Sec. 1.987-1T(b)(6)(iii) to apply section 987 is determined by 
reference to the residence of the CFC owner. This paragraph (b)(4) 
applies to any CFC that has made the election under Sec. 1.987-
1T(b)(6)(iii), including a CFC described in Sec. 1.987-1(b)(1)(ii).
    (c) [Reserved] For further guidance, see Sec. 1.987-6(c).
    (d) Effective/applicability date. This section applies to taxable 
years beginning on or after one year after the first day of the first 
taxable year following December 7, 2016. Notwithstanding the preceding 
sentence, if a taxpayer makes an election under Sec. 1.987-11(b), then 
this section applies to taxable years to which Sec. Sec. 1.987-1 
through 1.987-10 apply as a result of such election.
    (e) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9795, 81 FR 88874, Dec. 8, 2016]



Sec. 1.987-7  Section 987 aggregate partnerships.

    (a) In general. This section provides rules for determining an 
owner's share of the assets and liabilities of an eligible QBU that is 
owned indirectly, as described in Sec. 1.987-1(b)(4)(ii), through a 
section 987 aggregate partnership.
    (b) [Reserved]
    (c) Coordination with subchapter K. [Reserved]

[T.D. 9794, 81 FR 88845, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88874, Dec. 8, 2016; T.D. 9857, 84 FR 20796, May 13, 2019]



Sec. 1.987-8  Termination of a section 987 QBU.

    (a) Scope. This section provides rules regarding the termination of 
a section 987 QBU. Paragraph (b) of this section provides general rules 
for determining when a termination occurs. Paragraph (c) of this section 
provides exceptions to the general termination rules for certain 
transactions described in section 381(a). Paragraph (e) of this section 
describes certain effects of terminations. Paragraph (f) of this section 
contains examples that illustrate the principles of this section.
    (b) In general. Except as provided in paragraph (c) of this section, 
a section 987 QBU terminates if the conditions described in one of 
paragraphs (b)(1) through (4) is satisfied.
    (1) Trade or business ceases. A section 987 QBU ceases its trade or 
business. When a section 987 QBU ceases its trade or business is 
determined based on all the facts and circumstances, provided that an 
owner may continue to treat a section 987 QBU as a section 987 QBU for a 
reasonable period during the winding up of such trade or business, which 
period may in no event exceed two years from the date on which such QBU 
ceases its activities carried on for profit.
    (2) Substantially all assets transferred. The section 987 QBU 
transfers substantially all (within the meaning of section 368(a)(1)(C)) 
of its assets to its owner. For purposes of this paragraph (b)(2), the 
amount of assets transferred from the section 987 QBU to its owner as a 
result of a transaction shall be reduced by the amount of assets 
transferred from the owner to the section 987 QBU pursuant to the same 
transaction. See Examples 2, 5, and 6 in paragraph (f) of this section.
    (3) Owner no longer a CFC. A foreign corporation that is a 
controlled foreign corporation (as defined in section 957) that is the 
owner of a section 987 QBU ceases to be a controlled foreign corporation 
as a result of a transaction or

[[Page 695]]

series of transactions after which persons that were related to the 
corporation within the meaning of section 267(b) immediately before the 
transaction or series of transactions collectively own sufficient 
interests in the corporation such that the corporation would continue to 
be considered a controlled foreign corporation if such persons were 
United States shareholders within the meaning of section 951(b).
    (4) Owner ceases to exist. The owner of the section 987 QBU ceases 
to exist (including in connection with a transaction described in 
section 381(a)).
    (c) Transactions described in section 381(a)--(1) Liquidations. 
Notwithstanding paragraph (b) of this section, a termination does not 
occur when the owner of a section 987 QBU ceases to exist in a 
liquidation described in section 332, except in the following cases:
    (i) The distributor is a domestic corporation and the distributee is 
a foreign corporation.
    (ii) The distributor is a foreign corporation and the distributee is 
a domestic corporation.
    (iii) The distributor and the distributee are both foreign 
corporations and the functional currency of the distributee is the same 
as the functional currency of the distributor's section 987 QBU.
    (2) Reorganizations. Notwithstanding paragraph (b) of this section, 
a termination does not occur when the owner of the section 987 QBU 
ceases to exist in a reorganization described in section 381(a)(2), 
except in the following cases:
    (i) The transferor is a domestic corporation and the acquiring 
corporation is a foreign corporation.
    (ii) The transferor is a foreign corporation and the acquiring 
corporation is a domestic corporation.
    (iii) The transferor is a controlled foreign corporation immediately 
before the transfer, the acquiring corporation is a foreign corporation 
that is not a controlled foreign corporation immediately after the 
transfer, and the acquiring corporation was related to the transferor 
within the meaning of section 267(b) immediately before the transfer.
    (iv) The transferor and the acquiring corporation are foreign 
corporations and the functional currency of the acquiring corporation is 
the same as the functional currency of the transferor's section 987 QBU.
    (d) [Reserved] For further guidance, see Sec. 1.987-8T(d).
    (e) Effect of terminations. A termination of a section 987 QBU as 
determined in this section is treated as a remittance of all the gross 
assets of the section 987 QBU to its owner immediately before the 
section 987 QBU terminates. Thus, except as otherwise provided in these 
regulations under section 987, a termination results in the recognition 
of any net unrecognized section 987 gain or loss of the section 987 QBU. 
See Sec. 1.987-5(c)(3).
    (f) Examples. The following examples illustrate the principles of 
this section. Except as otherwise provided, U.S. Corp is a domestic 
corporation that has the U.S. dollar as its functional currency, and 
Business A is a section 987 QBU.

    Example 1. Cessation of operations. (i) Facts. U.S. Corp is the 
owner of Business A, a sales office of U.S. Corp in Country X. Business 
A ceases sales activities on December 31, 2021. During 2022, Business A 
sells all of the assets used in its sales activities and winds up its 
business, settling outstanding accounts.
    (ii) Analysis. Business A's trade or business ceases on December 31, 
2021. The cessation of Business A's trade or business causes a 
termination of the Business A section 987 QBU under paragraph (b)(1) of 
this section on December 31, 2021, unless U.S. Corp chooses to continue 
to treat Business A as a section 987 QBU until completion of the wind-up 
activities in 2022. If U.S. Corp chooses to continue to treat Business A 
as a section 987 QBU during the wind-up of Business A, Business A 
section 987 QBU would terminate under paragraph (b)(1) of this section 
upon completion of the wind-up in 2022.
    Example 2. Transfer of a section 987 QBU to a member of a 
consolidated group. (i) Facts. U.S. Corp, the owner of Business A, 
transfers all the assets and liabilities of Business A to DS, a domestic 
corporation all of the stock of which is owned by U.S. Corp, in a 
transaction qualifying under section 351. U.S. Corp and DS are members 
of the same consolidated group.
    (ii) Analysis. Pursuant to Sec. 1.987-2(c)(2)(i) and (ii), as a 
result of the deemed exchange of the assets and liabilities of Business 
A for DS stock in a section 351 transaction, Business A is treated as 
transferring its assets and liabilities to U.S. Corp immediately before 
the transfer by U.S. Corp of the assets and liabilities to DS. Because a 
section 351 transaction is not a transaction described in

[[Page 696]]

section 381(a), the transfer of all of the assets of Business A to U.S. 
Corp causes a termination of the Business A section 987 QBU under 
paragraph (b)(2) of this section.
    Example 3. Cessation of controlled foreign corporation status. (i) 
Facts. Foreign parent (FP) is a foreign corporation that owns all the 
stock of U.S. Corp, a domestic corporation. U.S. Corp owns all of the 
stock of FC, a controlled foreign corporation as defined in section 957. 
FC is the owner of Business A. FP contributes cash to FC in exchange for 
FC stock representing 60 percent of the voting power and value of all FC 
stock. FC no longer constitutes a controlled foreign corporation after 
the capital contribution.
    (ii) Analysis. Because FC ceases to qualify as a controlled foreign 
corporation as a result of a transaction after which persons that were 
related to FC within the meaning of section 267(b) immediately before 
the transaction collectively own sufficient interests in FC such that 
the FC would continue to be considered a controlled foreign corporation 
if such persons were United States shareholders within the meaning of 
section 951(b), the Business A section 987 QBU terminates pursuant to 
paragraph (b)(3) of this section.
    Example 4. Section 332 liquidation. (i) Facts. U.S. Corp owns all of 
the stock of FC, a foreign corporation. FC is the owner of Business A. 
Pursuant to a liquidation described in section 332, FC transfers all of 
its assets and liabilities to U.S. Corp.
    (ii) Analysis. FC's liquidation causes a termination of the Business 
A section 987 QBU as provided in paragraph (b)(4) of this section 
because FC ceases to exist as a result of the liquidation. The exception 
for certain section 332 liquidations provided under paragraph (c)(1) of 
this section does not apply because U.S. Corp is a domestic corporation 
and FC is a foreign corporation. See paragraph (c)(1)(ii) of this 
section.
    Example 5. Transfers to and from a section 987 QBU pursuant to the 
same transaction. (i) Facts. U.S. Corp owns 100 percent of DC1 and DC2, 
each a domestic corporation. DC1 owns Entity A, a DE that conducts a 
business (Business A) in Country X that constitutes a section 987 QBU of 
DC1. DC2 subsequently contributes property to Entity A in exchange for a 
95 percent interest in Entity A. The property DC2 contributes to Entity 
A is used in the business conducted by Business A and is reflected on 
its books and records as provided under Sec. 1.987-2(b).
    (ii) Analysis. (A) For general Federal income tax purposes, Entity A 
is converted to a partnership when DC2 contributes property to Entity A 
in exchange for a 95 percent interest in Entity A. DC2's contribution is 
treated as a contribution to a partnership in exchange for an ownership 
interest in the partnership. DC1 is treated as contributing all of 
Business A to the partnership in exchange for a partnership interest. 
See Rev. Rul. 99-5 (situation 2), (1999-1 CB 434) and Sec. 
601.601(d)(2) of this chapter. For purposes of this section, these 
deemed transactions are not taken into account. See Sec. 1.987-2(c) and 
Sec. 1.987-2(c)(10), Example 9.
    (B) Under Sec. 1.987-1(b)(5)(i), Entity A is converted to a section 
987 aggregate partnership when DC2 contributes property to Entity A in 
exchange for a 95 percent interest in Entity A because DC1 and DC2 own 
all the interests in partnership capital and profits, DC1 and DC2 are 
related within the meaning of section 267(b), and the requirements of 
Sec. 1.987-1(b)(5)(i)(B) are satisfied. Because DC2 is a partner in a 
section 987 aggregate partnership that owns Business A and because DC2 
and Business A have different functional currencies, DC2's portion of 
the Business A assets constitutes a section 987 QBU of DC2.
    (C) As a result of the conversion of Entity A to a partnership, DC2 
acquires an allocable share of 95 percent of the assets of Business A, 
as determined under Sec. 1.987-7. Accordingly, under Sec. 1.987-
2(c)(5), DC2 is treated as contributing 95 percent of its contributed 
property to its Business A section 987 QBU. In addition, DC2 is treated 
as transferring 5 percent of the contributed property to DC1, and DC1 is 
subsequently treated as transferring that property to DC1's Business A 
section 987 QBU. In addition, 95 percent of the original (pre-
conversion) assets of Business A cease being reflected on the books and 
records of DC1's section 987 QBU. Under Sec. 1.987-2(b)(5), these 
amounts are treated as if they are transferred from DC1's section 987 
QBU to DC1, and DC1 is treated as transferring these assets to DC2. DC2 
is subsequently treated as transferring these assets to DC2's Business A 
section 987 QBU. The other 5 percent of the original (pre-conversion) 
assets are treated as remaining on the books and records of DC1's 
section 987 QBU and are not deemed to be transferred.
    (D) For purposes of determining whether substantially all the assets 
of Business A were transferred from DC1's section 987 QBU as provided 
under paragraph (b)(2) of this section, the amount of assets transferred 
from Business A to DC1 under Sec. 1.987-2(c) (95 percent of the assets 
held by Business A before the contribution by DC2) must be reduced by 
the 5 percent of the assets contributed by DC2, which were treated as 
transferred from DC2 to DC1 and subsequently transferred from DC1 to its 
Business A section 987 QBU, as a result of the formation of the section 
987 aggregate partnership. Accordingly, the amount of assets transferred 
from DC1's section 987 QBU for purposes of paragraph (b)(2) of this 
section is equal to 95 percent of the original (pre-conversion) assets 
minus 5 percent of DC2's contributed assets.
    Example 6. Deemed transfers to a CFC upon a check-the-box election. 
(i) Facts. In 2021, U.S.

[[Page 697]]

Corp forms an entity in a foreign country, Entity A. Entity A owns 
Business A, which has the pound as its functional currency. Entity A 
forms Entity B in another foreign country. Entity B owns Business B, a 
section 987 QBU that has the euro as its functional currency. At the 
time of formation, Entity A and Entity B elect to be DEs. In 2026, 
Entity A files an election on Form 8832 to be classified as a 
corporation under Sec. 301.7701-3(g)(1)(iv) and becomes a CFC (FC) 
owned directly by U.S. Corp. FC has the pound as its functional 
currency.
    (ii) Analysis. (A) Under Sec. 1.987-1(b)(4)(i), U.S. Corp is the 
owner of Business A and Business B. In 2026, when Entity A elects to be 
classified as a corporation, U.S. Corp is deemed to contribute the 
assets and liabilities of Business A and Business B to FC under section 
351 in exchange for FC stock. Pursuant to Sec. 1.987-2(c)(2)(i) and 
(ii), as a result of the deemed exchange of the assets and liabilities 
of Business A and Business B for FC stock in a section 351 transaction, 
Business A and Business B are each treated as transferring their assets 
and liabilities to U.S. Corp immediately before U.S. Corp's transfer of 
such assets and liabilities to FC. The transfer of assets from Business 
A and Business B to U.S. Corp causes terminations of those section 987 
QBUs under paragraph (b)(2) of this section. The assets and liabilities 
of Business A and Business B are now owned by FC, but because FC and 
Business A have the same functional currency, only Business B qualifies 
as a section 987 QBU to which section 987 applies.
    (B) Terminations also would have occurred in 2026 if U.S. Corp had 
contributed Entity A and Entity B to an existing foreign corporation 
owned by U.S. Corp or to a newly created foreign corporation owned by 
U.S. Corp pursuant to a section 351 exchange because the transfer of all 
of the assets of Business A and Business B would cause terminations of 
those section 987 QBUs under paragraph (b)(2) of this section.
    Example 7. Sale of a section 987 QBU to a member of a consolidated 
group. (i) Facts. U.S. Corp, the owner of Business A, sells all of the 
assets and liabilities of Business A to DS, a domestic corporation, in 
exchange for cash. U.S. Corp and DS are members of the same consolidated 
group. The cash received on the sale is recorded on the books of U.S. 
Corp.
    (ii) Analysis. Pursuant to Sec. 1.987-2(c)(2)(i) and (ii), Business 
A is treated as transferring all of its assets and liabilities to U.S. 
Corp immediately before the sale by U.S. Corp to DS. As a result of this 
deemed transfer from Business A to U.S. Corp, the Business A section 987 
QBU terminates under paragraph (b)(2) of this section.

[T.D. 9794, 81 FR 88845, Dec. 8, 2016, as amended by T.D. 9795, 81 FR 
88875, Dec. 8, 2016]



Sec. 1.987-8T  Termination of a section 987 QBU (temporary).

    (a) through (c) [Reserved] For further guidance, see Sec. 1.987-
8(a) through (c).
    (d) Annual deemed termination election. A taxpayer, including a 
taxpayer described in Sec. 1.987-1(b)(1)(ii) to which Sec. Sec. 1.987-
1 through 1.987-11 generally do not apply, may elect under this 
paragraph (d) to deem all of the section 987 QBUs of which it is an 
owner to terminate on the last day of each taxable year for which the 
election is in effect. See Sec. 1.987-8(e) regarding the effect of such 
a deemed termination. The owner of a section 987 QBU that is deemed to 
terminate under this paragraph is treated as having transferred all of 
the assets and liabilities attributable to such section 987 QBU to a new 
section 987 QBU on the first day of the following taxable year.
    (e) through (f) [Reserved] For further guidance, see Sec. 1.987-
8(e) through (f).
    (g) Effective/applicability date. This section applies to taxable 
years beginning on or after December 7, 2016.
    (h) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9795, 81 FR 88875, Dec. 8, 2016]



Sec. 1.987-9  Recordkeeping requirements.

    (a) In general. A taxpayer that is an owner of a section 987 QBU 
shall keep a copy of each election made by the taxpayer in accordance 
with the rules of Sec. 1.987-1(g)(3) (if not required to be made on a 
form published by the Commissioner regarding section 987) and such 
reasonable records as are sufficient to establish the section 987 QBU's 
taxable income or loss and section 987 gain or loss.
    (b) Supplemental information. An owner's obligation to maintain 
records under section 6001 and paragraph (a) of this section is not 
satisfied unless the following information is maintained in such records 
with respect to each section 987 QBU:
    (1) The amount of the items of income, gain, deduction, or loss 
attributed to the section 987 QBU in the functional currency of the 
section 987 QBU.
    (2) The amount of assets and liabilities attributed to the section 
987 QBU

[[Page 698]]

in the functional currency of the section 987 QBU.
    (3) The exchange rates used to translate items of income, gain, 
deduction, or loss of the section 987 QBU into the owner's functional 
currency and, if a spot rate convention is used, the manner in which 
such convention is determined.
    (4) The exchange rates used to translate the assets and liabilities 
of the section 987 QBU into the owner's functional currency and, if a 
spot rate convention is used, the manner in which such convention is 
determined.
    (5) The amount of the items of income, gain, deduction, or loss 
attributed to the section 987 QBU translated into the functional 
currency of the owner.
    (6) The amount of assets and liabilities attributed to the section 
987 QBU translated into the functional currency of the owner.
    (7) The amount of assets and liabilities transferred by the owner to 
the section 987 QBU determined in the functional currency of the owner.
    (8) The amount of assets and liabilities transferred by the section 
987 QBU to the owner determined in the functional currency of the owner.
    (9) The amount of the unrecognized section 987 gain or loss for the 
taxable year.
    (10) The amount of the net accumulated unrecognized section 987 gain 
or loss at the close of the taxable year.
    (11) If a remittance is made, the computations determined under 
Sec. 1.861-9T(g) for purposes of sourcing and characterizing the 
remittance under Sec. 1.987-5.
    (12) The transition information required to be determined under 
Sec. 1.987-10(e).
    (c) Retention of records. The records required by this section, or 
records that support the information required on a form published by the 
Commissioner regarding section 987, must be maintained and kept at all 
times available for inspection by the Internal Revenue Service for so 
long as the contents thereof may become relevant in the administration 
of the Internal Revenue Code.
    (d) Information on a dedicated section 987 form. The requirements of 
paragraph (b) of this section shall be satisfied if the taxpayer 
provides the specific information required on a form published by the 
Commissioner for this purpose.

[T.D. 9794, 81 FR 88845, Dec. 8, 2016]



Sec. 1.987-10  Transition rules.

    (a) Scope. These transition rules shall apply to any taxpayer that 
is an owner of a section 987 QBU pursuant to Sec. 1.987-1(b)(4) on the 
transition date (as defined in Sec. 1.987-11(c)). Except as provided in 
paragraph (c) of this section, a taxpayer to which this section applies 
must transition from the method previously used to comply with section 
987 (the ``prior section 987 method'') to the method prescribed by these 
regulations pursuant to the fresh start transition method set forth in 
paragraph (b) of this section.
    (b) Fresh start transition method--(1) In general. Pursuant to the 
fresh start transition method, and solely for purposes of this section, 
all section 987 QBUs of a taxpayer, other than section 987 QBUs subject 
to paragraph (c) of this section, are deemed to terminate on the day 
before the transition date. No section 987 gain or loss is determined or 
recognized as a result of the deemed termination. The owner of a section 
987 QBU that is deemed to terminate under this section is treated as 
having transferred all of the assets and liabilities attributable to 
such QBU to a new section 987 QBU on the transition date. This deemed 
transfer of assets and liabilities is taken into account only for 
purposes of transitioning to these regulations under section 987 and 
shall not be taken into account in determining the amounts transferred 
from the owner to the section 987 QBU during the taxable year for 
purposes of Sec. 1.987-5(c)(1)(ii).
    (2) Application of Sec. 1.987-4. For purposes of applying Sec. 
1.987-4 with respect to a section 987 QBU described in paragraph (b)(1) 
of this section for the taxable year beginning on the transition date, 
the amount of assets and liabilities deemed transferred from the owner 
to the section 987 QBU on the transition date pursuant to paragraph 
(b)(1) of this section shall be determined by translating such assets 
and liabilities (without regard to whether

[[Page 699]]

the asset or liability is a marked item or a historic item) at the 
historic rate as determined under paragraph (b)(3) of this section.
    (3) Determination of historic rate. For purposes of applying these 
regulations with respect to a section 987 QBU described in paragraph 
(b)(1) of this section for taxable years beginning on or after the 
transition date, the historic rate (as defined in Sec. 1.987-1(c)(3)) 
for an asset or liability deemed transferred under paragraph (b)(1) of 
this section from an owner to the section 987 QBU on the transition date 
shall be the historic rate under Sec. 1.987-1(c)(3) determined by 
reference to the date the assets were acquired or liabilities entered 
into or assumed by the section 987 QBU deemed terminated (that is, 
without regard to the deemed termination or transfer described in 
paragraph (b)(1) of this section). However, if the owner is not able to 
determine reliably the historic rate for a particular asset or 
liability, then the historic rate must be determined based on reasonable 
assumptions (for example, assumptions about turnover and aging of 
accounts receivable), consistently applied.
    (4) Example. The provisions of this paragraph (b) are illustrated by 
the following example. Exchange rate assumptions used in the example are 
selected for the purpose of illustrating the principles of this section, 
and no inference is intended by their use. Additionally, the effect of 
depreciation is not taken into account for purposes of this example.

    Example. (i) U.S. Corp is a domestic corporation with the dollar as 
its functional currency. U.S. Corp owns Business A, a U.K. branch with 
the pound as its functional currency. Business A was formed on January 
1, year 1. U.S. Corp uses the method prescribed in the 1991 proposed 
section 987 regulations to determine the section 987 gain or loss of 
Business A. U.S. Corp contributed [pound]6,000 to Business A on January 
1, year 1. On the same day, Business A bought a truck for [pound]4,000 
and a computer for [pound]1,000. Business A had profits determined under 
Sec. 1.987-1(b)(1)(i) through (iii) of the 1991 proposed section 987 
regulations of [pound]250 in each of year 1, year 2, and year 3, and the 
yearly average exchange rate was used in each of those years to 
translate Business A's profits under the 1991 proposed section 987 
regulations. The yearly average exchange rate was [pound]1 = $1.10 in 
year 1, [pound]1 = $1.20 in year 2, and [pound]1 = $1.30 in year 3. 
Business A incurred a [pound]50 loss in each of year 4 and year 5. 
Business A made no remittances to U.S. Corp in any year.
    (ii) On January 1, year 5, Business A transitions to the method 
provided in these regulations pursuant to the fresh start transition 
method described in paragraph (b) of this section. Pursuant to paragraph 
(b)(1) of this section, Business A is deemed to terminate on December 
31, year 4. However, no section 987 gain or loss is determined or 
recognized as a result of the deemed termination. Pursuant to paragraph 
(b)(2) of this section, for purposes of applying Sec. 1.987-4 with 
respect to Business A for year 5, the amount of assets and liabilities 
transferred from U.S. Corp to Business A on the transition date shall be 
determined by translating all of Business A's assets at the historic 
rates for those assets as determined under Sec. 1.987-1(c)(3) and 
paragraph (b)(3) of this section. Because U.S. Corp is not able to 
determine reliably the historic rate for the pound currency it is deemed 
to transfer to Business A, U.S. Corp determines the historic rate for 
these pounds based on a last-in, first-out cash flow assumption. Thus, 
it is assumed that the [pound]50 loss in each of year 4 and year 5 first 
reduces the [pound]250 earned in year 3. Accordingly, for purposes of 
determining the amount of assets and liabilities deemed transferred from 
U.S. Corp to Business A on January 1, year 5, U.S. Corp translates 
Business A's assets and liabilities as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Amount in
                    Assets                          [pound]             Translation rate            Amount in $
----------------------------------------------------------------------------------------------------------------
Pounds........................................           1,000  [pound]1 = $1.10 (yearly average           1,100
                                                                 rate--year 1).
Pounds........................................             250  [pound]1 = $1.10 (yearly average             275
                                                                 rate--year 1).
Pounds........................................             250  [pound]1 = $1.20 (yearly average             300
                                                                 rate--year 2).
Pounds........................................             150  [pound]1 = $1.30 (yearly average             195
                                                                 rate--year 3).
Truck.........................................           4,000  [pound]1 = $1.10 (yearly average           4,400
                                                                 rate--year 1).
Computer......................................           1,000  [pound]1 = $1.10 (yearly average           1,100
                                                                 rate--year 1).
                                               -----------------------------------------------------------------
    Total assets..............................  ..............  ................................           7,370
Liabilities:
    Total liabilities.........................  ..............  ................................               0
----------------------------------------------------------------------------------------------------------------



[[Page 700]]

    (c) Transition of section 987 QBUs that applied the method set forth 
in the 2006 proposed section 987 regulations--(1) In general. If, with 
respect to a particular section 987 QBU, a taxpayer's prior section 987 
method was based on a reasonable application of the method described in 
the 2006 proposed section 987 regulations (REG-208270-86, 71 FR 52876), 
then the taxpayer shall apply these regulations under section 987 with 
respect to such section 987 QBU without regard to paragraph (b) of this 
section.
    (2) Application of Sec. 1.987-4. For purposes of applying Sec. 
1.987-4 with respect to a section 987 QBU described in paragraph (c)(1) 
for the taxable year beginning on the transition date, the owner 
functional currency net value of the section 987 QBU on the last day of 
the preceding taxable year under Sec. 1.987-4(d)(1)(B) shall be the 
amount that was determined under Sec. 1.987-4(d)(1)(A) of the 2006 
proposed section 987 regulations for the preceding taxable year. 
Additionally, for purposes of applying Sec. 1.987-4 with respect to a 
section 987 QBU described in paragraph (c)(1) for all taxable years that 
end after the transition date, the section 987 QBU's net unrecognized 
section 987 gain or loss for all prior taxable years under Sec. 1.987-
4(c) shall take into account the aggregate of the amounts determined 
under Sec. 1.987-4(d) of the 2006 proposed section 987 regulations for 
taxable years for which the taxpayer applied the 2006 proposed section 
987 regulations, reduced by the amounts taken into account under Sec. 
1.987-5 of the 2006 proposed section 987 regulations upon a remittance 
for all such prior taxable years.
    (3) Use of prior historic rate. For purposes of applying these 
regulations under section 987 with respect to historic items (as defined 
in Sec. 1.987-1(e)), other than inventory, that are reflected on the 
balance sheet of the section 987 QBU on the transition date, a taxpayer 
may use the same historic exchange rates as were used under the 
taxpayer's application of the 2006 proposed section 987 regulations in 
place of the historic rates that otherwise would be determined under 
Sec. 1.987-1(c)(3), provided that, for all taxable years that end after 
the transition date, the taxpayer does so with respect to all historic 
items (other than inventory) that are reflected on the balance sheet of 
the section 987 QBU on the transition date.
    (4) Example. The provisions of this paragraph (c) are illustrated by 
the following example. Exchange rate assumptions used in the example are 
selected for the purpose of illustrating the principles of this section, 
and no inference is intended by their use. Additionally, the effect of 
depreciation is not taken into account for purposes of this example.

    Example. (i) U.S. Corp is a domestic corporation with the dollar as 
its functional currency. U.S. Corp owns Business A, a U.K. branch with 
the pound as its functional currency. Business A was formed on January 
1, year 1. U.S. Corp uses a reasonable application of the method 
described in the 2006 proposed section 987 regulations to determine the 
section 987 gain or loss of Business A. On January 1, year 5, Business A 
transitions to the method provided in these regulations pursuant to the 
method described in this paragraph (c). Business A's opening balance 
sheet on January 1, year 5, includes pounds, a truck acquired in year 2, 
inventory accounted for under the FIFO method, and no liabilities. These 
assets remain on the balance sheet on December 31, year 5.
    (ii) Pursuant to paragraph (c)(3) of this section, U.S. Corp chooses 
to use the same historic exchange rates as were used under its 
application of the 2006 proposed regulations in place of the historic 
rates prescribed under Sec. 1.987-1(c)(3) for purposes of applying 
these regulations with respect to historic items (other than inventory) 
held on the transition date.
    (iii) The pounds are marked items under Sec. 1.987-1(d). Because 
the pounds are marked items, for purposes of determining the owner 
functional currency net value of Business A on the last day of year 5 
pursuant to Sec. 1.987-4(e), the pounds are translated into dollars 
using the spot rate (as defined in Sec. 1.987-1(c)(1)) applicable to 
the last day of year 5.
    (iv) The truck held on Business A's balance sheet on January 1, year 
5, is a historic item under Sec. 1.987-1(e). For purposes of 
determining the owner functional currency net value of Business A on the 
last day of year 5 pursuant to Sec. 1.987-4(e), the basis of the truck 
is translated into dollars using the spot rate on the day the truck was 
acquired in year 2, as determined under Sec. 1.987-1(c)(3) of the 2006 
proposed section 987 regulations. If U.S. Corp had not chosen pursuant 
to paragraph (c)(3) of this section to use the same historic exchange 
rates as were used under its application of the 2006 proposed 
regulations, the

[[Page 701]]

basis of the truck would have been translated into dollars using the 
historic rate described in Sec. 1.987-1(c)(3), which is the yearly 
average exchange rate for year 5.
    (v) The inventory held on Business A's balance sheet on January 1, 
year 5, is a historic item under Sec. 1.987-1(e). For purposes of 
determining the owner functional currency net value of Business A on the 
last day of year 5 pursuant to Sec. 1.987-4(e), the FIFO cost basis of 
the inventory is translated into dollars using the historic rate, which 
pursuant to Sec. 1.987-1(c)(3)(i)(B) is the yearly average exchange 
rate for year 5.
    (vi) Pursuant to paragraph (c)(3) of this section, for purposes of 
applying Sec. 1.987-4 with respect to Business A for year 5, the owner 
functional currency net value of Business A on the last day of year 4 
under Sec. 1.987-4(d)(1)(B) is the amount that was determined under 
Sec. 1.987-4(d)(1)(A) of the 2006 proposed section 987 regulations for 
year 4. Additionally, Business A's net unrecognized section 987 gain or 
loss for all prior years under Sec. 1.987-4(c) shall take into account 
the aggregate of the amounts determined under Sec. 1.987-4(d) of the 
2006 proposed section 987 regulations for year 1 through year 4, reduced 
by the amounts taken into account under Sec. 1.987-5 of the 2006 
proposed section 987 regulations upon a remittance for all such prior 
taxable years.

    (d) Adjustments to avoid double counting. If a difference between 
the treatment of any item under these regulations and the treatment of 
the item under the taxpayer's prior section 987 method would result in 
income, gain, deduction or loss being taken into account more than once, 
then the net unrecognized section 987 gain or loss of the section 987 
QBU, as determined under Sec. 1.987-4(b) for the first taxable year for 
which these regulations apply, shall be adjusted to account for the 
difference.
    (e) Reporting--(1) In general. Except as otherwise provided in this 
paragraph (e), the taxpayer must attach a statement titled ``Section 987 
Transition Information'' to its timely filed return for the first 
taxable year to which these regulations under section 987 apply 
providing the following information:
    (i) A description of each section 987 QBU to which these rules 
apply, the section 987 QBU's owner, the section 987 QBU's principal 
place of business, and a description of the prior section 987 method 
used by the taxpayer to determine section 987 gain or loss with respect 
to the section 987 QBU.
    (ii) Any assumptions used by the taxpayer for determining the 
exchange rates used to translate the amount of assets and liabilities 
transferred to the section 987 QBU on the transition date, as provided 
in paragraph (b)(3) of this section.
    (iii) With respect to each section 987 QBU subject to paragraph (c) 
of this section, a statement regarding whether historic items (as 
defined in Sec. 1.987-1(c)(3)) are translated pursuant to paragraph 
(c)(2) of this section at the same historic rates as were used under the 
taxpayer's application of the 2006 proposed regulations or at the 
historic rates determined under Sec. 1.987-1(c)(3).
    (iv) With respect to each section 987 QBU with respect to which an 
adjustment is made pursuant to paragraph (d) of this section, a 
description of the adjustment and the basis for the computation of such 
adjustments.
    (2) Attachments not required where information is reported on a 
form. Paragraph (e) of this section shall not apply to the extent the 
information described in such paragraph is required to be reported on a 
form published by the Commissioner.

[T.D. 9794, 81 FR 88845, Dec. 8, 2016]



Sec. 1.987-11  Effective/applicability date.

    (a) In general. Except as otherwise provided in this section, 
Sec. Sec. 1.987-1 through 1.987-10 shall apply to taxable years 
beginning on or after one year after the first day of the first taxable 
year following December 7, 2016.
    (b) Application of these regulations to taxable years beginning 
after December 7, 2016. A taxpayer may apply these regulations under 
section 987 to taxable years beginning after December 7, 2016, provided 
the taxpayer consistently applies these regulations to such taxable 
years with respect to all section 987 QBUs directly or indirectly owned 
by the taxpayer on the transition date (as defined in paragraph (b)(2) 
of this section) as well as all section 987 QBUs directly or indirectly 
owned on the transition date by members that file a consolidated return 
with the taxpayer or by any controlled foreign corporation, as defined 
in section 957, in which a member owns more than 50

[[Page 702]]

percent of the voting power or stock value, as determined under section 
958(a).
    (c) Transition date. The transition date is the first day of the 
first taxable year to which these regulations under section 987 are 
applicable with respect to a taxpayer under this section.

[T.D. 9794, 81 FR 88845, Dec. 8, 2016]



Sec. 1.987-12  Deferral of section 987 gain or loss.

    (a) In general--(1) Overview. This section provides rules that defer 
the recognition of section 987 gain or loss that, but for this section, 
would be recognized in connection with certain QBU terminations and 
certain other transactions involving partnerships. This paragraph (a) 
provides an overview of this section and describes the section's scope 
of application, including with respect to QBUs subject to section 987 
but to which Sec. Sec. 1.987-1 through 1.987-11 generally do not apply. 
Paragraph (b) of this section describes the extent to which section 987 
gain or loss is recognized under Sec. 1.987-5 or similar principles in 
the taxable year of a deferral event (as defined in paragraph (b)(2) of 
this section) with respect to a QBU. Paragraph (c) of this section 
describes the extent to which section 987 gain or loss that, as a result 
of paragraph (b), is not recognized under Sec. 1.987-5 or similar 
principles is recognized upon the occurrence of subsequent events. 
Paragraph (d) of this section describes the extent to which section 987 
loss is recognized under Sec. 1.987-5 or similar principles in the 
taxable year of an outbound loss event (as defined in paragraph (d)(2) 
of this section) with respect to a QBU. Paragraph (e) of this section 
provides rules for determining the source and character of gains and 
losses that, as a result of this section, are not recognized under Sec. 
1.987-5 or similar principles in the taxable year of a deferral event or 
outbound loss event. Paragraph (f) of this section defines controlled 
group and qualified successor for purposes of this section. Paragraph 
(g) of this section provides an anti-abuse rule. Paragraph (h) of this 
section provides examples illustrating the rules described in this 
section. Paragraph (i) of this section provides rules coordinating the 
application of this section with the fresh start transition method. 
Paragraph (j) of this section provides dates of applicability.
    (2) Scope. This section applies to any foreign currency gain or loss 
realized under section 987(3), including foreign currency gain or loss 
of an entity described in Sec. 1.987-1(b)(1)(ii) (certain entities not 
otherwise subject to the regulations under section 987). References in 
this section to section 987 gain or loss refer to any foreign currency 
gain or loss realized under section 987(3), references to a section 987 
QBU refer to any eligible QBU (as defined in Sec. 1.987-1(b)(3)(i), but 
without regard to Sec. 1.987-1(b)(3)(ii)) that is subject to section 
987, and references to a section 987 aggregate partnership refer to any 
partnership for which the acquisition or disposition of a partnership 
interest could give rise to foreign currency gain or loss realized under 
section 987(3). Additionally, references to recognition of section 987 
gain or loss under Sec. 1.987-5 encompass any determination and 
recognition of gain or loss under section 987(3) that would occur but 
for this section. Accordingly, the principles of this section apply to a 
QBU subject to section 987 regardless of whether the QBU otherwise is 
subject to Sec. Sec. 1.987-1 through 1.987-11. An owner of a QBU that 
is not subject to Sec. 1.987-5 must adapt the rules set forth in this 
section as necessary to recognize section 987 gains or losses that are 
subject to this section consistent with the principles of this section.
    (3) Exceptions--(i) Annual deemed termination elections. This 
section does not apply to section 987 gain or loss of a section 987 QBU 
with respect to which the annual deemed termination election described 
in Sec. 1.987-8(d) is in effect.
    (ii) De minimis exception. This section does not apply to a section 
987 QBU for a taxable year if the net unrecognized section 987 gain or 
loss of the section 987 QBU that, as a result of this section, would not 
be recognized under Sec. 1.987-5 in the taxable year does not exceed $5 
million.
    (b) Gain and loss recognition in connection with a deferral event--
(1) In general. Notwithstanding Sec. 1.987-5, the owner of a section 
987 QBU with respect to

[[Page 703]]

which a deferral event occurs (a deferral QBU) includes in taxable 
income section 987 gain or loss in connection with the deferral event 
only to the extent provided in paragraphs (b)(3) and (c) of this 
section. However, if the deferral event also constitutes an outbound 
loss event described in paragraph (d) of this section, the amount of 
loss recognized by the owner may be further limited under that 
paragraph.
    (2) Deferral event--(i) In general. A deferral event with respect to 
a section 987 QBU means any transaction or series of transactions that 
satisfy the conditions described in paragraphs (b)(2)(ii) and (iii) of 
this section.
    (ii) Transactions. The transaction or series of transactions include 
either:
    (A) A termination of the section 987 QBU other than any of the 
following terminations: A termination described in Sec. 1.987-8(b)(3), 
a termination described in Sec. 1.987-8(c), or a termination described 
solely in Sec. 1.987-8(b)(1); or
    (B) A disposition of part of an interest in a section 987 aggregate 
partnership or DE through which the section 987 QBU is owned, a 
disposition of part of a directly held section 987 QBU, or any 
contribution by another person to a section 987 aggregate partnership, 
DE, or section 987 QBU of assets that, immediately after the 
contribution, are not considered to be included on the books and records 
of an eligible QBU, provided that the contribution gives rise to a 
deemed transfer from the section 987 QBU to the owner. See paragraph (h) 
of this section, Examples 1, 2, and 4, for illustrations of this rule.
    (iii) Assets on books of successor QBU. Immediately after the 
transaction or series of transactions, assets of the section 987 QBU are 
reflected on the books and records of a successor QBU (as defined in 
paragraph (b)(4) of this section).
    (3) Gain or loss recognized under Sec. 1.987-5 in the taxable year 
of a deferral event. In the taxable year of a deferral event with 
respect to a deferral QBU, the owner of the deferral QBU recognizes 
section 987 gain or loss as determined under Sec. 1.987-5, except that, 
solely for purposes of applying Sec. 1.987-5, all assets and 
liabilities of the deferral QBU that, immediately after the deferral 
event, are reflected on the books and records of a successor QBU are 
treated as not having been transferred and therefore as remaining on the 
books and records of the deferral QBU notwithstanding the deferral 
event.
    (4) Successor QBU. For purposes of this section, a section 987 QBU 
(potential successor QBU) is a successor QBU with respect to a section 
987 QBU referred to in paragraph (b)(2)(ii) of this section if, 
immediately after the transaction or series of transactions described in 
that paragraph, the potential successor QBU satisfies all of the 
conditions described in paragraphs (b)(4)(i) through (iii) of this 
section.
    (i) The books and records of the potential successor QBU reflect 
assets that, immediately before the transaction or series of 
transactions described in paragraph (b)(2)(ii) of this section, were 
reflected on the books and records of the section 987 QBU referred to in 
that paragraph.
    (ii) The owner of the potential successor QBU and the owner of the 
section 987 QBU referred to in paragraph (b)(2)(ii) of this section 
immediately before the transaction or series of transactions described 
in that paragraph are members of the same controlled group.
    (iii) In the case of a section 987 QBU referred to in paragraph 
(b)(2)(ii)(A) of this section, if the owner of the section 987 QBU 
immediately before the transaction or series of transactions described 
in that paragraph was a U.S. person, the potential successor QBU is 
owned by a U.S. person.
    (c) Recognition of deferred section 987 gain or loss in the taxable 
year of a deferral event and in subsequent taxable years--(1) In 
general--(i) Deferred section 987 gain or loss. A deferral QBU owner (as 
defined in paragraph (c)(1)(ii) of this section) recognizes section 987 
gain or loss attributable to the deferral QBU that, as a result of 
paragraph (b) of this section, is not recognized in the taxable year of 
the deferral event under Sec. 1.987-5 (deferred section 987 gain or 
loss) in the taxable year of the deferral event and in subsequent 
taxable years as provided in paragraphs (c)(2) through (4) of this 
section.
    (ii) Deferral QBU owner. For purposes of this paragraph (c), a 
deferral QBU owner means, with respect to a deferral

[[Page 704]]

QBU, the owner of the deferral QBU immediately before the deferral 
event, or the owner's qualified successor.
    (2) Recognition upon a subsequent remittance--(i) In general. Except 
as provided in paragraph (c)(3) of this section, a deferral QBU owner 
recognizes deferred section 987 gain or loss in the taxable year of the 
deferral event and in subsequent taxable years upon a remittance from a 
successor QBU to the owner of the successor QBU (successor QBU owner) in 
the amount described in paragraph (c)(2)(ii) of this section.
    (ii) Amount. The amount of deferred section 987 gain or loss that is 
recognized pursuant to this paragraph (c)(2) in a taxable year of the 
deferral QBU owner is the outstanding deferred section 987 gain or loss 
(that is, the amount of deferred section 987 gain or loss not previously 
recognized) multiplied by the remittance proportion of the successor QBU 
owner with respect to the successor QBU for the taxable year ending with 
or within the taxable year of the deferral QBU owner, as determined 
under Sec. 1.987-5(b) (and, to the extent relevant, paragraphs (b) and 
(c)(2)(iii) of this section) without regard to any election under Sec. 
1.987-8(d). For purposes of computing this remittance proportion, 
multiple successor QBUs of the same deferral QBU are treated as a single 
successor QBU. See paragraph (h) of this section, Example 5, for an 
illustration of this rule.
    (iii) Deemed remittance when a successor QBU ceases to be owned by a 
member of the deferral QBU owner's controlled group. For purposes of 
this paragraph (c)(2), in a taxable year of the deferral QBU owner in 
which a successor QBU ceases to be owned by a member of a controlled 
group that includes the deferral QBU owner, the successor QBU owner is 
treated as having a remittance proportion of 1. Accordingly, if there is 
only one successor QBU with respect to a deferral QBU and that successor 
QBU ceases to be owned by a member of the controlled group that includes 
the deferral QBU owner, all outstanding deferred section 987 gain or 
loss with respect to that deferral QBU will be recognized. This 
paragraph (c)(2)(iii) does not affect the application of Sec. Sec. 
1.987-1 through 1.987-11 to the successor QBU owner with respect to its 
ownership of the successor QBU.
    (3) Recognition of deferred section 987 loss in certain outbound 
successor QBU terminations. Notwithstanding paragraph (c)(2) of this 
section, if assets of the successor QBU (transferred assets) are 
transferred (or deemed transferred) in a transaction that would 
constitute an outbound loss event if the successor QBU had a net 
accumulated section 987 loss at the time of the exchange, then the 
deferral QBU owner recognizes outstanding deferred section 987 loss, if 
any, to the extent it would recognize loss under paragraph (d)(1) of 
this section if (i) the deferral QBU owner owned the successor QBU, (ii) 
the deferral QBU owner had net unrecognized section 987 loss with 
respect to the successor QBU equal to its outstanding deferred section 
987 loss with respect to the deferral QBU, and (iii) the transferred 
assets were transferred (or deemed transferred) in an outbound loss 
event. Any outstanding deferred section 987 loss with respect to the 
deferral QBU that is not recognized as a result of the preceding 
sentence is recognized by the deferral QBU owner in the first taxable 
year in which the deferral QBU owner (including any qualified successor) 
ceases to be a member of a controlled group that includes the acquirer 
of the transferred assets or any qualified successor of such acquirer.
    (4) Special rules regarding successor QBUs--(i) Successor QBU with 
respect to a deferral QBU that is a successor QBU. If a section 987 QBU 
is a successor QBU with respect to a deferral QBU that is a successor 
QBU with respect to another deferral QBU, the first-mentioned section 
987 QBU is considered a successor QBU with respect to the second-
mentioned deferral QBU. For example, if QBU A is a successor QBU with 
respect to QBU B, and QBU B is a successor QBU with respect to QBU C, 
then QBU A is a successor QBU with respect to QBU C.
    (ii) Separation of a successor QBU. If a successor QBU with respect 
to a deferral QBU separates into two or more separated QBUs (as defined 
in Sec. 1.987-2(c)(9)(iii)), each separated QBU is considered a 
successor QBU with respect to the deferral QBU.

[[Page 705]]

    (iii) Combination of a successor QBU. If a successor QBU with 
respect to a deferral QBU combines with another section 987 QBU of the 
same owner, resulting in a combined QBU (as defined in Sec. 1.987-
2(c)(9)(i)), the combined QBU is considered a successor QBU with respect 
to the deferral QBU.
    (d) Loss recognition upon an outbound loss event--(1) In general. 
Notwithstanding Sec. 1.987-5, the owner of a section 987 QBU with 
respect to which an outbound loss event occurs (an outbound loss QBU) 
includes in taxable income in the taxable year of an outbound loss event 
section 987 loss with respect to that section 987 QBU only to the extent 
provided in paragraph (d)(3) of this section.
    (2) Outbound loss event. An outbound loss event means, with respect 
to a section 987 QBU:
    (i) Any termination of the section 987 QBU in connection with a 
transfer by a U.S. person of assets of the section 987 QBU to a foreign 
person that is a member of the same controlled group as the U.S. 
transferor immediately before the transaction or, if the transferee did 
not exist immediately before the transaction, immediately after the 
transaction (related foreign person), provided that the termination 
would result in the recognition of section 987 loss with respect to the 
section 987 QBU under Sec. 1.987-5 and paragraph (b) of this section 
but for this paragraph (d); or
    (ii) Any transfer by a U.S. person of part of an interest in a 
section 987 aggregate partnership or DE through which the U.S. person 
owns the section 987 QBU to a related foreign person that has the same 
functional currency as the section 987 QBU, or any contribution by such 
a related foreign person to such a partnership or DE of assets that, 
immediately after the contribution, are not considered to be included on 
the books and records of an eligible QBU, provided that the transfer 
would result in the recognition of section 987 loss with respect to the 
section 987 QBU under Sec. 1.987-5 and paragraph (b) of this section 
but for this paragraph (d). See paragraph (h) of this section, Example 
3, for an illustration of this rule.
    (3) Loss recognized upon an outbound loss event. In the taxable year 
of an outbound loss event with respect to an outbound loss QBU, the 
owner of the outbound loss QBU recognizes section 987 loss as determined 
under Sec. 1.987-5 and paragraphs (b) and (c) of this section, except 
that, solely for purposes of applying Sec. 1.987-5, the following 
assets and liabilities of the outbound loss QBU are treated as not 
having been transferred and therefore as remaining on the books and 
records of the outbound loss QBU notwithstanding the outbound loss 
event:
    (i) In the case of an outbound loss event described in paragraph 
(d)(2)(i) of this section, assets and liabilities that, immediately 
after the outbound loss event, are reflected on the books and records of 
the related foreign person described in that paragraph or of an eligible 
QBU owned by such related foreign person; and
    (ii) In the case of an outbound loss event described in paragraph 
(d)(2)(ii) of this section, assets and liabilities that, immediately 
after the outbound loss event, are reflected on the books and records of 
the eligible QBU from which the assets and liabilities of the outbound 
loss QBU are allocated and not on the books and records of a section 987 
QBU.
    (4) Adjustment of basis of stock received in certain nonrecognition 
transactions. If an outbound loss event results from the transfer of 
assets of the outbound loss QBU in a transaction described in section 
351 or section 361, the basis of the stock that is received in the 
transaction is increased by an amount equal to the section 987 loss 
that, as a result of this paragraph (d), is not recognized with respect 
to the outbound loss QBU in the taxable year of the outbound loss event 
(outbound section 987 loss).
    (5) Recognition of outbound section 987 loss that is not converted 
into stock basis. Outbound section 987 loss attributable to an outbound 
loss event that is not described in paragraph (d)(4) of this section is 
recognized by the owner of the outbound loss QBU in the first taxable 
year in which the owner or any qualified successor of the owner ceases 
to be a member of a controlled group that includes the related foreign 
person referred to in paragraph (d)(2)(i) or (ii)

[[Page 706]]

of this section, or any qualified successor of such person.
    (e) Source and character--(1) Deferred section 987 gain or loss and 
certain outbound section 987 loss. The source and character of deferred 
section 987 gain or loss recognized pursuant to paragraph (c) of this 
section, and of outbound section 987 loss recognized pursuant to 
paragraph (d)(5) of this section, is determined under Sec. 1.987-6 as 
if such deferred section 987 gain or loss were recognized pursuant to 
Sec. 1.987-5 without regard to this section on the date of the related 
deferral event or outbound loss event.
    (2) Outbound section 987 loss reflected in stock basis. If loss is 
recognized on the sale or exchange of stock described in paragraph 
(d)(4) of this section within two years of the outbound loss event 
described in that paragraph, then, to the extent of the outbound section 
987 loss, the source and character of the loss recognized on the sale or 
exchange is determined under Sec. 1.987-6 as if such loss were section 
987 loss recognized pursuant to Sec. 1.987-5 without regard to this 
section on the date of the outbound loss event.
    (f) Definitions--(1) Controlled group. For purposes of this section, 
a controlled group means all persons with the relationships to each 
other specified in sections 267(b) or 707(b).
    (2) Qualified successor. For purposes of this section, a qualified 
successor with respect to a corporation (transferor corporation) means 
another corporation (acquiring corporation) that acquires the assets of 
the transferor corporation in a transaction described in section 381(a), 
but only if (A) the acquiring corporation is a domestic corporation and 
the transferor corporation was a domestic corporation, or (B) the 
acquiring corporation is a controlled foreign corporation (as defined in 
section 957(a)) (CFC) and the transferor corporation was a CFC. A 
qualified successor of a corporation includes the qualified successor of 
a qualified successor of the corporation.
    (g) Anti-abuse. No section 987 loss is recognized under Sec. 1.987-
5 or this section in connection with a transaction or series of 
transactions that are undertaken with a principal purpose of avoiding 
the purposes of this section.
    (h) Examples. The following examples illustrate the application of 
this section. For purposes of the examples, DC1 is a domestic 
corporation that owns all of the stock of DC2, which is also a domestic 
corporation, and CFC1 and CFC2 are CFCs. In addition, DC1, DC2, CFC1, 
and CFC2 are members of a controlled group as defined in paragraph 
(f)(1) of this section, and the de minimis rule of paragraph (a)(3)(ii) 
of this section is not applicable. Finally, except as otherwise 
provided, Business A is a section 987 QBU with the euro as its 
functional currency, there are no transfers between Business A and its 
owner, and Business A's assets are not depreciable or amortizable.
    (1) Example 1. Contribution of a section 987 QBU to a member of the 
controlled group--(i) Facts. DC1 owns all of the interests in Business 
A. The balance sheet of Business A reflects assets with an aggregate 
adjusted basis of [euro]1,000x and no liabilities. DC1 contributes 
[euro]900x of Business A's assets to DC2 in an exchange to which section 
351 applies. Immediately after the contribution, the remaining 
[euro]100x of Business A's assets are no longer reflected on the books 
and records of a section 987 QBU. DC2, which has the U.S. dollar as its 
functional currency, uses the former Business A assets in a business 
(Business B) that constitutes a section 987 QBU. At the time of the 
contribution, Business A has net accumulated unrecognized section 987 
gain of $100x.
    (ii) Analysis. (A) Under Sec. 1.987-2(c)(2)(ii), DC1's contribution 
of [euro]900x of Business A's assets to DC2 is treated as a transfer of 
all of the assets of Business A to DC1, immediately followed by DC1's 
contribution of [euro]900x of Business A's assets to DC2. The 
contribution of Business A's assets is a deferral event within the 
meaning of paragraph (b)(2) of this section because:
    (1) The transfer from Business A to DC1 is a transfer of 
substantially all of Business A's assets to DC1, resulting in a 
termination of Business A under Sec. 1.987-8(b)(2); and
    (2) Immediately after the transaction, assets of Business A are 
reflected on the books and records of Business B, a section 987 QBU 
owned by a member of DC1's controlled group

[[Page 707]]

and a successor QBU within the meaning of paragraph (b)(4) of this 
section. Accordingly, Business A is a deferral QBU within the meaning of 
paragraph (b)(1) of this section, and DC1 is a deferral QBU owner of 
Business A within the meaning of paragraph (c)(1)(ii) of this section.
    (B) Under paragraph (b)(3) of this section, DC1's taxable income in 
the taxable year of the deferral event includes DC1's section 987 gain 
or loss determined with respect to Business A under Sec. 1.987-5, 
except that, for purposes of applying Sec. 1.987-5, all assets and 
liabilities of Business A that are reflected on the books and records of 
Business B immediately after Business A's termination are treated as not 
having been transferred and therefore as though they remained on 
Business A's books and records (notwithstanding the deemed transfer of 
those assets under Sec. 1.987-8(e)). Accordingly, in the taxable year 
of the deferral event, DC1 is treated as making a remittance of 
[euro]100x, corresponding to the assets of Business A that are no longer 
reflected on the books and records of a section 987 QBU, and is treated 
as having a remittance proportion with respect to Business A of 0.1, 
determined by dividing the [euro]100x remittance by the sum of the 
remittance and the [euro]900x aggregate adjusted basis of the gross 
assets deemed to remain on Business A's books at the end of the year. 
Thus, DC1 recognizes $10x of section 987 gain in the taxable year of the 
deferral event. DC1's deferred section 987 gain equals $90x, which is 
the amount of section 987 gain that, but for the application of 
paragraph (b) of this section, DC1 would have recognized under Sec. 
1.987-5 ($100x), less the amount of section 987 gain recognized by DC1 
under Sec. 1.987-5 and this section ($10x).
    (2) Example 2. Election to be classified as a corporation--(i) 
Facts. DC1 owns all of the interests in Entity A, a DE. Entity A 
conducts Business A, which has net accumulated unrecognized section 987 
gain of $500x. Entity A elects to be classified as a corporation under 
Sec. 301.7701-3(a). As a result of the election and pursuant to Sec. 
301.7701-3(g)(1)(iv), DC1 is treated as contributing all of the assets 
and liabilities of Business A to newly-formed CFC1, which has the euro 
as its functional currency. Immediately after the contribution, the 
assets and liabilities of Business A are reflected on CFC1's balance 
sheet.
    (ii) Analysis. Under Sec. 1.987-2(c)(2)(ii), DC1's contribution of 
all of the assets and liabilities of Business A to CFC1 is treated as a 
transfer of all of the assets and liabilities of Business A to DC1, 
followed immediately by DC1's contribution of those assets and 
liabilities to CFC1. Because the deemed transfer from Business A to DC1 
is a transfer of substantially all of Business A's assets to DC1, the 
Business A QBU terminates under Sec. 1.987-8(b)(2). The contribution of 
Business A's assets is not a deferral event within the meaning of 
paragraph (b)(2) of this section because, immediately after the 
transaction, no assets of Business A are reflected on the books and 
records of a successor QBU within the meaning of paragraph (b)(4) of 
this section due to the fact that the assets of Business A are not 
reflected on the books and records of a section 987 QBU immediately 
after the termination as well as the fact that the requirement of 
paragraph (b)(4)(iii) of this section is not met. Accordingly, DC1 
recognizes section 987 gain with respect to Business A under Sec. 
1.987-5 without regard to this section. Because the requirement of 
paragraph (b)(4)(iii) of this section is not met, the result would be 
the same even if the assets of Business A were transferred in a section 
351 exchange to an existing foreign corporation that had a different 
functional currency than Business A.
    (3) Example 3. Outbound loss event--(i) Facts. The facts are the 
same as in Example 2 in paragraph (h)(2) of this section, except that 
Business A has net accumulated unrecognized section 987 loss of $500x 
rather than net accumulated unrecognized section 987 gain of $500x.
    (ii) Analysis. (A) The analysis of the transactions under Sec. Sec. 
1.987-2(c)(2)(ii), 1.987-8(b)(2), and paragraph (b) of this section is 
the same as in Example 2 in paragraph (h)(2) of this section. However, 
the termination of Business A as a result of the transfer of the assets 
of Business A by a U.S. person (DC1) to a foreign person (CFC1) that is 
a member

[[Page 708]]

of DC1's controlled group is an outbound loss event described in 
paragraph (d)(2) of this section.
    (B) Under paragraphs (d)(1) and (3) of this section, in the taxable 
year of the outbound loss event, DC1 includes in taxable income section 
987 loss recognized with respect to Business A as determined under Sec. 
1.987-5, except that, for purposes of applying Sec. 1.987-5, all assets 
and liabilities of Business A that are reflected on the books and 
records of CFC1, a related foreign person described in paragraph (d)(2) 
of this section, are treated as not having been transferred. 
Accordingly, DC1's remittance proportion with respect to Business A is 
0, and DC1 recognizes no section 987 loss with respect to Business A. 
DC1's outbound section 987 loss is $500x, which is the amount of section 
987 loss that DC1 would have recognized under Sec. 1.987-5 ($500x) 
without regard to paragraph (d) of this section, less the amount of 
section 987 loss recognized by DC1 under paragraph (d)(3) of this 
section ($0). Under paragraph (d)(4) of this section, DC1 must increase 
its basis in its CFC1 shares by the amount of the outbound section 987 
loss ($500x).
    (4) Example 4. Conversion of a DE to a partnership--(i) Facts. (A) 
DC1 owns all of the interests in Entity A, a DE that conducts Business 
A. On the last day of Year 1, DC1 sells 50 percent of its interest in 
Entity A to DC2 (the Entity A sale).
    (B) For Federal income tax purposes, Entity A is converted to a 
partnership when DC2 purchases the 50 percent interest in Entity A. 
DC2's purchase is treated as the purchase of 50 percent of the assets of 
Entity A (that is, the assets of Business A), which, prior to the 
purchase, were treated as held directly by DC1 for Federal income tax 
purposes. Immediately after DC2's deemed purchase of 50 percent of 
Business A assets, DC1 and DC2 are treated as contributing their 
respective interests in Business A assets to a partnership. See Rev. 
Rul. 99-5, 1999-1 CB 434 (situation 1). In connection with the deemed 
contribution, DC1 and DC2 agree to share equally in all items of the 
partnership's profits and loss, and, for purposes of Sec. 1.987-7, to 
determine their share of assets and liabilities of the resulting 
partnership in accordance with their respective shares of partnership 
profits.
    (ii) Analysis. (A) The transactions deemed to occur under Rev. Rul. 
99-5 are not taken into account for purposes of this section. The Entity 
A sale and resulting existence of a partnership, however, have 
consequences under section 987 and this section, as described in this 
Example 4 in paragraphs (h)(4)(ii)(B) through (D) of this section.
    (B) Immediately after the Entity A sale, Entity A is a section 987 
aggregate partnership within the meaning of Sec. 1.987-1(b)(5) because 
DC1 and DC2 own all the interests in partnership capital and profits, 
DC1 and DC2 are related within the meaning of section 267(b), and the 
partnership has an eligible QBU (Business A) that would be a section 987 
QBU with respect to a partner if owned by the partner directly. As a 
result of the Entity A sale, 50 percent of the assets and liabilities of 
Business A ceased to be reflected on the books and records of DC1's 
Business A section 987 QBU. As a result, such assets and liabilities are 
treated as if they were transferred from DC1's Business A section 987 
QBU to DC1. Additionally, following DC2's acquisition of 50 percent of 
the interest in Entity A, DC2 is allocated 50 percent of the assets and 
liabilities of Business A under Sec. Sec. 1.987-2(b). Because DC2 and 
Business A have different functional currencies, DC2's portion of the 
Business A assets and liabilities constitutes a section 987 QBU. 
Accordingly, 50 percent of the assets and liabilities of Business A are 
treated as transferred by DC2 to DC2's Business A section 987 QBU.
    (C) The Entity A sale is a deferral event described in paragraph 
(b)(2) of this section because:
    (1) The sale constitutes the disposition of part of an interest in a 
DE; and
    (2) Immediately after the transaction, assets of DC1's Business A 
section 987 QBU are reflected on the books and records of DC1's Business 
A section 987 QBU and DC2's Business A section 987 QBU, each of which is 
a successor QBU with respect to DC1's Business A section 987 QBU within 
the meaning of paragraph (b)(4) of this section. Accordingly, DC1's 
Business A section 987 QBU is a deferral QBU within the

[[Page 709]]

meaning of paragraph (b)(1) of this section, and DC1 is a deferral QBU 
owner within the meaning of paragraph (c)(1)(ii) of this section. Under 
paragraph (b)(1) of this section, DC1 includes in taxable income section 
987 gain or loss with respect to Business A in connection with the 
deferral event to the extent provided in paragraphs (b)(3) and (c) of 
this section.
    (D) Under paragraph (b) of this section, in the taxable year of the 
Entity A sale, DC1 includes in taxable income section 987 gain or loss 
with respect to Business A as determined under Sec. 1.987-5, except 
that, for purposes of applying Sec. 1.987-5, all assets and liabilities 
of Business A that, immediately after the Entity A sale, are reflected 
on the books and records of successor QBUs are treated as though they 
were not transferred and therefore as remaining on the books and records 
of DC1's Business A section 987 QBU notwithstanding the Entity A sale. 
Accordingly, DC1's remittance amount under Sec. 1.987-5 is $0, and DC1 
recognizes no section 987 gain or loss with respect to Business A.
    (5) Example 5. Partial recognition of deferred gain or loss--(i) 
Facts. DC1 owns all of the interests in Entity A, a DE that conducts 
Business A in Country X. During Year 1, DC1 contributes all of its 
interests in Entity A to DC2 in an exchange to which section 351 
applies. At the time of the contribution, Business A has net accumulated 
unrecognized section 987 gain of $100x. After the contribution, Entity A 
continues to conduct business in Country X (Business B). In Year 3, as a 
result of a net transfer of property from Business B to DC2, DC2's 
remittance proportion with respect to Business B, as determined under 
Sec. 1.987-5, is 0.25.
    (ii) Analysis. (A) For the reasons described in Example 1 in 
paragraph (h)(1) of this section, the contribution of Entity A by DC1 to 
DC2 results in a termination of Business A and a deferral event with 
respect to Business A, a deferral QBU; DC1 is a deferral QBU owner 
within the meaning of paragraph (c)(1)(ii) of this section; Business B 
is a successor QBU with respect to Business A; DC2 is a successor QBU 
owner; and the $100x of net accumulated unrecognized section 987 gain 
with respect to Business A becomes deferred section 987 gain as a result 
of the deferral event.
    (B) Under paragraph (c)(1) of this section, DC1 recognizes deferred 
section 987 gain with respect to Business A in accordance with 
paragraphs (c)(2) through (4) of this section. Under paragraph (c)(2)(i) 
of this section, DC1 recognizes deferred section 987 gain in Year 3 as a 
result of the remittance from Business B to DC2. Under paragraph 
(c)(2)(ii) of this section, the amount of deferred section 987 gain that 
DC1 recognizes is $25x, which is DC1's outstanding deferred section 987 
gain or loss ($100x) with respect to Business A multiplied by the 
remittance proportion (0.25) of DC2 with respect to Business B for the 
taxable year as determined under Sec. 1.987-5(b).
    (i) Coordination with fresh start transition method--(1) In general. 
If a taxpayer is a deferral QBU owner, or is or was the owner of an 
outbound loss QBU, and the taxpayer is required under Sec. 1.987-10(a) 
to apply the fresh start transition method described in Sec. 1.987-
10(b) to the deferral QBU or outbound loss QBU, or would have been so 
required if the taxpayer had owned the deferral QBU or outbound loss QBU 
on the transition date (as defined in Sec. 1.987-11(c)), the 
adjustments described in paragraphs (i)(2) and (3) of this section, as 
applicable, must be made on the transition date.
    (2) Adjustment to deferred section 987 gain or loss. The amount of 
any outstanding deferred section 987 gain or loss of a deferral QBU 
owner with respect to a deferral QBU described in paragraph (i)(1) of 
this section must be adjusted to equal the amount of outstanding 
deferred section 987 gain or loss that the deferral QBU owner would have 
had with respect to the deferral QBU on the transition date if, 
immediately before the deferral event, the deferral QBU had transitioned 
to the method prescribed by Sec. Sec. 1.987-1 through 1.987-10 pursuant 
to the fresh start transition method.
    (3) Adjustments in the case of an outbound loss event. The basis of 
any stock described in paragraph (d)(4) of this section that was 
received in connection with the transfer (or deemed transfer)

[[Page 710]]

of assets of an outbound loss QBU described in paragraph (i)(1) of this 
section and that is held on the transition date must be adjusted to 
equal the basis that such stock would have had on the transition date 
if, immediately prior to the outbound loss event, the outbound loss QBU 
had transitioned to the method prescribed by Sec. Sec. 1.987-1 through 
1.987-10 pursuant to the fresh start transition method. If no such stock 
was received, the amount of any outbound section 987 loss with respect 
to the outbound loss QBU that may be recognized on or after the 
transition date pursuant to paragraph (d)(5) of this section must be 
adjusted to equal the amount of such loss that would be outstanding and 
that may be recognized pursuant to that paragraph if, immediately before 
the outbound loss event, the outbound loss QBU had transitioned to the 
method prescribed by Sec. Sec. 1.987-1 through 1.987-10 pursuant to the 
fresh start transition method.
    (j) Applicability date--(1) In general. Except as described in 
paragraph (j)(2) of this section, this section applies to any deferral 
event or outbound loss event that occurs on or after January 6, 2017. 
This section also applies to any deferral event or outbound loss event 
that occurs as a result of an entity classification election made under 
Sec. 301.7701-3 that is filed on or after January 6, 2017, and that is 
effective before January 6, 2017.
    (2) Exceptions--(i) Principal purpose. This section applies to any 
deferral event or outbound loss event occurring on or after December 7, 
2016, if such deferral event or outbound loss event was undertaken with 
a principal purpose of recognizing section 987 loss.
    (ii) Entity classification. This section also applies to any 
deferral event or outbound loss event that occurs as a result of an 
entity classification election made under Sec. 301.7701-3 that was 
filed on or after December 22, 2016, that was effective before December 
7, 2016, and that was undertaken with a principal purpose of recognizing 
section 987 loss.

[T.D. 9857, 84 FR 20796, May 13, 2019]



Sec. 1.988-0  Taxation of gain or loss from a section 988 
transaction; Table of Contents.

    This section lists captioned paragraphs contained in Sec. Sec. 
1.988-1 through 1.988-6.

          Sec. 1.988-1 Certain definitions and special rules.

    (a) Section 988 transaction.
    (1) In general.
    (2) Description of transactions.
    (3) [Reserved]
    (4) Treatment of assets and liabilities of a section 987 aggregate 
partnership or DE that are not attributed to an eligible QBU.
    (5) [Reserved]
    (6) Examples.
    (7) Special rules for regulated futures contracts and non-equity 
options.
    (8) Special rules for qualified funds.
    (9) Exception for certain transactions entered into by an 
individual.
    (10) Intra-taxpayer transactions.
    (11) Authority of Commissioner to include or exclude transactions 
from section 988.
    (b) Spot contract.
    (c) Nonfunctional currency.
    (d) Spot rate.
    (1) In general.
    (2) Consistency required in valuing transactions subject to section 
988.
    (3) Use of certain spot rate conventions for payables and 
receivables denominated in nonfunctional currency.
    (4) Currency where an official government established rate differs 
from a free market rate.
    (e) Exchange gain or loss.
    (f) Hyperinflationary currency.
    (g) Fair market value.
    (h) Interaction with sections 1092 and 1256 in examples.
    (i) Effective date.

   Sec. 1.988-2 Recognition and computation of exchange gain or loss.

    (a) Disposition of nonfunctional currency.
    (1) Recognition of exchange gain or loss.
    (2) Computation of exchange gain or loss.
    (b) Translation of interest income or expense and determination of 
exchange gain or loss with respect to debt instruments.
    (1) Translation of interest income received with respect to a 
nonfunctional currency demand account.
    (2) Translation of nonfunctional currency interest income or expense 
received or paid with respect to a debt instrument described in Sec. 
1.988-1(a)(1)(ii) and (2)(i).
    (3) Exchange gain or loss recognized by the holder with respect to 
accrued interest income.
    (4) Exchange gain or loss recognized by the obligor with respect to 
accrued interest expense.

[[Page 711]]

    (5) Exchange gain or loss recognized by the holder of a debt 
instrument with respect to principal.
    (6) Exchange gain or loss recognized by the obligor of a debt 
instrument with respect to principal.
    (7) Payment ordering rules.
    (8) Limitation of exchange gain or loss on payment or disposition of 
a debt instrument.
    (9) Examples.
    (10) Treatment of bond premium.
    (11) Market discount.
    (12) Tax exempt bonds.
    (13) Nonfunctional currency debt exchanged for stock of obligor.
    (14) [Reserved]
    (15) Debt instruments and deposits denominated in hyperinflationary 
currencies.
    (16) [Reserved]
    (17) Coordination with installment method under section 453.
    (18) Interaction of section 988 and Sec. 1.1275-2(g).
    (c) Item of expense or gross income or receipts which is to be paid 
or received after the date accrued.
    (1) In general.
    (2) Determination of exchange gain or loss with respect to an item 
of gross income or receipts.
    (3) Determination of exchange gain or loss with respect to an item 
of expense.
    (4) Examples.
    (d) Exchange gain or loss with respect to forward contracts, futures 
contracts and option contracts.
    (1) Scope.
    (2) Realization of exchange gain or loss.
    (3) Recognition of exchange gain or loss.
    (4) Determination of exchange gain or loss.
    (5) Hyperinflationary contracts.
    (e) Currency swaps and notional principal contracts.
    (1) Notional principal contract denominated in a single 
nonfunctional currency.
    (2) Special rules for currency swaps.
    (3) Amortization of swap premium or discount in the case of off 
market swaps.
    (4) Treatment of taxpayer disposing of a currency swap.
    (5) Examples.
    (6) Special effective date for rules regarding currency swaps.
    (7) Special rules for currency swap contracts in hyperinflationary 
currencies.
    (f) Substance over form.
    (1) In general.
    (2) Example.
    (g) Effective date.
    (h) Timing of income and deductions from notional principal 
contracts.
    (i) [Reserved]

            Sec. 1.988-3 Character of exchange gain or loss.

    (a) In general.
    (b) Election to characterize exchange gain or loss on certain 
identified forward contracts, futures contracts and option contracts as 
capital gain or loss.
    (1) In general.
    (2) Special rule for contracts that become part of a straddle after 
the election is made.
    (3) Requirements for making the election.
    (4) Verification.
    (5) Independent verification.
    (6) Effective date.
    (c) Exchange gain or loss treated as interest.
    (1) In general.
    (2) Exchange loss realized by the holder on nonfunctional currency 
tax exempt bonds.
    (d) Effective date.

     Sec. 1.988-4 Source of gain or loss realized on a section 988 
                              transaction.

    (a) In general.
    (b) Qualified business unit.
    (1) In general.
    (2) Proper reflection on the books of the taxpayer or qualified 
business unit.
    (c) Effectively connected exchange gain or loss.
    (d) Residence.
    (1) In general.
    (2) Exception.
    (3) Partner in a partnership not engaged in a U.S. trade or business 
under section 864(b)(2).
    (e) Special rule for certain related party loans.
    (1) In general.
    (2) United States person.
    (3) Loans by related person.
    (4) 10 percent owned foreign corporation.
    (f) Exchange gain or loss treated as interest under Sec. 1.988-3.
    (g) Exchange gain or loss allocated in the same manner as interest 
under Sec. 1.861-9T.
    (h) Effective date.

           Sec. 1.988-5 Section 988(d) hedging transactions.

    (a) Integration of a nonfunctional currency debt instrument and a 
Sec. 1.988-5(a) hedge.
    (1) In general.
    (2) Exception.
    (3) Qualifying debt instrument.
    (4) Section 1.988-5(a) hedge.
    (5) Definition of integrated economic transaction.
    (6) Special rules for legging in and legging out of integrated 
treatment.
    (7) Transactions part of a straddle.
    (8) Identification requirements.
    (9) Taxation of qualified hedging transactions.
    (10) Transition rules and effective dates.
    (b) Hedged executory contracts.
    (1) In general.
    (2) Definitions.
    (3) Identification rules.
    (4) Effect of hedged executory contract.
    (5) References to this paragraph (b).

[[Page 712]]

    (c) Hedges of period between trade date and settlement date on 
purchase or sale of publicly traded stock or security.
    (d) [Reserved]
    (e) Advance rulings regarding net hedging and anticipatory hedging 
systems.
    (f) [Reserved]
    (g) General effective date.

Sec. 1.988-6 Nonfunctional Currency Contingent Payment Debt Instruments

    (a) In general.
    (1) Scope.
    (2) Exception for hyperinflationary currencies.
    (b) Instruments described in paragraph (a)(1)(i) of this section.
    (1) In general.
    (2) Application of noncontingent bond method.
    (3) Treatment and translation of amounts determined under 
noncontingent bond method.
    (4) Determination of gain or loss not attributable to foreign 
currency.
    (5) Determination of foreign currency gain or loss.
    (6) Source of gain or loss.
    (7) Basis different from adjusted issue price.
    (8) Fixed but deferred contingent payments.
    (c) Examples.
    (d) Multicurrency debt instruments.
    (1) In general.
    (2) Determination of denomination currency.
    (3) Issuer/holder consistency.
    (4) Treatment of payments in currencies other than the denomination 
currency.
    (e) Instruments issued for nonpublicly traded property.
    (1) Applicability.
    (2) Separation into components.
    (3) Treatment of components consisting of one or more noncontingent 
payments in the same currency.
    (4) Treatment of components consisting of contingent payments.
    (5) Basis different from adjusted issue price.
    (6) Treatment of holder on sale, exchange, or retirement.
    (f) Rules for nonfunctional currency tax exempt obligations 
described in Sec. 1.1275-4(d).
    (g) Effective date.

[T.D. 8400, 57 FR 9177, Mar. 17, 1992, as amended by T.D. 8860, 65 FR 
2028, Jan. 13, 2000; T.D. 9157, 69 FR 52818, Aug. 30, 2004; T.D. 9794, 
81 FR 88850, Dec. 8, 2016; T.D. 9795, 81 FR 88879, Dec. 8, 2016]



Sec. 1.988-1  Certain definitions and special rules.

    (a) Section 988 transaction--(1) In general. The term ``section 988 
transaction'' means any of the following transactions--
    (i) A disposition of nonfunctional currency as defined in paragraph 
(c) of this section;
    (ii) Any transaction described in paragraph (a)(2) of this section 
if any amount which the taxpayer is entitled to receive or is required 
to pay by reason of such transaction is denominated in terms of a 
nonfunctional currency or is determined by reference to the value of one 
or more nonfunctional currencies.


A transaction described in this paragraph (a) need not require or permit 
payment with a nonfunctional currency as long as any amount paid or 
received is determined by reference to the value of one or more 
nonfunctional currencies. The acquisition of nonfunctional currency is 
treated as a section 988 transaction for purposes of establishing the 
taxpayer's basis in such currency and determining exchange gain or loss 
thereon.
    (2) Description of transactions. The following transactions are 
described in this paragraph (a)(2).
    (i) Debt instruments. Acquiring a debt instrument or becoming an 
obligor under a debt instrument. The term ``debt instrument'' means a 
bond, debenture, note, certificate or other evidence of indebtedness.
    (ii) Payables, receivables, etc. Accruing, or otherwise taking into 
account, for purposes of subtitle A of the Internal Revenue Code, any 
item of expense or gross income or receipts which is to be paid or 
received after the date on which so accrued or taken into account. A 
payable relating to cost of goods sold, or a payable or receivable 
relating to a capital expenditure or receipt, is within the meaning of 
this paragraph (a)(2)(ii). Generally, a payable relating to foreign 
taxes (whether or not claimed as a credit under section 901) is within 
the meaning of this paragraph (a)(2)(ii). However, a payable of a 
domestic person relating to accrued foreign taxes of its qualified 
business unit (QBU branch) is not within the meaning of this paragraph 
(a)(2)(ii) if the QBU branch's functional currency is the U.S. dollar 
and the foreign taxes are claimed as a credit under section 901.

[[Page 713]]

    (iii) Forward contract, futures contract, option contract, or 
similar financial instrument. Except as otherwise provided in this 
paragraph (a)(2)(iii) and paragraph (a)(4)(i) of this section, entering 
into or acquiring any forward contract, futures contract, option, 
warrant, or similar financial instrument.
    (A) Limitation for certain derivative instruments. A forward 
contract, futures contract, option, warrant, or similar financial 
instrument is within this paragraph (a)(2)(iii) only if the underlying 
property to which the instrument ultimately relates is a nonfunctional 
currency or is otherwise described in paragraph (a)(1)(ii) of this 
section. Thus, if the underlying property of an instrument is another 
financial instrument (e.g., an option on a futures contract), then the 
underlying property to which such other instrument (e.g., the futures 
contract) ultimately relates must be a nonfunctional currency. For 
example, a forward contract to purchase wheat denominated in a 
nonfunctional currency, an option to enter into a forward contract to 
purchase wheat denominated in a nonfunctional currency, or a warrant to 
purchase stock denominated in a nonfunctional currency is not described 
in this paragraph (a)(2)(iii). On the other hand, a forward contract to 
purchase a nonfunctional currency, an option to enter into a forward 
contract to purchase a nonfunctional currency, an option to purchase a 
bond denominated in or the payments of which are determined by reference 
to the value of a nonfunctional currency, or a warrant to purchase 
nonfunctional currency is described in this paragraph (a)(2)(iii).
    (B) Nonfunctional currency notional principal contracts--(1) In 
general. The term ``similar financial instrument'' includes a notional 
principal contract only if the payments required to be made or received 
under the contract are determined with reference to a nonfunctional 
currency.
    (2) Definition of notional principal contract. The term ``notional 
principal contract'' means a contract (e.g., a swap, cap, floor or 
collar) that provides for the payment of amounts by one party to another 
at specified intervals calculated by reference to a specified index upon 
a notional principal amount in exchange for specified consideration or a 
promise to pay similar amounts. For this purpose, a ``notional principal 
contract'' shall only include an instrument where the underlying 
property to which the instrument ultimately relates is money (e.g., 
functional currency), nonfunctional currency, or property the value of 
which is determined by reference to an interest rate. Thus, the term 
``notional principal contract'' includes a currency swap as defined in 
Sec. 1.988-2(e)(2)(ii), but does not include a swap referenced to a 
commodity or equity index.
    (C) Effective date with respect to certain contracts. This paragraph 
(a)(2)(iii) does not apply to any forward contract, futures contract, 
option, warrant, or similar financial instrument entered into or 
acquired on or before October 21, 1988, if such instrument would have 
been marked to market under section 1256 if held on the last day of the 
taxable year.
    (3) [Reserved] For further guidance, see Sec. 1.988-1T(a)(3).
    (4) Treatment of assets and liabilities of a section 987 aggregate 
partnership or DE that are not attributed to an eligible QBU--(i) Scope. 
This paragraph (a)(4) applies to assets and liabilities of a section 987 
aggregate partnership as defined in Sec. 1.987-1(b)(5), or of an entity 
disregarded as an entity separate from its owner for Federal income tax 
purposes (DE), that are not attributable to an eligible QBU as defined 
in Sec. 1.987-1(b)(3).
    (ii) Section 987 Aggregate Partnerships. For purposes of applying 
section 988 and the applicable regulations to transactions involving 
assets and liabilities described in paragraph (a)(4)(i) of this section 
that are held by a section 987 aggregate partnership, the owners of the 
section 987 aggregate partnership (within the meaning of Sec. 1.987-
1(b)(4)) shall be treated as owning their share of such assets and 
liabilities. Section 1.987-7(b) shall apply for purposes of determining 
an owner's share of such assets or liabilities.
    (iii) Disregarded entities. For purposes of applying section 988 and 
the applicable regulations to transactions involving assets and 
liabilities described in paragraph (a)(4)(i) of this section that are 
held by a DE, the owner of the DE

[[Page 714]]

(within the meaning of Sec. 1.987-1(b)(4)) shall be treated as owning 
all such assets and liabilities.
    (iv) Example. The following example illustrates the application of 
paragraph (a)(4) of this section:

    Example. Liability held through a section 987 aggregate partnership. 
(i) Facts. P, a foreign partnership, has two equal partners, X and Y. X 
is a domestic corporation with the dollar as its functional currency. Y 
is a foreign corporation wholly owned by X that has the yen as its 
functional currency. P is a section 987 aggregate partnership. On 
January 1, 2021, P borrowed yen and issued a note to the lender that 
obligated P to pay interest and repay principal to the lender in yen. 
Also on January 1, 2021, P used the yen it borrowed from the lender to 
acquire all of the stock of F, a foreign corporation, from an unrelated 
person. P also holds an eligible QBU (within the meaning of Sec. 1.987-
1(b)(3)) that has the yen as its functional currency. P maintains one 
set of books and records. The assets and liabilities of the eligible QBU 
are reflected on the books and records of P as provided under Sec. 
1.987-2(b). The F stock held by P, and the yen liability incurred to 
acquire the F stock, are also recorded on the books and records of P 
but, pursuant to Sec. 1.987-2(b)(2)(i), are not considered to be 
reflected on the books and records of the eligible QBU for purposes of 
section 987.
    (ii) Analysis. X's portion of the assets and liabilities of the 
eligible QBU owned by P is a section 987 QBU. Y's portion of the assets 
and liabilities of the eligible QBU owned by P is not a section 987 QBU 
because Y and the eligible QBU have the same functional currency. 
Because the F stock and yen-denominated liability incurred to acquire 
such stock are not considered reflected on the books and records of the 
eligible QBU, they are not subject to section 987. In addition, because 
the F stock and the yen-denominated liability incurred to acquire such 
stock are held by P (but not attributable to P's eligible QBU), X and Y 
are treated as owning their respective shares of such stock and 
liability pursuant to Sec. 1.988-1(a)(4)(ii) for purposes of applying 
section 988. As a result, P's becoming the obligor on the portion of the 
yen-denominated note that is treated as an obligation of X is a section 
988 transaction pursuant to paragraphs (a)(1)(ii), (a)(2)(ii) and (a)(3) 
of this section. Similarly, the dispositions of yen to make payments of 
interest and principal on the liability, to the extent such yen are 
treated as owned by X under paragraph (a)(4)(ii) of this section, are 
section 988 transactions under paragraphs (a)(1)(i) and (a)(3) of this 
section. To the extent the yen are treated as owned by the eligible QBU, 
see Sec. 1.987-2(c) for the treatment of the payment of yen as a 
transfer from the eligible QBU to X. P's becoming the obligor on Y's 
portion of the yen-denominated note, and Y's portion of the yen disposed 
of in connection with payments on such note, are not section 988 
transactions because Y has the yen as its functional currency.

    (5) [Reserved]
    (6) Examples. The following examples illustrate the application of 
paragraph (a) of this section. The examples assume that X is a U.S. 
corporation on an accrual method with the calendar year as its taxable 
year. Because X is a U.S. corporation the U.S. dollar is its functional 
currency under section 985. The examples also assume that section 988(d) 
does not apply.

    Example 1. On January 1, 1989, X acquires 10,000 Canadian dollars. 
On January 15, 1989, X uses the 10,000 Canadian dollars to purchase 
inventory. The acquisition of the 10,000 Canadian dollars is a section 
988 transaction for purposes of establishing X's basis in such Canadian 
dollars. The disposition of the 10,000 Canadian dollars is a section 988 
transaction pursuant to paragraph (a)(1) of this section.
    Example 2. On January 1, 1989, X acquires 10,000 Canadian dollars. 
On January 15, 1989, X converts the 10,000 Canadian dollars to U.S. 
dollars. The acquisition of the 10,000 Canadian dollars is a section 988 
transaction for purposes of establishing X's basis in such Canadian 
dollars. The conversion of the 10,000 Canadian dollars to U.S. dollars 
is a section 988 transaction pursuant to paragraph (a)(1) of this 
section.
    Example 3. On January 1, 1989, X borrows 100,000 British pounds 
([pound]) for a period of 10 years and issues a note to the lender with 
a face amount of [pound]100,000. The note provides for payments of 
interest at an annual rate of 10% paid quarterly in pounds and has a 
stated redemption price at maturity of [pound]100,000. X's becoming the 
obligor under the note is a section 988 transaction pursuant to 
paragraphs (a)(1)(ii) and (2)(i) of this section. Because X is an 
accrual basis taxpayer, the accrual of interest expense under X's note 
is a section 988 transaction pursuant to paragraphs (a)(1)(ii) and 
(2)(ii) of this section. In addition, the acquisition of the British 
pounds to make payments under the note is a section 988 transaction for 
purposes of establishing X's basis in such pounds, and the disposition 
of such pounds is a section 988 transaction under paragraph (a)(1)(i) of 
this section. See Sec. 1.988-2(b) with respect to the translation of 
accrued interest expense and the determination of exchange gain or loss 
upon payment of accrued interest expense.
    Example 4. On January 1, 1989, X purchases an original issue for 
74,621.54 British pounds ([pound]) a 3-year bond maturing on December 
31,

[[Page 715]]

1991, at a stated redemption price of [pound]100,000. The bond provides 
for no stated interest. The bond has a yield to maturity of 10% 
compounded semiannually and has [pound]25,378.46 of original issue 
discount. The acquisition of the bond is a section 988 transaction as 
provided in paragraphs (a)(1)(ii) and (2)(i) of this section. The 
accrual of original issue discount with respect to the bond is a section 
988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of this section. 
See Sec. 1.988-2(b) with respect to the translation of original issue 
discount and the determination of exchange gain or loss upon receipt of 
such amounts.
    Example 5. On January 1, 1989, X sells and delivers inventory to Y 
for 10,000,000 Italian lira for payment on April 1, 1989. Under X's 
method of accounting, January 1, 1989 is the accrual date. Because X is 
an accrual basis taxpayer, the accrual of a nonfunctional currency 
denominated item of gross receipts on January 1, 1989, for payment after 
the date of accrual is a section 988 transaction under paragraphs 
(a)(1)(ii) and (2)(ii) of this section.
    Example 6. On January 1, 1989, X agrees to purchase a machine from Y 
for delivery on March 1, 1990 for 1,000,000 yen. The agreement calls for 
X to pay Y for the machine on June 1, 1990. Under X's method of 
accounting, the expenditure for the machine does not accrue until 
delivery on March 1, 1990. The agreement to purchase the machine is not 
a section 988 transaction. In particular, the agreement to purchase the 
machine is not described in paragraph (a)(2)(ii) of this section because 
the agreement is not an item of expense taken into account under 
subtitle A (but rather is an agreement to purchase a capital asset in 
the future). However, the payable that will arise on the delivery date 
is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of 
this section even though the payable relates to a capital expenditure. 
In addition, the disposition of yen to satisfy the payable on June 1, 
1990, is a section 988 transaction under paragraph (a)(1)(i) of this 
section.
    Example 7. On January 1, 1989, X purchases and takes delivery of 
inventory for 10,000 French francs with payment to be made on April 1, 
1989. Under X's method of accounting, the expense accrues on January 1, 
1989. On January 1, 1989, X also enters into a forward contract with a 
bank to purchase 10,000 French francs for $2,000 on April 1, 1989. 
Because X is an accrual basis taxpayer, the accrual of a nonfunctional 
currency denominated item of expense on January 1, 1989, for payment 
after the date of accrual is a section 988 transaction under paragraphs 
(a)(1)(ii) and (2)(ii) of this section. Entering into the forward 
contract to purchase the 10,000 French francs is a section 988 
transaction under paragraphs (a)(1)(ii) and (2)(iii) of this section.
    Example 8. On January 1, 1989, X acquires 100,000 Norwegian krone. 
On January 15, 1989, X purchases and takes delivery of 1,000 shares of 
common stock with the 100,000 krone acquired on January 1, 1989. On 
August 1, 1989, X sells the 1,000 shares of common stock and receives 
120,000 krone in payment. On August 30, 1989, X converts the 120,000 
krone to U.S. dollars. The acquisition of the 100,000 krone on January 
1, 1989, and the acquisition of the 120,000 krone on August 1, 1989, are 
section 988 transactions for purposes of establishing the basis of such 
krone. The disposition of the 100,000 krone on January 15, 1989, and the 
120,000 krone on August 30, 1989, are section 988 transactions as 
provided in paragraph (a)(1)(i) of this section. Neither the acquisition 
on January 15, 1989, nor the disposition on August 1, 1989, of the stock 
is a section 988 transaction.
    Example 9. On May 11, 1989, X purchases a one year note at original 
issue for its issue price of $1,000. The note pays interest in dollars 
at the rate of 4 percent compounded semiannually. The amount of 
principal received by X upon maturity is equal to $1,000 plus the 
equivalent of the excess, if any, of (a) the Financial Times One Hundred 
Stock Index (an index of stocks traded on the London Stock Exchange 
hereafter referred to as the FT100) determined and translated into 
dollars on the last business day prior to the maturity date, over (b) 
[pound]2,150, the ``stated value'' of the FT100, which is equal to 110% 
of the average value of the index for the six months prior to the issue 
date, translated at the exchange rate of [pound]1 = $1.50. The purchase 
by X of the instrument described above is not a section 988 transaction 
because the index used to compute the principal amount received upon 
maturity is determined with reference to the value of stock and not 
nonfunctional currency.
    Example 10. On April 9, 1989, X enters into an interest rate swap 
that provides for the payment of amounts by X to its counterparty based 
on 4% of a 10,000 yen principal amount in exchange for amounts based on 
yen LIBOR rates. Pursuant to paragraphs (a)(1)(ii) and (2)(iii) of this 
section, this yen for yen interest rate swap is a section 988 
transaction.
    Example 11. On August 11, 1989, X enters into an option contract for 
sale of a group of stocks traded on the Japanese Nikkei exchange. The 
contract is not a section 988 transaction within the meaning of Sec. 
1.988-1(a)(2)(iii) because the underlying property to which the option 
relates is a group of stocks and not nonfunctional currency.

    (7) Special rules for regulated futures contracts and non-equity 
options--(i) In general. Except as provided in paragraph (a)(7)(ii) of 
this section, paragraph (a)(2)(iii) of this section shall not

[[Page 716]]

apply to any regulated futures contract or non-equity option which would 
be marked to market under section 1256 if held on the last day of the 
taxable year.
    (ii) Election to have paragraph (a)(2)(iii) of this section apply. 
Notwithstanding paragraph (a)(7)(i) of this section, a taxpayer may 
elect to have paragraph (a)(2)(iii) of this section apply to regulated 
futures contracts and non-equity options as provided in paragraphs 
(a)(7)(iii) and (iv) of this section.
    (iii) Procedure for making the election. A taxpayer shall make the 
election provided in paragraph (a)(7)(ii) of this section by sending to 
the Internal Revenue Service Center, Examination Branch, Stop Number 92, 
Kansas City, MO 64999 a statement titled ``Election to Treat Regulated 
Futures Contracts and Non-Equity Options as Section 988 Transactions 
Under Section 988 (c)(1)(D)(ii)'' that contains the following:
    (A) The taxpayer's name, address, and taxpayer identification 
number;
    (B) The date the notice is mailed or otherwise delivered to the 
Internal Revenue Service Center;
    (C) A statement that the taxpayer (including all members of such 
person's affiliated group as defined in section 1504 or in the case of 
an individual all persons filing a joint return with such individual) 
elects to have section 988(c)(1)(D)(i) and Sec. 1.988-1(a)(7)(i) not 
apply;
    (D) The date of the beginning of the taxable year for which the 
election is being made;
    (E) If the election is filed after the first day of the taxable 
year, a statement regarding whether the taxpayer has previously held a 
contract described in section 988(c)(1)(D)(i) or Sec. 1.988-1(a)(7)(i) 
during such taxable year, and if so, the first date during the taxable 
year on which such contract was held; and
    (F) The signature of the person making the election (in the case of 
individuals filing a joint return, the signature of all persons filing 
such return).


The election shall be made by the following persons: in the case of an 
individual, by such individual; in the case of a partnership, by each 
partner separately; effective for taxable years beginning after March 
17, 1992, in the case of tiered partnerships, each ultimate partner; in 
the case of an S corporation, by each shareholder separately; in the 
case of a trust (other than a grantor trust) or estate, by the fiduciary 
of such trust or estate; in the case of any corporation other than an S 
corporation, by such corporation (in the case of a corporation that is a 
member of an affiliated group that files a consolidated return, such 
election shall be valid and binding only if made by the common parent, 
as that term is used in Sec. 1.1502-77(a)); in the case of a controlled 
foreign corporation, by its controlling United States shareholders under 
Sec. 1.964-1(c)(3). With respect to a corporation (other than an S 
corporation), the election, when made by the common parent, shall be 
binding on all members of such corporation's affiliated group as defined 
in section 1504 that file a consolidated return. The election shall be 
binding on any income or loss derived from the partner's share 
(determined under the principles of section 702(a)) of all contracts 
described in section 988(c)(1)(D)(i) or paragraph (a)(7)(i) of this 
section in which the taxpayer holds a direct interest or indirect 
interest through a partnership or S corporation; however, the election 
shall not apply to any income or loss of a partnership for any taxable 
year if such partnership made an election under section 
988(c)(1)(E)(iii)(V) for such year or any preceding year. Generally, a 
copy of the election must be attached to the taxpayer's income tax 
return for the first year it is effective. It is not required to be 
attached to subsequent returns. However, in the case of a partner, a 
copy of the election must be attached to the taxpayer's income tax 
return for every year during which the taxpayer is a partner in a 
partnership that engages in a transaction that is subject to the 
election.
    (iv) Time for making the election--(A) In general. Unless the 
requirements for making a late election described in paragraph 
(a)(7)(iv)(B) of this section are satisfied, an election under section 
988 (c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section for any 
taxable year shall be made on or before the first day

[[Page 717]]

of the taxable year or, if later, on or before the first day during such 
taxable year on which the taxpayer holds a contract described in section 
988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section. The election 
under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section 
shall apply to contracts entered into or acquired after October 21, 
1988, and held on or after the effective date of the election. The 
election shall be effective as of the beginning of the taxable year and 
shall be binding with respect to all succeeding taxable years unless 
revoked with the prior consent of the Commissioner. In determining 
whether to grant revocation of the election, recapture of the tax 
benefit derived from the election in previous taxable years will be 
considered.
    (B) Late elections. A taxpayer may make an election under section 
988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section within 30 days 
after the time prescribed in the first sentence of paragraph 
(a)(7)(iv)(A) of this section. Such a late election shall be effective 
as of the beginning of the taxable year; however, any losses recognized 
during the taxable year with respect to contracts described in section 
988(c)(1)(D)(ii) or paragraph (a)(7)(ii) of this section which were 
entered into or acquired after October 21, 1988, and held on or before 
the date on which the late election is mailed or otherwise delivered to 
the Internal Revenue Service Center shall not be treated as derived from 
a section 988 transaction. A late election must comply with the 
procedures set forth in paragraph (a)(7)(iii) of this section.
    (v) Transition rule. An election made prior to September 21, 1989 
which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, 
shall be deemed to satisfy the requirements of paragraphs (a)(7)(iii) 
and (iv) of this section.
    (vi) General effective date provision. This paragraph (a)(7) shall 
apply with respect to futures contracts and options entered into or 
acquired after October 21, 1988.
    (8) Special rules for qualified funds--(i) Definition of qualified 
fund. The term ``qualified fund'' means any partnership if--
    (A) At all times during the taxable year (and during each preceding 
taxable year to which an election under section 988(c)(1)(E)(iii)(V) 
applied) such partnership has at least 20 partners and no single partner 
owns more than 20 percent of the interests in the capital or profits of 
the partnership;
    (B) The principa1 activity of such partnership for such taxable year 
(and each such preceding taxable year) consists of buying and selling 
options, futures, or forwards with respect to commodities;
    (C) At least 90 percent of the gross income of the partnership for 
the taxable year (and each such preceding year) consists of income or 
gains described in subparagraph (A), (B), or (G) of section 7704(d)(1) 
or gain from the sale or disposition of capital assets held for the 
production of interest or dividends;
    (D) No more than a de minimis amount of the gross income of the 
partnership for the taxable year (and each such preceding taxable year) 
was derived from buying and selling commodities; and
    (E) An election under section 988 (c)(1)(E)(iii)(V) as provided in 
paragraph (a)(8)(iv) of this section applies to the taxable year.
    (ii) Special rules relating to paragraph (a)(8)(i)(A) of this 
section--(A) Certain general partners. The interest of a general partner 
in the partnership shall not be treated as failing to meet the 20 
percent ownership requirement of paragraph (a)(8)(i)(A) of this section 
for any taxable year of the partnership if, for the taxable year of the 
partner in which such partnership's taxable year ends, such partner (and 
each corporation filing a consolidated return with such partner) had no 
ordinary income or loss from a section 988 transaction (other than 
income from the partnership) which is exchange gain or loss (as the case 
may be).
    (B) Treatment of incentive compensation. For purposes of paragraph 
(a)(8)(i)(A) of this section, any income allocable to a general partner 
as incentive compensation based on profits rather than capital shall not 
be taken into account in determining such partner's interest in the 
profits of the partnership.

[[Page 718]]

    (C) Treatment of tax exempt partners. The interest of a partner in 
the partnership shall not be treated as failing to meet the 20 percent 
ownership requirements of paragraph (a)(5)(8)(A) of this section if none 
of the income of such partner from such partnership is subject to tax 
under chapter 1 of subtitle A of the Internal Revenue Code (whether 
directly or through one or more pass-through entities).
    (D) Look-through rule. In determining whether the 20 percent 
ownership requirement of paragraph (a)(8)(i)(A) of this section is met 
with respect to any partnership, any interest in such partnership held 
by another partnership shall be treated as held proportionately by the 
partners in such other partnership.
    (iii) Other special rules--(A) Related persons. Interests in the 
partnership held by persons related to each other (within the meaning of 
section 267(b) or 707(b)) shall be treated as held by one person.
    (B) Predecessors. Reference to any partnership shall include a 
reference to any predecessor thereof.
    (C) Treatment of certain debt instruments. Solely for purposes of 
paragraph (a)(8)(i)(D) of this section, any debt instrument which is 
described in both paragraphs (a)(1)(ii) and (2)(i) of this section shall 
be treated as a commodity.
    (iv) Procedure for making the election provided in section 
988(c)(1)(E)(iii)(V). A partnership shall make the election provided in 
section 988(c)(1)(E)(iii)(V) by sending to the Internal Revenue Service 
Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a 
statement titled ``QUALIFIED FUND ELECTION UNDER SECTION 
988(c)(1)(E)(iii)(V)'' that contains the following:
    (A) The partnership's name, address, and taxpayer identification 
number;
    (B) The name, address and taxpayer identification number of the 
general partner making the election on behalf of the partnership;
    (C) The date the notice is mailed or otherwise delivered to the 
Internal Revenue Service Center;
    (D) A brief description of the activity of the partnership;
    (E) A statement that the partnership is making the election provided 
in section 988(c)(1)(E)(iii)(V);
    (F) The date of the beginning of the taxable year for which the 
election is being made;
    (G) If the election is filed after the first day of the taxable 
year, then a statement regarding whether the partnership previously held 
an instrument referred to in section 988(c)(1)(E)(i) during such taxable 
year and, if so, the first date during the taxable year on which such 
contract was held; and
    (H) The signature of the general partner making the election.


The election shall be made by a general partner with management 
responsibility of the partnership's activities and a copy of such 
election shall be attached to the partnership's income tax return (Form 
1065) for the first taxable year it is effective. It is not required to 
be attached to subsequent returns.
    (v) Time for making the election. The election under section 
988(c)(1)(E)(iii)(V) for any taxable year shall be made on or before the 
first day of the taxable year or, if later, on or before the first day 
during such year on which the partnership holds an instrument described 
in section 988(c)(1)(E)(i). The election under section 
988(c)(1)(E)(iii)(V) shall apply to the taxable year for which made and 
all succeeding taxable years. Such election may only be revoked with the 
consent of the Commissioner. In determining whether to grant revocation 
of the election, recapture by the partners of the tax benefit derived 
from the election in previous taxable years will be considered.
    (vi) Operative rules applicable to qualified funds--(A) In general. 
In the case of a qualified fund, any bank forward contract or any 
foreign currency futures contract traded on a foreign exchange which is 
not otherwise a section 1256 contract shall be treated as a section 1256 
contract for purposes of section 1256.
    (B) Gains and losses treated as short-term. In the case of any 
instrument treated as a section 1256 contract under paragraph 
(a)(8)(vi)(A) of this section, subparagraph (A) of section 1256(a)(3) 
shall be applied by substituting ``100

[[Page 719]]

percent'' for ``40 percent'' (and subparagraph (B) of such section shall 
not apply).
    (vii) Transition rule. An election made prior to September 21, 1989, 
which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, 
shall be deemed to satisfy the requirements of Sec. 1.988-1(a)(8)(iv) 
and (v).
    (viii) General effective date rules--(A) The requirements of 
subclause (IV) of section 988(c)(1)(E)(iii) shall not apply to contracts 
entered into or acquired on or before October 21, 1988.
    (B) In the case of any partner in an existing partnership, the 20 
percent ownership requirements of subclause (I) of section 
988(c)(1)(E)(iii) shall be treated as met during any period during which 
such partner does not own a percentage interest in the capital or 
profits of such partnership greater than 33\1/3\ percent (or, if lower, 
the lowest such percentage interest of such partner during any period 
after October 21, 1988, during which such partnership is in existence). 
For purposes of the preceding sentence, the term ``existing 
partnership'' means any partnership if--
    (1) Such partnership was in existence on October 21, 1988, and 
principally engaged on such date in buying and selling options, futures, 
or forwards with respect to commodities; or
    (2) A registration statement was filed with respect to such 
partnership with the Securities and Exchange Commission on or before 
such date and such registration statement indicated that the principal 
activity of such partnership will consist of buying and selling 
instruments referred to in paragraph (a)(8)(viii)(B)(1) of this section.
    (9) Exception for certain transactions entered into by an 
individual--(i) In general. A transaction entered into by an individual 
which otherwise qualifies as a section 988 transaction shall be 
considered a section 988 transaction only to the extent expenses 
properly allocable to such transaction meet the requirements of section 
162 or 212 (other than the part of section 212 dealing with expenses 
incurred in connection with taxes).
    (ii) Examples. The following examples illustrate the application of 
paragraph (a)(9) of this section.

    Example 1. X is a U.S. citizen who therefore has the U.S. dollar as 
his functional currency. On January 1, 1990, X enters into a spot 
contract to purchase 10,000 British pounds ([pound]) for $15,000 for 
delivery on January 3, 1990. Immediately upon delivery, X acquires at 
original issue a pound denominated bond with an issue price of 
[pound]10,000. The bond matures on January 3, 1993, pays interest in 
pounds at a rate of 10% compounded semiannually, and has no original 
issue discount. Assume that all expenses properly allocable to these 
transactions would meet the requirements of section 212. Under Sec. 
1.988-2(d)(1)(ii), entering into the spot contract on January 1, 1990, 
is not a section 988 transaction. The acquisition of the pounds on 
January 3, 1990, under the spot contract is a section 988 transaction 
for purposes of establishing X's basis in the pounds. The disposition of 
the pounds and the acquisition of the bond by X are section 988 
transactions. These transactions are not excluded from the definition of 
a section 988 transaction under paragraph (a)(9) of this section because 
expenses properly allocable to such transactions meet the requirements 
of section 212.
    Example 2. X is a U.S. citizen who therefore has the dollar as his 
functional currency. In preparation for X's vacation, X purchases 1,000 
British pounds ([pound]) from a bank on June 1, 1989. During the period 
of X's vacation in the United Kingdom beginning June 10, 1989, and 
ending June 20, 1989, X spends [pound]500 for hotel rooms, [pound]300 
for food and [pound]200 for miscellaneous vacation expenses. The 
expenses properly allocable to such dispositions do not meet the 
requirements of section 162 or 212. Thus, the disposition of the pounds 
by X on his vacation are not section 988 transactions.

    (10) Intra-taxpayer transactions--(i) In general. Except as provided 
in paragraph (a)(10)(ii) of this section, transactions between or among 
the taxpayer and/or qualified business units of that taxpayer (``intra-
taxpayer transactions'') are not section 988 transactions. See section 
987 and the regulations thereunder.
    (ii) Certain intra-taxpayer transfers of section 988 transactions 
that result in the recognition of section 988 gain or loss--(A) In 
general. Exchange gain or loss with respect to nonfunctional currency or 
any item described in paragraph (a)(2) of this section entered into with 
another taxpayer shall be realized upon a transfer (as defined under 
Sec. 1.987-2(c)) of such currency or item from an owner to a section 
987 QBU or from a section 987 QBU to an owner if as a result of such 
transfer--

[[Page 720]]

    (1) The currency or item loses its character as nonfunctional 
currency or as an item described in paragraph (a)(2) of this section; or
    (2) The source of the exchange gain or loss could be altered absent 
the application of paragraph (a)(10)(ii)(B) of this section.
    (B) Computation of exchange gain or loss. Exchange gain or loss 
described in section (a)(10)(ii)(A) of this section shall be computed in 
accordance with Sec. 1.988-2 (without regard to Sec. 1.988-2(b)(8)) as 
if the nonfunctional currency or item described in paragraph (a)(2) of 
this section had been sold or otherwise transferred at fair market value 
between unrelated taxpayers. For purposes of the preceding sentence, a 
taxpayer must use a translation rate that is consistent with the 
translation conventions of the section 987 QBU to or from which, as the 
case may be, the item is being transferred. In the case of a gain or 
loss incurred in a transaction described in this paragraph (a)(10)(ii) 
that does not have a significant business purpose, the Commissioner may 
defer such gain or loss.
    (iii) Example. The following example illustrates the provisions of 
this paragraph (a)(10).

    Example. (A) X, a corporation with the U.S. dollar as its functional 
currency, operates through foreign branches Y and Z. Y and Z are 
qualified business units as defined in section 989(a) with the LC as 
their functional currency. X computes Y's and Z's income under section 
987 (relating to branch transactions). On November 12, 1988, Y transfers 
$25 to the home office of X when the fair market value of such amount 
equals LC120. Y has a basis of LC100 in the $25. Under paragraph 
(a)(10)(ii) of this section, Y realizes foreign source exchange gain of 
LC20 (LC120--LC100) as the result of the $25 transfer. For purposes of 
determining whether the transfer is a remittance resulting in additional 
gain or loss, see section 987 and the regulations thereunder.
    (B) If instead Y transfers the $25 to Z, exchange gain is not 
realized because the $25 is nonfunctional currency with respect to Z and 
if Z were to immediately convert the $25 into LCs, the gain would be 
foreign source. For purposes of determining whether the transfer is a 
remittance resulting in additional gain or loss, see section 987 and the 
regulations thereunder.

    (11) Authority to include or exclude transactions from section 988--
(i) In general. The Commissioner may recharacterize a transaction (or 
series of transactions) in whole or in part as a section 988 transaction 
if the effect of such transaction (or series of transactions) is to 
avoid section 988. In addition, the Commissioner may exclude a 
transaction (or series of transactions) which in form is a section 988 
transaction from the provisions of section 988 if the substance of the 
transaction (or series of transactions) indicates that it is not 
properly considered a section 988 transaction.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (a)(11).

    Example. B is an individual with the U.S. dollar as its functional 
currency. B holds 500,000 Swiss francs which have a basis of $100,000 
and a fair market value of $400,000 as of October 15, 1989. On October 
16, 1989, B transfers the 500,000 Swiss francs to a newly formed U.S. 
corporation, X, with the dollar as its functional currency. On October 
16, 1989, B sells the stock of X for $400,000. Assume the transfer to X 
qualified for nonrecognition under section 351. Because the sale of the 
stock of X is a substitute for the disposition of an asset subject to 
section 988, the Commissioner may recharacterize the sale of the stock 
as a section 988 transaction. The same result would obtain if B 
transferred the Swiss francs to a partnership and then sold the 
partnership interest.

    (b) Spot contract. A spot contract is a contract to buy or sell 
nonfunctional currency on or before two business days following the date 
of the execution of the contract. See Sec. 1.988-2 (d)(1)(ii) for 
operative rules regarding spot contracts.
    (c) Nonfunctional currency. The term ``nonfunctional currency'' 
means with respect to a taxpayer or a qualified business unit (as 
defined in section 989 (a)) a currency (including the European Currency 
Unit) other than the taxpayer's or the qualified business unit's 
functional currency as defined in section 985 and the regulations 
thereunder. For rules relating to nonrecognition of exchange gain or 
loss with respect to certain dispositions of nonfunctional currency, see 
Sec. 1.988-2 (a)(1)(iii).
    (d) Spot rate--(1) In general. Except as otherwise provided in this 
paragraph, the term ``spot rate'' means a rate demonstrated to the 
satisfaction of the

[[Page 721]]

District Director or the Assistant Commissioner (International) to 
reflect a fair market rate of exchange available to the public for 
currency under a spot contract in a free market and involving 
representative amounts. In the absence of such a demonstration, the 
District Director or the Assistant Commissioner (International), in his 
or her sole discretion, shall determine the spot rate from a source of 
exchange rate information reflecting actual transactions conducted in a 
free market. For example, the taxpayer or the District Director or the 
Assistant Commissioner (International) may determine the spot rate by 
reference to exchange rates published in the pertinent monthly issue of 
``International Financial Statistics'' or a successor publication of the 
International Monetary Fund; exchange rates published by the Board of 
Governors of the Federal Reserve System pursuant to 31 U.S.C. section 
5151; exchange rates published in newspapers, financial journals or 
other daily financial news sources; or exchange rates quoted by 
electronic financial news services.
    (2) Consistency required in valuing transactions subject to section 
988. If the use of inconsistent sources of spot rate quotations results 
in the distortion of income, the District Director or the Assistant 
Commissioner (International) may determine the appropriate spot rate.
    (3) Use of certain spot rate conventions for payables and 
receivables denominated in nonfunctional currency. If consistent with 
the taxpayer's financial accounting, a taxpayer may utilize a spot rate 
convention determined at intervals of one quarter year or less for 
purposes of computing exchange gain or loss with respect to payables and 
receivables denominated in a nonfunctional currency that are incurred in 
the ordinary course of business with respect to the acquisition or sale 
of goods or the obtaining or performance of services. For example, if 
consistent with the taxpayer's financial accounting, a taxpayer may 
accrue all payables and receivables incurred during the month of January 
at the spot rate on December 31 or January 31 (or at an average of any 
spot rates occurring between these two dates) and record the payment or 
receipt of amounts in satisfaction of such payables and receivables 
consistent with such convention. The use of a spot rate convention 
cannot be changed without the consent of the Commissioner.
    (4) Currency where an official government established rate differs 
from a free market rate--(i) In general. If a currency has an official 
government established rate that differs from a free market rate, the 
spot rate shall be the rate which most clearly reflects the taxpayer's 
income. Generally, this shall be the free market rate.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (d)(4).

    Example 1. X is an accrual method U.S. corporation with the dollar 
as its functional currency. X owns all the stock of a Country L 
subsidiary, CFC. CFC has the currency of Country L, the LC, as its 
functional currency. Country L imposes restrictions on the remittance of 
dividends. On April 1, 1990, CFC pays a dividend to X in the amount of 
LC100. Assume that the official governnent established rate is $1 = LC1 
and the free market rate, which takes into account the remittance 
restrictions and which is the rate that most clearly reflects income, is 
$1 = LC4. On April 1, 1990, X donates the LC100 in a transaction that 
otherwise qualifies as a charitable contribution under section 170 (c). 
Both the amount of the dividend income and the deduction under section 
170 is $25 (LC100 x the free market rate, $.25).
    Example 2. X, a corporation with the U.S. dollar as its functional 
currency, operates in foreign country L through branch Y. Y is a 
qualified business unit as defined in section 989 (a). X computes Y's 
income under the dollar approximate separate transactions method as 
described in Sec. 1.985-3. The currency of L is the LC. X can purchase 
legally United States dollars ($) in L only from the L government. In 
order to take advantage of an arbitrage between the official and 
secondary dollar to LC exchange rates in L:
    (i) X purchases LC100 for $60 in L on the secondary market when the 
official exchange rate is S1 = LC1;
    (ii) X transfers the LC100 to Y;
    (iii) Y purchases $100 for LC100; and
    (iv) Y transfers $65 ($100 less an L tax withheld of $35 on the 
transfer) to the home office of X.


Under paragraph (a)(7) of this section, the transfer of the LC100 by X 
to Y is a realization event. X has a basis of $60 in the LC100. Under 
these facts, the appropriate dollar to LC exchange rate for computing 
the amount realized by X is the official exchange rate.

[[Page 722]]

Therefore, X realizes $40 ($100-$60) of U.S. source gain from the 
transfer to Y. The same result would obtain if Y rather than X purchased 
the LC100 on the secondary market in L with $60 supplied by X, because 
the substance of this transaction is that X is performing the arbitrage.

    (e) Exchange gain or loss. The term ``exchange gain or loss'' means 
the amount of gain or loss realized as determined in Sec. 1.988-2 with 
respect to a section 988 transaction. Except as otherwise provided in 
these regulations (e.g., Sec. 1.98B-5), the amount of exchange gain or 
loss from a section 988 transaction shall be separately computed for 
each section 988 transaction, and such amount shall not be integrated 
with gain or loss recognized on another transaction (whether or not such 
transaction is economically related to the section 988 transaction). See 
Sec. 1.988-2 (b)(8) for a special rule with respect to debt 
instruments.
    (f) Hyperinflationary currency--(1) Definition--(i) General rule. 
For purposes of section 988, a hyperinflationary currency means a 
currency described in Sec. 1.985-1(b)(2)(ii)(D). Unless otherwise 
provided, the currency in any example used in Sec. Sec. 1.988-1 through 
1.988-5 is not a hyperinflationary currency.
    (ii) Special rules for determining base period. In determining 
whether a currency is hyperinflationary under Sec. 1.985-1(b)(2)(ii)(D) 
for purposes of this paragraph (f), the following rules will apply:
    (A) The base period means the thirty-six calendar month period 
ending on the last day of the taxpayer's (or qualified business unit's) 
current taxable year. Thus, for example, if for 1996, 1997, and 1998, a 
country's annual inflation rates are 6 percent, 11 percent, and 90 
percent, respectively, the cumulative inflation rate for the three-year 
base period is 124% [((1.06 x 1.11 x 1.90) - 1.0 = 1.24) x 100 = 124%]. 
Accordingly, assuming the QBU has a calendar year as its taxable year, 
the currency of the country is hyperinflationary for the 1998 taxable 
year. This change in the Sec. 1.985-1(b)(2)(ii)(D) base period shall 
not apply to any section 988 transaction of an entity described in 
section 851 (regulated investment company (RIC)) or section 856 (real 
estate investment trust (REIT)). The Service may, by notice, provide 
that the foregoing change in the Sec. 1.985-1(b)(2)(ii)(D) base period 
does not apply to any section 988 transaction of an entity with 
distribution requirements similar to a RIC or REIT.
    (B) The last sentence of Sec. 1.985-1(b)(2)(ii)(D) shall not apply 
to alter the base period for purposes of this paragraph (f) in 
determining whether a currency is hyperinflationary for purposes of 
section 988. Accordingly, generally accepted accounting principles may 
not apply to alter the base period for purposes of this paragraph (f).
    (2) Effective date. Paragraph (f)(1) of this section shall apply to 
transactions entered into after February 14, 2000.
    (g) Fair market value. The fair market value of an item shall, where 
relevant, reflect an appropriate premium or discount for the time value 
of money (e.g., the fair market value of a forward contract to buy or 
sell nonfunctional currency shall reflect the present value of the 
difference between the units of nonfunctional currency times the market 
forward rate at the time of valuation and the units of nonfunctional 
currency times the forward rate set forth in the contract). However, if 
consistent with the taxpayer's method of financial accounting (and 
consistently applied from year to year), the preceding sentence shall 
not apply to a financial instrument that matures within one year from 
the date of issuance or acquisition. Unless otherwise provided, the fair 
market value given in any example used in Sec. Sec. 1.988-1 through 
1.988-5 is deemed to reflect appropriately the time value of money. If 
the use of inconsistent sources of forward or other market rate 
quotations results in the distortion of income, the District Director or 
the Assistant Commissioner (International) may determine the appropriate 
rate.
    (h) Interaction with sections 1092 and 1256. Unless otherwise 
provided, it is assumed for purposes of Sec. Sec. 1.988-1 through 
1.988-5 that any contract used in any example is not a section 1256 
contract and is not part of a straddle as defined in section 1092. No 
inference is intended regarding the application of section 1092 or 1256 
unless expressly stated.
    (i) Effective date. Except as otherwise provided in this section, 
this section

[[Page 723]]

shall be effective for taxable years beginning after December 31, 1986. 
Thus, except as otherwise provided in this section, any payments made or 
received with respect to a section 988 transaction in taxable years 
beginning after December 31, 1986, are subject to this section. 
Generally, the revisions to paragraphs (a)(3), (a)(4), and (a)(10)(ii) 
of this section shall apply to taxable years beginning 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 the revisions to 
paragraphs (a)(3), (a)(4), and (a)(10)(ii) of this section shall apply 
to taxable years of the taxpayer beginning on or after the first day of 
such prior taxable year.

[T.D. 8400, 57 FR 9178, Mar. 17, 1992, as amended by T.D. 8914, 66 FR 
280, Jan. 3, 2001; T.D. 9794, 81 FR 88850, Dec. 8, 2016; T.D. 9795, 81 
FR 88879, Dec. 8, 2016]



Sec. 1.988-1T  Certain definitions and special rules (temporary).

    (a)(1) through (a)(2) [Reserved] For further guidance, see Sec. 
1.988-1(a)(1) through (2).
    (3) Specified owner functional currency transactions of a section 
987 QBU not treated as section 988 transactions. Specified owner 
functional currency transactions, as defined in Sec. 1.987-
3T(b)(4)(ii), held by a section 987 QBU are not treated as section 988 
transactions. Thus, no currency gain or loss shall be recognized by a 
section 987 QBU under section 988 with respect to such transactions.
    (4) through (i) [Reserved] For further guidance, see Sec. 1.988-
1(a)(4) through (i).
    (j) Effective/applicability date. This section applies to taxable 
years beginning on or after one year after the first day of the first 
taxable year following December 7, 2016. Notwithstanding the preceding 
sentence, if a taxpayer makes an election under Sec. 1.987-11(b), then 
this section applies to taxable years to which Sec. Sec. 1.987-1 
through 1.987-10 apply as a result of such election.
    (k) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9795, 81 FR 88879, Dec. 8, 2016]



Sec. 1.988-2  Recognition and computation of exchange gain or loss.

    (a) Disposition of nonfunctional currency--(1) Recognition of 
exchange gain or loss--(i) In general. Except as otherwise provided in 
this section, Sec. 1.988-1(a)(7)(ii), and Sec. 1.988-5, the 
recognition of exchange gain or loss upon the sale or other disposition 
of nonfunctional currency shall be governed by the recognition 
provisions of the Internal Revenue Code which apply to the sale or 
disposition of property (e.g., section 1001 or, to the extent provided 
in regulations, section 1092). The disposition of nonfunctional currency 
in settlement of a forward contract, futures contract, option contract, 
or similar financial instrument is considered to be a sale or 
disposition of the nonfunctional currency for purposes of the preceding 
sentence.
    (ii) Clarification of section 1031. An amount of one nonfunctional 
currency is not ``property of like kind'' with respect to an amount of a 
different nonfunctional currency.
    (iii) Coordination with section 988(c)(1)(C)(ii). No exchange gain 
or loss is recognized with respect to the following transactions--
    (A) An exchange of units of nonfunctional currency for different 
units of the same nonfunctional currency;
    (B) The deposit of nonfunctional currency in a demand or time 
deposit or similar instrument (including a certificate of deposit) 
issued by a bank or other financial institution if such instrument is 
denominated in such currency;
    (C) The withdrawal of nonfunctional currency from a demand or time 
deposit or similar instrument issued by a bank or other financial 
institution if such instrument is denominated in such currency;
    (D) The receipt of nonfunctional currency from a bank or other 
financial institution from which the taxpayer purchased a certificate of 
deposit or similar instrument denominated in such currency by reason of 
the maturing or other termination of such instrument; and
    (E) The transfer of nonfunctional currency from a demand or time 
deposit or similar instrument issued by a bank or other financial 
institution to

[[Page 724]]

another demand or time deposit or similar instrument denominated in the 
same nonfunctional currency issued by a bank or other financial 
institution.


The taxpayer's basis in the units of nonfunctional currency or other 
property received in the transaction shall be the adjusted basis of the 
units of nonfunctional currency or other property transferred. See 
paragraph (b) of this section with respect to the timing of interest 
income or expense and the determination of exchange gain or loss 
thereon.
    (iv) Example. The following example illustrates the provisions of 
paragraph (a)(1)(iii) of this section.

    Example. X is a corporation on the accrual method of accounting with 
the U.S. dollar as its functional currency. On January 1, 1989, X 
acquires 1,500 British pounds ([pound]) for $2,250 ([pound]1 = $1.50). 
On January 3, 1989, when the spot rate is [pound]1 = $1.49, X deposits 
the [pound]1,500 with a British financial institution in a non-interest 
bearing demand account. On February 1, 1989, when the spot rate is 
[pound]1 = $1.45, X withdraws the [pound]1,500. On February 5, 1989, 
when the spot rate is [pound]1 = $1.42, X purchases inventory in the 
amount of [pound]1,500. Pursuant to paragraph (a)(1)(iii) of this 
section, no exchange loss is realized until February 5, 1989, when X 
disposes of the [pound]1,500 for inventory. At that time, X realizes 
exchange loss in the amount of $120 computed under paragraph (a)(2) of 
this section. The loss is not an adjustment to the cost of the 
inventory.

    (2) Computation of gain or loss--(i) In general. Exchange gain 
realized from the sale or other disposition of nonfunctional currency 
shall be the excess of the amount realized over the adjusted basis of 
such currency, and exchange loss realized shall be the excess of the 
adjusted basis of such currency over the amount realized.
    (ii) Amount realized--(A) In general. The amount realized from the 
disposition of nonfunctional currency shall be determined under section 
1001(b). A taxpayer that uses a spot rate convention under Sec. 1.988-
1(d)(3) to determine exchange gain or loss with respect to a payable 
shall determine the amount realized upon the disposition of 
nonfunctional currency paid in satisfaction of the payable in a manner 
consistent with such convention.
    (B) Exchange of nonfunctional currency for property. For purpose of 
paragraph (a)(2) of this section, the exchange of nonfunctional currency 
for property (other than nonfunctional currency) shall be treated as--
    (1) An exchange of the units of nonfunctional currency for units of 
functional currency at the spot rate on the date of the exchange, and
    (2) The purchase or sale of the property for such units of 
functional currency.
    (C) Example. The following example illustrates the provisions of 
paragraph (a)(2)(ii)(B) of this section.

    Example. G is a U.S. corporation with the U.S. dollar as its 
functional currency. On January 1, 1989, G enters into a contract to 
purchase a paper manufacturing machine for 10,000,000 British pounds 
([pound]) for delivery on January 1, 1991. On January 1, 1991, when G 
exchanges [pound]10,000,000 (which G purchased for $12,000,000) for the 
machine, the fair market value of the machine is [pound]17,000,000. On 
January 1, 1991, the spot exchange rate is [pound]1 = $1.50. Under 
paragraph (a)(2)(ii)(B) of this section, the transaction is treated as 
an exchange of [pound]10,000,000 for $15,000,000 and the purchase of the 
machine for $15,000,000. Accordingly, in computing G's exchange gain of 
$3,000,000 on the disposition of the [pound]10,000,000, the amount 
realized is $15,000,000. G's basis in the machine is $15,000,000. No 
gain is recognized on the bargain purchase of the machine.

    (iii) Adjusted basis--(A) In general. Except as provided in 
paragraphs (a)(2)(iii)(B) and (C) of this section, the adjusted basis of 
nonfunctional currency is determined under the applicable provisions of 
the Internal Revenue Code (e.g., sections 1011 through 1023). A taxpayer 
that uses a spot rate convention under Sec. 1.988-1 (d)(3) to determine 
exchange gain or loss with respect to a receivable shall determine the 
basis of nonfunctional currency received in satisfaction of such 
receivable in a manner consistent with such convention.
    (B) Determination of the basis of nonfunctional currency withdrawn 
from an account with a bank or other financial institution--(1) In 
general. The basis of nonfunctional currency withdrawn from an account 
with a bank or other financial institution shall be determined under any 
reasonable method that is consistently applied from year to year by the 
taxpayer to all accounts denominated in a nonfunctional currency. For 
example, a taxpayer may

[[Page 725]]

use a first in first out method, a last in first out method, a pro rata 
method (as illustrated in the example below), or any other reasonable 
method that is consistently applied. However, a method that consistently 
results in units of nonfunctional currency with the highest basis being 
withdrawn first shall not be considered reasonable.
    (2) Example. The following example illustrates the provisions of 
this paragraph (a)(2)(iii)(B).

    Example. (i) X, a cash basis individual with the dollar as his 
functional currency, opens a demand account with a Swiss bank. Assume 
expenses associated with the demand account are deductible under section 
212. The following chart indicates Swiss franc deposits to the account, 
Swiss franc interest credited to the account, the dollar basis of each 
deposit, and the determination of the aggregate dollar basis of all 
Swiss francs in the account. Assume that the taxpayer has properly 
translated all the amounts specified in the chart and that all 
transactions are subject to section 988.

----------------------------------------------------------------------------------------------------------------
                                                                                                      Aggregate
               Date                  Swiss francs deposited       Interest received     U.S. dollar  U.S. dollar
                                                                                           basis        basis
----------------------------------------------------------------------------------------------------------------
1/01/89..........................  1000 Sf                    ........................         $500         $500
3/31/89..........................  .........................  50 Sf                              25          525
6/30/89..........................  .........................  50 Sf                              24          549
9/30/89..........................  .........................  50 Sf                              25          574
12/31/89.........................  .........................  50 Sf                              26          600
----------------------------------------------------------------------------------------------------------------

    (ii) On January 1, 1990, X withdraws 500 Swiss francs from the 
account. X may determine his basis in the Swiss francs by multiplying 
the aggregate U.S. dollar basis of Swiss francs in the account by a 
fraction the numerator of which is the number of Swiss francs withdrawn 
from the account and the denominator is the total number of Swiss francs 
in the account. Under this method, X's basis in the 500 Swiss francs is 
$250 computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.070

    (iii) X's basis in the Swiss francs remaining in the account is $350 
($600-$250). X must use this method consistently from year to year with 
respect to withdrawals of nonfunctional currency from all of X's 
accounts.
    (C) Basis in refunded foreign income tax. See Sec. 1.986(a)-1(e) 
for rules relating to the determination of basis in refunded foreign 
income tax denominated in nonfunctional currency.
    (iv) Purchase and sale of stock or securities traded on an 
established securities market by cash basis taxpayer--
    (A) Amount realized. If stock or securities traded on an established 
securities market are sold by a cash basis taxpayer for nonfunctional 
currency, the amount realized with respect to the stock or securities 
(as determined on the trade date) shall be computed by translating the 
units of nonfunctional currency received into functional currency at the 
spot rate on the settlement date of the sale. This rule applies 
notwithstanding that the stock or securities are treated as disposed of 
on a date other than the settlement date under another section of the 
Code. See section 453(k).
    (B) Basis. If stock or securities traded on an established 
securities market are purchased by a cash basis taxpayer for 
nonfunctional currency, the basis of the stock or securities shall be 
determined by translating the units of nonfunctional currency paid into 
functional currency at the spot rate on the settlement date of the 
purchase.

    (C) Example. The following example illustrates the provisions of 
this paragraph (a)(2)(iv).

    Example. On November 1, 1989 (the trade date), X, a calendar year 
cash basis U.S. individual, purchases stock for [pound]100 for 
settlement on November 5, 1989. On November 1, 1989, the spot value of 
the [pound]100 is $140. On November 5, 1989, X purchases [pound]100 for 
$141 which X uses to pay for the stock. X's basis in the stock is $141. 
On December 30, 1990 (the trade date), X sells the stock for [pound]110 
for settlement on January 5, 1991. On December 30, 1990, the spot value 
of [pound]110 is $165. On January 5, 1991, X transfers the stock and 
receives [pound]110 which, translated at the spot rate, equal $166. 
Under section 453(k), the stock is considered disposed of on December 
30, 1990. The amount realized with respect to such disposition is the 
value of the [pound]110 on January 5, 1991 ($166). Accordingly, X's gain 
realized on December 30, 1990, from the disposition of the stock is $25 
($166 amount realized less $141

[[Page 726]]

basis). X's basis in the [pound]110 received from the sale of the stock 
is $166.

    (v) Purchase and sale of stock or securities traded on an 
established securities market by accrual basis taxpayer. For taxable 
years beginning after March 17, 1992, an accrual basis taxpayer may 
elect to apply the rules of paragraph (a)(2)(iv) of this section. The 
election shall be made by filing a statement with the taxpayer's first 
return in which the election is effective clearly indicating that the 
election has been made. A method so elected must be applied consistently 
from year to year and cannot be changed without the consent of the 
Commissioner.
    (b) Translation of interest income or expense and determination of 
exchange gain or loss with respect to debt instruments--(1) Translation 
of interest income received with respect to a nonfunctional currency 
demand account. Interest income received with respect to a demand 
account with a bank or other financial institution which is denominated 
in (or the payments of which are determined by reference to) a 
nonfunctional currency shall be translated into functional currency at 
the spot rate on the date received or accrued or pursuant to any 
reasonable spot rate convention consistently applied by the taxpayer to 
all taxable years and to all accounts denominated in nonfunctional 
currency in the same financial institution. For example, a taxpayer may 
translate interest income received with respect to a demand account on 
the last day of each month of the taxable year, on the last day of each 
quarter of the taxable year, on the last day of each half of the taxable 
year, or on the last day of the taxable year. No exchange gain or loss 
is realized upon the receipt or accrual of interest income with respect 
to a demand account subject to this paragraph (b)(1).
    (2) Translation of nonfunctional currency interest income or expense 
received or paid with respect to a debt instrument described in Sec. 
1.988-1(a)(1)(ii) and (2)(i)--(i) Scope--(A) In general. Paragraph (b) 
of this section only applies to debt instruments described in Sec. 
1.988-1(a)(1)(ii) and (2)(i) where all payments are denominated in, or 
determined with reference to, a single nonfunctional currency. Except as 
provided in paragraph (b)(2)(i)(B) of this section, this paragraph (b) 
shall not apply to contingent payment debt instruments.
    (B) Nonfunctional currency contingent payment debt instruments--(1) 
Operative rules. See Sec. 1.988-6 for rules applicable to contingent 
payment debt instruments for which one or more payments are denominated 
in, or determined by reference to, a nonfunctional currency.
    (2) Certain instruments are not contingent payment debt instruments. 
For purposes of sections 163(e) and 1271 through 1275 and the 
regulations thereunder, a debt instrument does not provide for 
contingent payments merely because the instrument is denominated in, or 
all payments of which are determined with reference to, a single 
nonfunctional currency. See Sec. 1.988-6 for the treatment of 
nonfunctional currency contingent payment debt instruments.
    (ii) Determination and translation of interest income or expense--
(A) In general. Interest income or expense on a debt instrument 
described in paragraph (b)(2)(i) of this section (including original 
issue discount determined in accordance with sections 1271 through 1275 
and 163(e) as adjusted for acquisition premium under section 1272(a)(7), 
and acquisition discount determined in accordance with sections 1281 
through 1283) shall be determined in units of nonfunctional currency and 
translated into functional currency as provided in paragraphs 
(b)(2)(ii)(B) and (C) of this section. For purposes of sections 483, 
1273(b)(5) and 1274, the nonfunctional currency in which an instrument 
is denominated (or by reference to which payments are determined) shall 
be considered money.
    (B) Translation of interest income or expense that is not required 
to be accrued prior to receipt or payment. With respect to an instrument 
described in paragraph (b)(2)(i) of this section, interest income or 
expense received or paid that is not required to be accrued by the 
taxpayer prior to receipt or payment shall be translated at the spot 
rate on the date of receipt or payment. No exchange gain or loss is 
realized with respect to the receipt or payment of such interest income 
or expense (other than the exchange gain or loss that might be realized 
under paragraph

[[Page 727]]

(a) of this section upon the disposition of the nonfunctional currency 
so received or paid).
    (C) Translation of interest income or expense that is required to be 
accrued prior to receipt or payment. With respect to an instrument 
described in paragraph (b)(2)(i) of this section, interest income or 
expense that is required to be accrued prior to receipt or payment 
(e.g., under section 1272, 1281 or 163(e) or because the taxpayer uses 
an accrual method of accounting) shall be translated at the average rate 
(or other rate specified in paragraph (b)(2)(iii)(B) of this section) 
for the interest accrual period or, with respect to an interest accrual 
period that spans two taxable years, at the average rate (or other rate 
specified in paragraph (b)(2)(iii)(B) of this section) for the partial 
period within the taxable year. See paragraphs (b)(3) and (4) of this 
section for the determination of exchange gain or loss on the receipt or 
payment of accrued interest income or expense.
    (iii) Determination of average rate or other accrual convention--(A) 
In general. For purposes of this paragraph (b), the average rate for an 
accrual period (or partial period) shall be a simple average of the spot 
exchange rates for each business day of such period or other average 
exchange rate for the period reasonably derived and consistently applied 
by the taxpayer.
    (B) Election to use spot accrual convention. For taxable years 
beginning after March 17, 1992, a taxpayer may elect to translate 
interest income and expense at the spot rate on the last day of the 
interest accrual period (and in the case of a partial accrual period, 
the spot rate on the last day of the taxable year). If the last day of 
the interest accrual period is within five business days of the date of 
receipt or payment, the taxpayer may translate interest income or 
expense at the spot rate on the date of receipt or payment. The election 
shall be made by filing a statement with the taxpayer's first return in 
which the election is effective clearly indicating that the election has 
been made. A method so elected must be applied consistently to all debt 
instruments from year to year and cannot be changed without the consent 
of the Commissioner.
    (3) Exchange gain or loss recognized by the holder with respect to 
accrued interest income. The holder of a debt instrument described in 
paragraph (b)(2)(i) of this section shall realize exchange gain or loss 
with respect to accrued interest income on the date such accrued 
interest income is received or the instrument is disposed of (including 
a deemed disposition under section 1001 that results from a material 
change in terms of the instrument). Except as otherwise provided in this 
paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or 
loss realized with respect to accrued interest income shall be 
recognized in accordance with the applicable recognition provisions of 
the Internal Revenue Code. The amount of exchange gain or loss so 
realized with respect to accrued interest income is determined for each 
accrual period by--
    (i) Translating the units of nonfunctional currency interest income 
received with respect to such accrual period (as determined under the 
ordering rules of paragraph (b)(7) of this section) into functional 
currency at the spot rate on the date the interest income is received or 
the instrument is disposed of (or deemed disposed of), and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency interest income accrued with respect 
to such income received at the average rate (or other rate specified in 
paragraph (b)(2)(iii)(B) of this section) for the accrual period.
    (4) Exchange gain or loss recognized by the obligor with respect to 
accrued interest expense. The obligor under a debt instrument described 
in paragraph (b)(2)(i) of this section shall realize exchange gain or 
loss with respect to accrued interest expense on the date such accrued 
interest expense is paid or the obligation to make payments is 
transferred or extinguished (including a deemed disposition under 
section 1001 that results from a material change in terms of the 
instrument). Except as otherwise provided in this paragraph (b) (e.g., 
paragraph (b)(8) of this section), exchange gain or loss realized with 
respect to accrued interest expense shall be recognized in accordance

[[Page 728]]

with the applicable recognition provisions of the Internal Revenue Code. 
The amount of exchange gain or loss so realized with respect to accrued 
interest expense is determined for each accrual period by--
    (i) Translating the units of nonfunctional currency interest expense 
accrued with respect to the amount of interest paid into functional 
currency at the average rate (or other rate specified in paragraph 
(b)(2)(iii)(B) of this section) for such accrual period; and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency interest paid (or, if the obligation 
to make payments is extinguished or transferred, the units accrued) with 
respect to such accrual period (as determined under the ordering rules 
in paragraph (b)(7) of this section) into functional currency at the 
spot rate on the date payment is made or the obligation is transferred 
or extinguished (or deemed extinguished).
    (5) Exchange gain or loss recognized by the holder of a debt 
instrument with respect to principal. The holder of a debt instrument 
described in paragraph (b)(2)(i) of this section shall realize exchange 
gain or loss with respect to the principal amount of such instrument on 
the date principal (determined under the ordering rules of paragraph 
(b)(7) of this section) is received from the obligor or the instrument 
is disposed of (including a deemed disposition under section 1001 that 
results from a material change in terms of the instrument). For purposes 
of computing exchange gain or loss, the principal amount of a debt 
instrument is the holder's purchase price in units of nonfunctional 
currency. See paragraph (b)(10) of this section for rules regarding the 
amortization of that part of the principal amount that represents bond 
premium and the computation of exchange gain or loss thereon. If, 
however, the holder acquired the instrument in a transaction in which 
exchange gain or loss was realized but not recognized by the transferor, 
the nonfunctional currency principal amount of the instrument with 
respect to the holder shall be the same as that of the transferor. 
Except as otherwise provided in this paragraph (b) (e.g., paragraph 
(b)(8) of this section), exchange gain or loss realized with respect to 
such principal amount shall be recognized in accordance with the 
applicable recognition provisions of the Internal Revenue Code. The 
amount of exchange gain or loss so realized by the holder with respect 
to principal is determined by--
    (i) Translating the units of nonfunctional currency principal at the 
spot rate on the date payment is received or the instrument is disposed 
of (or deemed disposed of); and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency principal at the spot rate on the 
date the holder (or a transferor from whom the nonfunctional principal 
amount is carried over) acquired the instrument (is deemed to acquire 
the instrument).
    (6) Exchange gain or loss recognized by the obligor of a debt 
instrument with respect to principal. The obligor under a debt 
instrument described in paragraph (b)(2)(i) of this section shall 
realize exchange gain or loss with respect to the principal amount of 
such instrument on the date principal (determined under the ordering 
rules of paragraph (b)(7) of this section) is paid or the obligation to 
make payments is transferred or extinguished (including a deemed 
disposition under section 1001 that results from a material change in 
terms of the instrument). For purposes of computing exchange gain or 
loss, the principal amount of a debt instrument is the amount received 
by the obligor for the debt instrument in units of nonfunctional 
currency. See paragraph (b)(10) of this section for rules regarding the 
amortization of that part of the principal amount that represents bond 
premium and the computation of exchange gain or loss thereon. If, 
however, the obligor became the obligor in a transaction in which 
exchange gain or loss was realized but not recognized by the transferor, 
the nonfunctional currency principal amount of the instrument with 
respect to such obligor shall be the same as that of the transferor. 
Except as otherwise provided in this paragraph (b) (e.g., paragraph 
(b)(8) of this section), exchange gain or loss realized with respect to 
such principal shall be recognized in accordance with

[[Page 729]]

the applicable recognition provisions of the Internal Revenue Code. The 
amount of exchange gain or loss so realized by the obligor is determined 
by--
    (i) Translating the units of nonfunctional currency principal at the 
spot rate on the date the obligor (or a transferor from whom the 
principal amount is carried over) became the obligor (or is deemed to 
have become the obligor); and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency principal at the spot rate on the 
date payment is made or the obligation is transferred or extinguished 
(or deemed extinguished).
    (7) Payment ordering rules--(i) Debt instruments subject to the 
rules of sections 163(e), or 1271 through 1288. In the case of a debt 
instrument described in paragraph (b)(2)(i) of this section that is 
subject to the rules of sections 163(e), or 1272 through 1288, units of 
nonfunctional currency (or an amount determined with reference to 
nonfunctional currency) received or paid with respect to such debt 
instrument shall be treated first as a receipt or payment of periodic 
interest under the principles of section 1273 and the regulations 
thereunder, second as a receipt or payment of original issue discount to 
the extent accrued as of the date of the receipt or payment, and finally 
as a receipt or payment of principal. Units of nonfunctional currency 
(or an amount determined with reference to nonfunctional currency) 
treated as a receipt or payment of original issue discount under the 
preceding sentence are attributed to the earliest accrual period in 
which original issue discount has accrued and to which prior receipts or 
payments have not been attributed. No portion thereof shall be treated 
as prepaid interest. These rules are illustrated by Example 10 of 
paragraph (b)(9) of this section.
    (ii) Other debt instruments. In the case of a debt instrument 
described in paragraph (b)(2)(i) of this section that is not subject to 
the rules of section 163(e) or 1272 through 1288, whether units of 
nonfunctional currency (or an amount determined with reference to 
nonfunctional currency) received or paid with respect to such debt 
instrument are treated as interest or principal shall be determined 
under section 163 or other applicable section of the Code.
    (8) Limitation of exchange gain or loss on payment or disposition of 
a debt instrument. When a debt instrument described in paragraph 
(b)(2)(i) of this section is paid or disposed of, or when the obligation 
to make payments thereunder is satisfied by another person, or 
extinguished or assumed by another person, exchange gain or loss is 
computed with respect to both principal and any accrued interest 
(including original issue discount), as provided in paragraph (b)(3) 
through (7) of this section. However, pursuant to section 988(b)(1) and 
(2), the sum of any exchange gain or loss with respect to the principal 
and interest of any such debt instrument shall be realized only to the 
extent of the total gain or loss realized on the transaction. The gain 
or loss realized shall be recognized in accordance with the general 
principles of the Code. See Examples 3, 4 and 6 of paragraph (b)(9) of 
this section.
    (9) Examples. The preceding provisions are illustrated in the 
following examples. The examples assume that any transaction involving 
an individual is a section 988 transaction.

    Example 1. (i) X is an individual on the cash method of accounting 
with the dollar as his functional currency. On January 1, 1992, X 
converts $13,000 to 10,000 British pounds ([pound]) at the spot rate of 
[pound]1 = $1.30 and loans the [pound]10,000 to Y for 3 years. The terms 
of the loan provide that Y will make interest payments of [pound]1,000 
on December 31 of 1992, 1993, and 1994, and will repay X's [pound]10,000 
principal on December 31, 1994. Assume the spot rates for the pertinent 
dates are as follows:

------------------------------------------------------------------------
                                                              Spot rate
                            Date                              (pounds to
                                                               dollars)
------------------------------------------------------------------------
Jan. 1, 1992...............................................   [pound]1 =
                                                                   $1.30
Dec. 31, 1992..............................................   [pound]1 =
                                                                   $1.35
Dec. 31, 1993..............................................   [pound]1 =
                                                                   $1.40
Dec. 31, 1994..............................................   [pound]1 =
                                                                   $1.45
------------------------------------------------------------------------

    (ii) Under paragraph (b)(2)(ii)(B) of this section, X will trans1ate 
the [pound]1,000 interest payments at the spot rate on the date 
received. Accordingly, X will have interest income of $1,350 in 1992, 
$1,400 in 1993, and $1,450 in 1994. Because X is a cash basis taxpayer, 
X does not realize exchange gain or loss on the receipt of interest 
income.

[[Page 730]]

    (iii) Under paragraph (b)(5) of this section, X will realize 
exchange gain upon repayment of the [pound]10,000 principal amount 
determined by translating the [pound]10,000 at the spot rate on the date 
it is received ([pound]10,000 x $1.45 = $14,500) and subtracting from 
such amount, the amount determined by translating the [pound]10,000 at 
the spot rate on the date the loan was made ([pound]10,000 x $1.30 = 
$13,000). Accordingly, X will realize an exchange gain of $1,500 on the 
repayment of the loan on December 31, 1994.
    Example 2. (i) Assume the same facts as in Example 1 except that X 
is an accrual method taxpayer and that average rates are as follows:

------------------------------------------------------------------------
                                               Average rate (pounds to
              Accrual period                          dollars)
------------------------------------------------------------------------
1992......................................  [pound]1 = $1.32
1993......................................  [pound]1 = $1.37
1994......................................  [pound]1 = $1.42
------------------------------------------------------------------------

    (ii) Under paragraph (b)(2)(ii)(C) of this section, X will accrue 
the [pound]1,000 interest payments at the average rate for the accrual 
period. Accordingly, X will have interest income of $1,320 in 1992, 
$1,370 in 1993, and $1,420 in 1994. Because X is an accrual basis 
taxpayer, X determines exchange gain or loss for each interest accrual 
period by translating the units of nonfunctional currency interest 
income received with respect to such accrual period at the spot rate on 
the date received and subtracting the amounts of interest income accrued 
for such period. Thus, X will realize $90 of exchange gain with respect 
to interest received under the loan, computed as follows:

------------------------------------------------------------------------
                                            Spot     Accrued
                                           value     interest    Exch.
                  Year                    interest  @ average     gain
                                          received     rate
------------------------------------------------------------------------
1992...................................     $1,350     $1,320        $30
1993...................................      1,400      1,370         30
1994...................................      1,450      1,420         30
                                                              ----------
  Total................................  .........  .........        $90
------------------------------------------------------------------------

    (iii) Under paragraph (b)(5) of this section, X will realize 
exchange gain upon repayment of the [pound]10,000 loan principal 
determined in the same manner as in Example 1. Accordingly, X will 
realize an exchange gain of $1,500 on the repayment of the loan 
principal on December 31, 1994.
    Example 3. Assume the same facts as in Example 1 except that X is a 
calendar year taxpayer on the accrual method of accounting that elects 
to use a spot rate convention to translate interest income as provided 
in Sec. 1.988-2(b)(2)(iii)(B). Interest income is received by X on the 
last day of each accrual period. Under paragraph (b)(2)(ii)(C), X will 
translate the interest income at the spot rate on the last day of each 
interest accrual period. Accordingly, X will have interest income of 
$1,350 in 1992, and $1,400 in 1993, $1,450 in 1994. Because the rate at 
which the interest income is translated is the same as the rate on the 
day of receipt, X will not realize any exchange gain or loss with 
respect to the interest income. Under paragraph (b)(5) of this section, 
X will realize exchange gain upon repayment of the [pound]10,000 loan 
principal determined in the same manner as in Example 1. Accordingly, X 
will realize an exchange gain of $1,500 on the repayment of the loan 
principal on December 31, 1994.
    Example 4. Assume the same facts as in Example 1 except that on 
December 31, 1993, X sells Y's note for 9,821.13 British pounds 
([pound]) after the interest payment. Under paragraph (b)(8) of this 
section, X will compute exchange gain on the [pound]10,000 principal. 
The exchange gain is $1,000 [([pound]10,000 x $1.40)-([pound]10,000 x 
$1.30)]. This exchange gain, however, is only realized to the extent of 
the total gain on the disposition. X's total gain is $749.58 
[([pound]9,821.13 x $1.40)-([pound]10,000 x $1.30)]. Thus, X will 
realize $749.58 of exchange gain (and will realize no market loss).
    Example 5. (i) The facts are the same as in Example 1 except that Y 
becomes insolvent and fails to repay the full [pound]10,000 principal 
when due. Instead, X and Y agree to compromise the debt for a payment of 
[pound]8,000 on December 31, 1994. Under paragraph (b)(8) of this 
section, X will compute exchange gain on the [pound]10,000 originally 
booked. The exchange gain is $1,500 [([pound]10,000 x $1.45)-
([pound]10,000 x $1.30) = $1,500]. This exchange gain, however, is only 
realized to the extent of the total gain on the disposition. X realizes 
an overall loss on the disposition of $1,400 [([pound]8,000 x $1.45)-
([pound]10,000 x $1.30) = ($1,400)]. Thus, X will realize no exchange 
gain (and a $1400 market loss).
    (ii) If the exchange rate on December 31, 1994, were [pound]1 = 
$1.25, rather than [pound]1 = $1.45, X would compute exchange loss under 
paragraph (b)(8) of this section, on the [pound]10,000 originally 
booked. The exchange loss would be $500 [([pound]10,000 x $1.25)-
([pound]10,000 x $1.30) = ($500)]. X's total loss on the disposition 
would be $3,000 [([pound]8,000 x $1.25)-([pound]10,000 x $1.30) = 
($3,000)]. Thus, X would realize $500 of exchange loss and a $2,500 
market loss on the disposition.
    Example 6. (i) X is an individual with the dollar as his functional 
currency. X is on the cash method of accounting. On January 1, 1989, X 
borrows 10,000 British pounds ([pound]) from Y, an unrelated person. The 
terms of the loan provide that X will make interest payments of 
[pound]1,200 on December 31 of 1989 and 1990 and will repay Y's 
[pound]10,000 principal on December 31, 1990. The spot rates for the 
pertinent dates are as follows:

------------------------------------------------------------------------
                                                              Spot rate
                            Date                                 \1\
------------------------------------------------------------------------
Jan. 1, 1989...............................................    1 = $1.50
Dec. 31, 1989..............................................     1 = 1.60

[[Page 731]]

 
Dec. 31, 1990..............................................     1 = 1.70
------------------------------------------------------------------------
\1\ Pounds to dollars.


Assume that the basis of the [pound]1,200 paid as interest by X on 
December 31, 1989, is $2,000, the basis of the [pound]1,200 paid as 
interest by X on December 31, 1990, is $2,020 and the basis of the 
[pound]10,000 principal paid by X on December 31, 1990, is $16,000.
    (ii) Under paragraph (b)(2)(ii)(B) of this section, X translates the 
[pound]1,200 interest payments at the spot rate on the day paid. Thus, X 
paid $1,920 ([pound]1,200 x $1.60) of interest on December 31, 1989, and 
$2,040 ([pound]1,200 x $1.70) of interest on December 31, 1990. In 
addition, X will realize exchange gain or loss on the disposition of the 
[pound]1,200 on December 31, 1989 and 1990, under paragraph (a) of this 
section. Pursuant to paragraph (a)(2) of this section, X will realize an 
exchange loss of $80 [([pound]1,200 x $1.60)-$2,000] on December 31, 
1989, and exchange gain of $20 [([pound]1,200 x $1.70)-$2,020] on 
December 31, 1990.
    (iii) Under paragraph (b)(6) of this section, X will realize 
exchange loss on December 31, 1990, upon repayment of the [pound]10,000 
principal amount determined by translating the [pound]10,000 received at 
the spot rate on January 1, 1989 ([pound]10,000 x $1.50 = $15,000) and 
subtracting from such amount, the amount determined by translating the 
[pound]10,000 paid at the spot rate on December 31, 1990 ([pound]10,000 
x $1.70 = $17,000). Thus, under paragraph (b)(6) of this section, X has 
an exchange loss with respect to the [pound]10,000 principal of $2,000. 
Further, under paragraph (a)(2) of this section, X will realize an 
exchange gain upon disposition of the [pound]10,000 on December 31, 
1990. Under paragraph (a)(2) of this section, X will subtract his 
adjusted basis in the [pound]10,000 ($16,000) from the amount realized 
upon the disposition of the [pound]10,000 ([pound]10,000 x $1.70 = 
$17,000) resulting in a gain of $1,000. Accordingly, X's combined 
exchange gain and loss realized on December 31, 1990, with respect to 
the repayment of the [pound]10,000 is a $1,000 exchange loss.
    Example 7. (i) X is a calendar year corporation on the accrual 
method of accounting and with the dollar as its functional currency. On 
January 1, 1989, X purchases at original issue for 82.64 Canadian 
dollars (C$) M corporation's 2 year note maturing on December 31, 1990, 
at a stated redemption price of C$100. The yield to maturity in Canadian 
dollars is 10 percent and the accrual period is the one year period 
beginning January 1 and ending December 31. The note has C$17.36 of 
original issue discount. Assume that the spot rates are as follows: C$1 
= U.S.$.72 on January 1, 1989; C$1 = U.S.$.80 on January 1, 1990; C$1 = 
U.S.$ .82 on December 31, 1990. Assume further that the average rate for 
1989 is C$1 = U.S.$ .76 and for 1990 is C$1 = U.S. $.81.
    (ii) Under paragraph (b)(2)(ii)(A) of this section, X will determine 
its interest income in Canadian dollars. Accordingly, under section 
1272, X must take into account original issue discount in the amount of 
C$8.26 on December 31, 1989, and C$9.10 on December 31, 1990. Pursuant 
to paragraph (b)(2)(ii)(C) of this section, X will translate these 
amounts into U.S. dollars at the average exchange rate for the relevant 
accrual period. Thus, the amount of interest income taken into account 
in 1989 is U.S.$6.28 (C$8.26 x U.S.$.76) and in 1990 is U.S.$7.37 
(C$9.10 x U.S.$.81). Pursuant to paragraph (b)(3)(ii) of this section, X 
will realize exchange gain or loss with respect to the accrued interest 
determined for each accrual period by translating the Canadian dollars 
received with respect to such accrual period into U.S. dollars at the 
spot rate on the date the interest is received and subtracting from that 
amount the amount accrued in U.S. dollars. Thus, the amount of exchange 
gain realized on December 31, 1990, is U.S.$.58 (U.S.$.49 from 1989 + 
U.S.$.09 from 1990). Pursuant to paragraph (b)(5) of this section, X 
shall realize exchange gain or loss with respect to the principal 
(C$82.64) on December 31, 1990, computed by translating the C$82.64 at 
the spot rate on December 31, 1990 (U.S.$67.76) and subtracting the 
C$82.64 translated at the spot rate on January 1, 1989 (U.S.$59.50) for 
an exchange gain of U.S.$8.26. Thus, X's combined exchange gain is 
U.S.$8.84 (U.S.$.49 + U.S.$.09 + U.S.$8.26).
    (iii) Assume instead that on January 1, 1990, X sells the note for 
C$86.95, which it immediately converts to U.S. dollars. X's exchange 
gain is computed under paragraph (b)(8) of this section with reference 
to the nonfunctional currency denominated principal amount (C$82.64) and 
the nonfunctional currency denominated accrued original issue discount 
(C$8.26). X will compute an exchange gain of U.S.$6.61 with respect to 
the issue price [(C$82.64 x U.S.$.80)-(C$82.64 x U.S.$.72)] and an 
exchange gain of U.S.$.33 with respect to the accrued original issue 
discount [(C$8.26 x U.S.$.80)- (C$8.26 x U.S.$ .76)]. Accordingly, prior 
to the application of paragraph (b)(8) of this section, X's total 
exchange gain is U.S.$6.94 (U.S.$6.61 + U.S.$.33), and X's market loss 
is U.S.$3.16 [(C$90.90-C$86.95) x U.S.$.80]. Pursuant to paragraph 
(b)(8) of this section, however, X's market loss on the note of 
U.S.$3.16 is netted against X's exchange gain of U.S.$6.94, resulting in 
a realized exchange gain of U.S.$3.78 and no market loss.
    Example 8. (i) The facts are the same as in Example 7 (i) except 
that on January 1, 1990, X contributes the M corporation note to Y, a 
wholly-owned U.S. subsidiary of X with the dollar as its functional 
currency, and Y collects C$100 from M corporation at maturity on 
December 31, 1990, when the spot rate is C$1 = U.S.$.82. The transfer of 
the note from

[[Page 732]]

X to Y qualifies for nonrecognition of gain under section 351(a). On 
December 31, 1990, Y includes C$9.10 of accrued interest in income which 
translated at the average exchange rate of C$1 = U.S.$.81 for the year 
results in U.S.$7.37 of interest income.
    (ii) Y's exchange gain is computed under paragraph (b)(3) of this 
section with respect to accrued interest income and paragraph (b)(5) of 
this section with respect to the nonfunctional currency principal 
amount. Under paragraph (b)(3) of this section, Y will realize exchange 
gain or loss for each accrual period computed by translating the units 
of nonfunctional currency interest income received with respect to such 
accrual period at the spot rate on the day received and subtracting the 
amounts of interest income accrued for such period. Thus, Y will realize 
$.49 of exchange gain with respect to original issue discount accrued in 
1989 [(C$8.26 x U.S.$.82)-(C$8.26 x U.S.$.76) = U.S. $.49] and $.09 of 
exchange gain with respect to original issue discount accrued in 1990 
[(C$9.10 x U.S.$.82)-(C$9.10 x U.S.$.81) = $.09].
    (iii) Pursuant to paragraph (b)(5) of this section, the 
nonfunctional currency principal amount of the M bond in the hands of Y 
is C$82.64, the amount carried over from X, the transferor. Y's exchange 
gain with respect to the nonfunctional currency principal amount is 
$8.26 [(C$82.64 x U.S.$.82)- (C$82.64 x U.S.$.72) = U.S. $8.26]. 
Accordingly, Y's combined exchange gain is U.S. $8.84 ($.49 + $.09 + 
$8.26). Because the amount realized in Canadian dollars equals the 
adjusted issue price (C$100) on retirement of the M note, there is no 
market loss, and the netting rule of paragraph (b)(8) of this section 
does not limit realization of the exchange gain.
    Example 9. (i) X is a calendar year corporation on the accrual 
method of accounting and with the dollar as its functional currency. X 
elects to use the spot rate convention to translate interest income as 
provided in paragraph (b)(2)(iii)(B) of this section. On January 31, 
1992, X loans [pound]1000 to Y, an unrelated person. Under the terms of 
the loan, Y will pay X interest of [pound]50 on July 31, 1992, and 
January 31, 1993, and will repay the [pound]1000 principal on January 
31, 1993. Assume the following spot exchange rates:

------------------------------------------------------------------------
                                                              Spot rate
                            Date                                 \1\
------------------------------------------------------------------------
Jan. 31, 1992..............................................   [pound]1 =
                                                                   $1.50
July 31, 1992..............................................   [pound]1 =
                                                                    1.55
Dec. 31, 1992..............................................   [pound]1 =
                                                                    1.60
Jan. 31, 1993..............................................   [pound]1 =
                                                                    1.61
------------------------------------------------------------------------
\1\ Pounds to dollars.

    (ii) Under paragraph (b)(2)(ii)(C) of this section, X will translate 
the interest income at the spot rate on the last day of each interest 
accrual period (and in the case of a partial accrual period, at the spot 
rate on the last day of the taxable year). Accordingly, X will have 
interest income of $77.50 ([pound]50 x $1.55) on July 31, 1992. Assuming 
under X's method of accounting that interest is accrued daily, X will 
accrue $66.50 (153 / 184 x [pound]50) x $1.60) of interest income on 
December 31, 1992. On January 31, 1993, X will have interest income of 
$13.60 ((31/184 x [pound]50) x $1.61). Because the rate at which the 
interest income is translated is the same as the rate on the day of 
receipt, X will not realize any exchange gain or loss with respect to 
the interest income received on July 31, 1992. However, X will realize 
exchange gain on the [pound]41.50 (153/184 x [pound]50) of accrued 
interest income of $.41 [([pound]41.50 x $1.61) - ([pound]41.50 x $1.60) 
= $.41].
    (iii) Under paragraph (b)(5) of this section, X will realize 
exchange gain upon repayment of the [pound]100 principal amount 
determined by translating the [pound]100 at the spot rate on the date it 
is received ([pound]100 x $1.61 = $161.00) and subtracting from such 
amount, the amount determined by translating the [pound]100 at the spot 
rate on the date the loan was made ([pound]100 x $1.50 = $150.00). 
Accordingly, X will realize an exchange gain of $11 on the repayment of 
the loan on January 31, 1993.
    Example 10. (i) X, a cash basis taxpayer with the dollar as its 
functional currency, has the calendar year as its taxable year. On 
January 1, 1992, X purchases at original issue for 65.88 British pounds 
([pound]) M corporation's 5-year bond maturing on December 31, 1996, 
having a stated redemption price at maturity of [pound]100. The bond 
provides for annual payments of interest in pounds of 1 pound per year 
on December 31 of each year. The bond has 34.12 British pounds of 
original issue discount. The yield to maturity is 10 percent in British 
pounds and the accrual period is the one year period beginning January 1 
and ending December 31 of each calendar year. The amount of original 
issue discount is determined in pounds for each accrual period by 
multiplying the adjusted issue price expressed in pounds by the yield 
and subtracting from such amount the periodic interest payments 
expressed in pounds for such period. The periodic interest payments are 
translated at the spot rate on the payment date (December 31 of each 
year). The original issue discount is translated at the average rate for 
the accrual period (January 1 through December 31). The following chart 
describes the determination of interest income with respect to the facts 
presented and provides other pertinent information.

[[Page 733]]



                                                     Table 1
----------------------------------------------------------------------------------------------------------------
                                                                                  Original
                                                                    Periodic        issue
                                                                    interest     discount in    Total
                Periodic  Original             Assumed   Assumed   payments in     pounds     interest
                interest    issue     Issue     spot     average     pounds      multiplied    income
                payments  discount  price or   rate on  rate for   multiplied      by the        in     Adjusted
Year (Dec. 31)     in        in     adjusted   Dec. 31   accrual  by spot rate  average rate   dollars    issue
                 pounds    pounds     issue    (pounds   period    on the date     for the     (column  price in
                 for the   for the  price in     to      (pounds   of payment      accrual     7 plus    dollars
                 accrual   accrual   pounds   dollars)     to       (column 2      period      column
                 period    period                       dollars)  times column    (column 3      8)
                                                                       5)       times column
                                                                                     6)
1                      2         3         4         5         6             7             8         9       10
----------------------------------------------------------------------------------------------------------------
Issue Date:
                ........  ........     65.88       1 =  ........  ............  ............  ........   $79.06
                                                 $1.20
1992                   1      5.59     71.47  1 = 1.30       1 =         $1.30         $6.99     $8.29    86.05
                                                           $1.25
1993                   1      6.15     77.62  1 = 1.40  1 = 1.35          1.40          8.30      9.70    94.35
1994                   1      6.76     84.38  1 = 1.50  1 = 1.45          1.50          9.80     11.30   104.15
1995                   1      7.44     91.82  1 = 1.60  1 = 1.55          1.60         11.53     13.13   115.68
1996                   1      8.18    100.00  1 = 1.70  1 = 1.65          1.70         13.50     15.20   129.18
----------------------------------------------------------------------------------------------------------------

    (ii) Because X is a cash basis taxpayer, X does not realize exchange 
gain or loss on the receipt of the [pound]1 periodic interest payments. 
However, X will realize exchange gain on December 31, 1996 totaling 
$7.88 with respect to the original issue discount. Exchange gain is 
determined for each interest accrual period by translating the units of 
nonfunctional currency interest income received with respect to such 
accrual period at the spot rate on the date received and subtracting 
from such amount, the amount computed by translating the units of 
nonfunctional currency interest income accrued for such period at the 
average rate for the period. The following chart illustrates this 
computation:

                                                     Table 2
----------------------------------------------------------------------------------------------------------------
                                                                                           IOD in
                                                                Interest                   pounds
                                                   Assumed      received     Assumed     times the
                                    OID accrued   spot rate    times spot    average      average      Exchange
                                     in pounds     on date    rate on the    rate for     rate for     gain or
               Year                   for each     payment        date       accrual    the accrual   loss (col.
                                      accrual      received     received      period       period    4 less col.
                                       period     (pounds to    (col. 2     (pounds to    (col. 2         6)
                                                   dollars)    times col.    dollars)    times col.
                                                                   3)                        5)
1                                             2            3            4            5            6            7
----------------------------------------------------------------------------------------------------------------
1992..............................         5.59    1 = $1.70        $9.50    1 = $1.25        $6.99        $2.51
1993..............................         6.15     1 = 1.70        10.46     1 = 1.35         8.30         2.16
1994..............................         6.76     1 = 1.70        11.49     1 = 1.45         9.80         1.69
1995..............................         7.44     1 = 1.70        12.65     1 = 1.55        11.53         1.12
1996..............................         8.18     1 = 1.70        13.90     1 = 1.65        13.50          .40
                                                                                                    ------------
  Total...........................  ...........  ...........  ...........  ...........  ...........        $7.88
----------------------------------------------------------------------------------------------------------------

    (iii) X will also realize exchange gain with respect to the 
principal of the loan (i.e., the issue price of 65.88 British pounds) on 
December 31, 1996 computed by translating the units of nonfunctional 
currency principal received at the spot rate on the date principal is 
received (65.88 British pounds x $1.70 = $112.00) and subtracting from 
such amount, the units of nonfunctional currency principal received 
translated at the spot rate on the date the instrument was acquired 
(65.88 British pounds x $1.20 = $79.06). Accordingly, X's exchange gain 
on the principal is $32.94 and X's total exchange gain with respect to 
the accrued interest and principal is $40.82. It should be noted that, 
under this fact pattern, the total exchange gain may be determined in an 
alternative fashion. Exchange gain may be computed by subtracting the 
adjusted issue price in dollars at maturity ($129.18--see column 10 of 
Table 1) from the amount computed by multiplying the stated redemption 
price at maturity in pounds times the spot rate on the maturity date 
([pound]100 x $1.70 = $170), which equals $40.82.
    Example 11. (i) The facts are the same as in Example 10 except that 
X makes an election under paragraph (b)(2)(iii) of this section to 
translate accrued interest on the last day of the accrual period. 
Accordingly, columns 8, 9 and 10 in Table 1 would change as follows:

[[Page 734]]



------------------------------------------------------------------------
                                     Original
                                      issue
                                   discount in     Total
                                      pounds      interest
                                    multiplied   income in     Adjusted
          Year (Dec. 31)           by the spot    dollars    issue price
                                     rate on     (column 7    in dollars
                                   last day of  plus column
                                     accrual         8)
                                      period
                                    (Dec. 31)
1                                            8            9           10
------------------------------------------------------------------------
                                                                  $79.06
1992.............................        $7.27        $8.57        87.63
1993.............................         8.61        10.01        97.64
1994.............................        10.14        11.64       109.28
1995.............................        11.90        13.50       122.78
1996.............................        13.91        15.61       138.39
------------------------------------------------------------------------

    (ii) Because X is a cash basis taxpayer, X does not realize exchange 
gain or loss on the receipt of the [pound]1 periodic interest payments. 
However, X will realize exchange gain on December 31, 1993 totaling 
$6.18 with respect to the original issue discount. Exchange gain is 
determined for each interest accrual period by translating the units of 
nonfunctional currency interest income received with respect to such 
accrual period at the spot rate on the date received and subtracting 
from such amount, the amount computed by translating the units of 
nonfunctional currency interest income accrued for such period at the 
spot rate on the last day of the accrual period. Accordingly, columns 5, 
6 and 7 of Table 2 would change as follows:

------------------------------------------------------------------------
                                                   OID in
                                                   pounds
                                                 times the
                                    Spot rate    spot rate     Exchange
                                   on last day  on the last    gain or
               Year                 of accrual   day of the   loss (col.
                                      period      accrual    4 less col.
                                                period (col       6)
                                                  2 times
                                                  col. 3)
1                                            5            6            7
------------------------------------------------------------------------
1992.............................        $1.30        $7.27        $2.23
1993.............................         1.40         8.61         1.85
1994.............................         1.50        10.14         1.35
1995.............................         1.60        11.90         0.75
1996.............................         1.70        13.90         0.00
                                                            ------------
                                                                    6.18
------------------------------------------------------------------------

    (iii) X will realize exchange gain with respect to the principal 
amount of the loan as provided in the preceding example.
    Example 12. (i) C is a corporation that is a calendar year accrual 
method taxpayer with the dollar as its functional currency. On January 
1, 1989, C lends 100 British pounds ([pound]) in exchange for a note 
under the terms of which C will receive two equal payments of 
[pound]57.62 on December 31, 1989, and December 31, 1990. Each payment 
of [pound]57.62 represents the annual payment necessary to amortize the 
[pound]100 principal amount at a rate of 10% compounded annually over a 
two year period. The following tables reflect the amounts of principal 
and interest that compose each payment and assumptions as to the 
relevant exchange rates:

------------------------------------------------------------------------
                     Date                        Principal     Interest
------------------------------------------------------------------------
Dec. 31, 1989.................................  [pound]47.6  [pound]10.0
                                                          2            0
Dec. 12, 1990.................................  [pound]52.3  [pound]5.24
                                                          8
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                               Average
                     Date                        Spot rate     rate for
                                                 [pound]1=   year ending
------------------------------------------------------------------------
Jan. 1, 1989..................................        $1.30
Dec. 31, 1989.................................         1.40         1.35
Dec. 31, 1990.................................         1.50         1.45
------------------------------------------------------------------------

    (ii) Because each interest payment is equal to the product of the 
outstanding principal balance of the obligation and a single fixed rate 
of interest, each stated interest payment constitutes periodic interest 
under the principles of section 1273. Accordingly, there is no original 
issue discount.
    (iii) Because C is an accrual basis taxpayer, C will translate the 
interest income at the average rate for the annual accrual period 
pursuant to paragraph (b)(2)(ii)(C) of this section. Thus, C's interest 
income is $13.50 ([pound]10.00 x $1.35) in 1989, and $7.60 ([pound]5.24 
x $1.45) in 1990. C will realize exchange gain or loss upon receipt of 
accrued interest computed in accordance with paragraph (b)(3) of this 
section. Thus, C will realize exchange gain in the amount of $.50 
[([pound]10.00 x $1.40)-$13.50] in 1989, and $.26 [([pound]5.24 x 
$1.50)-$7.60] in 1990.
    (iv) In addition, C will realize exchange gain or loss upon the 
receipt of principal each year computed under paragraph (b)(5) of this 
section. Thus, C will realize exchange gain in the amount of $4.76 
[([pound]47.62 x $1.40)-([pound]47.62 x $1.30)] in 1989, and $10.48 
[([pound]52.38 x $1.50)-([pound]52.38 x $1.30)] in 1990.

    (10) Treatment of bond premium--(i) In general. Amortizable bond 
premium on a bond described in paragraph (b)(2)(i) of this section shall 
be computed in the units of nonfunctional currency in which the bond is 
denominated (or in which the payments are determined). Amortizable bond 
premium properly taken into account under section 171 or Sec. 1.61-12 
(or the successor provision thereof) shall reduce interest income or 
expense in units of nonfunctional currency. Exchange gain or loss is 
realized with respect to bond premium described in the preceding 
sentence by treating the portion of premium amortized with respect to 
any period as a return of principal. With respect to a holder that does 
not elect to amortize bond premium under section 171, the amount of bond 
premium will constitute a market loss when the bond matures. See 
paragraph (b)(8) of this

[[Page 735]]

section. The principles set forth in this paragraph (b)(10) shall apply 
to determine the treatment of acquisition premium described in section 
1272(a)(7).
    (ii) Example. The following example illustrates the provisions of 
this paragraph (b)(10).

    Example. (A) X is an individual on the cash method of accounting 
with the dollar as his functional currency. On January 1, 1989, X 
purchases Y corporation's note for 107.99 British pounds ([pound]) from 
Z, an unrelated party. The note has an issue price of [pound]100, a 
stated redemption price at maturity of [pound]100, pays interest in 
pounds at the rate of 10% compounded annually, and matures on December 
31, 1993. X elects to amortize the bond premium of [pound]7.99 under the 
rules of section 171. Pursuant to paragraph (b)(10)(i) of this section, 
bond premium is determined and amortized in British pounds. Assume the 
amortization schedule is as follows:

------------------------------------------------------------------------
                                                Unamortized
                                       Bond       premium
        Year ending 12/31            premium        plus       Interest
                                    amortized    principal
------------------------------------------------------------------------
                                                [pound]107.
                                                         99
1989.............................  [pound]1.36  [pound]106.  [pound]8.64
                                                         63
1990.............................  [pound]1.47  [pound]105.  [pound]8.53
                                                         16
1991.............................  [pound]1.59  [pound]103.  [pound]8.41
                                                         57
1992.............................  [pound]1.71  [pound]101.  [pound]8.29
                                                         86
1993.............................  [pound]1.85  [pound]100.  [pound]8.15
                                                         00
------------------------------------------------------------------------

    (B) The bond premium reduces X's pound interest income under the 
note. For example, the [pound]10 stated interest payment made in 1989 is 
reduced by [pound]1.36 of bond premium, and the resulting [pound]8.64 
interest income is translated into dollars at the spot rate on December 
31, 1989. Exchange gain or loss is realized on the [pound]1.36 bond 
premium based on the difference between the spot rates on January 1, 
1989, the date the premium is paid to acquire the bond, and December 31, 
1989, the date the bond premium is returned as part of the stated 
interest. The [pound]1.36 bond premium reduces the unamortized premium 
plus principal to [pound]106.63 ([pound]107.99-[pound]1.36). On December 
31, 1993, when the bond matures and the [pound]7.99 of bond premium has 
been fully amortized, X will realize exchange gain or loss with respect 
to the remaining purchase price of [pound]100.

    (11) Market discount--(i) In general. Market discount as defined in 
section 1278(a)(2) shall be determined in units of nonfunctional 
currency in which the market discount bond is denominated (or in which 
the payments are determined). Accrued market discount (other than market 
discount currently included in income pursuant to section 1278(b)) shall 
be translated into functional currency at the spot rate on the date the 
market discount bond is disposed of. No part of such accrued market 
discount is treated as exchange gain or loss. Accrued market discount 
currently includible in income pursuant to section 1278(b) shall be 
translated into functional currency at the average exchange rate for the 
accrual period. Exchange gain or loss with respect to accrued market 
discount currently includible in income under section 1278(b) shall be 
determined in accordance with paragraph (b)(3) of this section relating 
to accrued interest income.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (b)(11).

    Example. (A) X is a calendar year corporation with the U.S. dollar 
as its functional currency. On January 1, 1990, X purchases a bond of M 
corporation for 96,530 British pounds ([pound]). The bond, which was 
issued on January 1, 1989, has an issue price of [pound]100,000, a 
stated redemption price at maturity of [pound]100,000, and provides for 
annual pound payments of interest at 8 percent. The bond matures on 
December 31, 1991. X purchased the bond at a market discount of 3,470 
pounds and did not elect to include the market discount currently in 
income under section 1278(b). X holds the bond to maturity and on 
December 31, 1991, receives payment of [pound]100,000 (plus [pound]8,000 
interest) when the exchange rate is [pound]1 = $1.50.
    (B) Pursuant to paragraph (b)(11) of this section, X computes market 
discount in units of nonfunctional currency. Thus, the market discount 
as defined under section 1278(a)(2) is [pound]3,470. Accrued market 
discount (other than market discount currently included in income 
pursuant to section 1278(b)) is translated at the spot rate on the date 
the market discount bond is disposed of. Accordingly, X will translate 
the accrued market discount of [pound]3,470 at the spot rate on December 
31, 1991 ([pound]3,470 x $1.50 = $5,205). No exchange gain or loss is 
realized with respect to the [pound]3,470 of accrued market discount. 
See paragraphs (b)(3) and (5) of this section for the realization and 
recognition of exchange gain or loss with respect to accrued interest 
and principal.

    (12) Tax exempt bonds. See Sec. 1.988-3(c)(2), which characterizes 
exchange loss realized with respect to a nonfunctional currency tax 
exempt bond as a reduction of interest income.
    (13) Nonfunctional currency debt exchanged for stock of obligor--(i) 
In general. Notwithstanding any other section of the Code other than 
section 267,

[[Page 736]]

1091 or 1092, exchange gain or loss shall be realized and recognized by 
the holder and the obligor in accordance with the rules of paragraphs 
(b)(3) through (7) of this section with respect to the principal and 
accrued interest of a debt instrument described in paragraph (b)(2)(i) 
of this section that is acquired by the obligor in exchange for its 
stock, provided however, that such gain or loss shall be recognized only 
to the extent of the total gain or loss on the exchange (regardless of 
whether such gain or loss would otherwise be recognized). This rule 
shall apply whether the debt instrument is converted into stock 
according to its terms or exchanged pursuant to a separate agreement 
between the obligor and the holder. A debt instrument that is acquired 
by the obligor from a shareholder as a contribution to capital shall be 
treated for purposes of this section as exchanged for stock, whether or 
not additional stock is issued.
    (ii) Coordination with section 108. Section 988 and this section 
shall apply before section 108. Exchange gain realized by the obligor on 
an exchange described in paragraph (b)(13)(i) of this section shall not 
be treated as discharge of indebtedness income, but shall be considered 
to reduce the amount of the liability for purposes of computing the 
obligor's income on the exchange under section 108(e)(4), section 
108(e)(6) or section 108(e)(10).
    (iii) Effective date. This paragraph (b)(13) shall be effective for 
exchanges of debt for stock effected after September 21, 1989.
    (iv) Examples. The following examples illustrate the operation of 
this paragraph (b)(13). In each such example, assume that sections 267, 
1091 and 1092 do not apply.

    Example 1. (i) X is a calendar year U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 1990 (the issue date), 
X acquired a convertible bond maturing on December 31, 1998, issued by Y 
corporation, a U.K. corporation with the British pound ([pound]) as its 
functional currency. The issue price of the bond is [pound]100,000, the 
stated redemption price at maturity is [pound]100,000, and the bond 
provides for annual pound interest payments at the rate of 10%. The 
terms of the bond also provide that at any time prior to December 31, 
1998, the holder may surrender all of his interest in the bond in 
exchange for 20 shares of Y common stock. On January 1, 1994, X 
surrenders his interest in the bond for 20 shares of Y common stock. 
Assume the following: (a) The spot rate on January 1, 1990, is [pound]1 
= $1.30, (b) The spot rate on January 1, 1994, is [pound]1 = $1.50, and 
(c) The 20 shares of Y common stock have a market value of 
[pound]200,000 on January 1, 1994.
    (ii) Pursuant to paragraph (b)(13) of this section, X will realize 
and recognize exchange gain with respect to the issue price 
([pound]100,000) of the bond on January 1, 1994, when the bond is 
converted to stock. X will compute exchange gain pursuant to paragraph 
(b)(5) of this section by translating the issue price at the spot rate 
on the conversion date ([pound]100.000 x $1.50 = $150,000) and 
subtracting from such amount the issue price translated at the spot rate 
on the date X acquired the bond ([pound]100,000 x $1.30 = $130,000). 
Thus, X will realize and recognize $20,000 of exchange gain. X's basis 
in the 20 shares of Y common stock is $150,000 ($130,000 substituted 
basis + $20,000 recognized gain).
    Example 2. (i) X, a foreign corporation with the British pound 
([pound]) as its functional currency, lends [pound]100 at a market rate 
of interest to Y, its wholly-owned U.S. subsidiary, on January 1, 1990, 
on which date the spot exchange rate is [pound]1 = $1. Y's functional 
currency is the U.S. dollar. On January 1, 1992, when the spot exchange 
rate is [pound]1 = $.50, X cancels the debt as a contribution to 
capital. Pursuant to paragraph (b)(13) of this section, Y will realize 
and recognize exchange gain with respect to the [pound]100 issue price 
of the debt instrument on January 1, 1992. Y will compute exchange gain 
pursuant to paragraph (b)(6) of this section by translating the issue 
price at the spot rate on the date Y became the obligor ([pound]100 x $1 
= $100) and subtracting from such amount the issue price translated at 
the spot rate on the date of extinguishment ([pound]100 x $.50 = $50). 
Thus, Y will realize and recognize $50 of exchange gain.
    (ii) Under section 108(e)(6), on the acquisition of its indebtedness 
from X as a contribution to capital Y is treated as having satisfied the 
debt with an amount of money equal to X's adjusted basis in the debt 
([pound]100). For purposes of section 108(e)(6), X's adjusted basis is 
translated into United States dollars at the spot rate on the date Y 
acquires the debt ([pound]1 = $.50). Therefore, Y is treated as having 
satisfied the debt for $50. Pursuant to paragraph (b)(13) of this 
section, for purposes of section 108 the amount of the indebtedness is 
considered to be reduced by the exchange gain from $100 to $50. 
Accordingly, Y recognizes $50 of exchange gain and no discharge of 
indebtedness income on the extinguishment of its debt to X.
    (iii) If X were a United States taxpayer with a dollar functional 
currency and a $100 basis in Y's obligation. X would realize and

[[Page 737]]

recognize an exchange loss of $50 under paragraph (b)(5) of this section 
on the contribution of the debt to Y. The recognized loss would reduce 
X's adjusted basis in the debt from $100 to $50, so that for purposes of 
applying section 108(e)(6) Y is treated as having satisfied the debt for 
$50. Accordingly, under these facts as well Y would recognize $50 of 
exchange gain and no discharge of indebtedness income.
    Example 3. (i) X and Y are unrelated calendar year U.S. corporations 
with the U.S. dollar as their functional currency. On January 1, 1990 
(the issue date), X acquires Y's bond maturing on December 31, 1999. The 
issue price of the bond is [pound]100,000, the stated redemption price 
at maturity is [pound]100,000, and the bond provides for annual pound 
interest payments at the rate of 10%. On January 1, 1994, X and Y agree 
that Y will redeem its bond from X in exchange for 20 shares of Y common 
stock. Assume the following:
    (a) The spot rate on January 1, 1990, is [pound]1 = $1.00,
    (b) The spot rate on January 1, 1994, is [pound]1 = $.50,
    (c) Interest rates on equivalent bonds have increased so that as of 
January 1, 1994, the value of Y's bond has declined to [pound]90,000, 
and
    (d) The 20 shares of Y common stock have a market value of 
[pound]90,000 as of January 1, 1994.
    (ii) Pursuant to paragraph (b)(13) of this section, X will realize 
and recognize exchange loss with respect to the issue price 
([pound]100,000) of the bond on January 1, 1994, when the bond is 
exchanged for stock. X will compute exchange loss pursuant to paragraph 
(b)(5) of this section by translating the issue price at the spot rate 
on the exchange date ([pound]100,000 x $.50 = $50,000) and subtracting 
from such amount the issue price translated at the spot rate on the date 
X acquired the bond ([pound]100,000 x $1.00 = $100,000). Thus, X will 
compute $50,000 of exchange loss, all of which will be realized and 
recognized because it does not exceed the total $55,000 realized loss on 
the exchange ($45,000 worth of stock received less $100,000 basis in the 
exchanged bond).
    (iii) Pursuant to paragraph (b)(13) of this section, Y will realize 
and recognize exchange gain with respect to the issue price, computed 
under paragraph (b)(6) of this section by translating the issue price at 
the spot rate on the date Y became the obligor ([pound]100,000 x $1.00 = 
$100,000) and subtracting from such amount the issue price translated at 
the spot rate on the exchange date ([pound]100,000 x $.50 = $50,000). 
Thus, Y will realize and recognize $50,000 of exchange gain. Under 
section 108(e)(10), on the transfer of stock to X in satisfaction of its 
indebtedness Y is treated as having satisfied the indebtedness with an 
amount of money equal to the fair market value of the stock 
([pound]90,000 x $.50 = $45,000). Pursuant to paragraph (b)(13) of this 
section, for purposes of section 108 the amount of the indebtedness is 
considered to be reduced by the recognized exchange gain from $100,000 
to $50,000. Accordingly, Y recognizes an additional $5,000 of discharge 
of indebtedness income on the exchange.
    Example 4. (i) The facts are the same as in Example 3 except that 
interest rates on equivalent bonds have declined, rather than increased, 
so that the value of Y's bond on January 1, 1994, has risen to 
[pound]112,500; and X and Y agree that Y will redeem its bond from X on 
that date in exchange for 25 shares of Y common stock worth 
[pound]112,500. Pursuant to paragraphs (b)(13) and (b)(5) of this 
section, X will compute $50,000 of exchange loss on the exchange with 
respect to the [pound]100,000 issue price of the bond. See Example 3. 
However, because X's total loss on the exchange is only $43,750 ($56,250 
worth of stock received less $100,000 basis in the exchanged bond), 
under the netting rule of paragraph (b)(13) of this section the realized 
exchange loss is limited to $43,750.
    (ii) Pursuant to paragraphs (b)(13) and (b)(6) of this section, Y 
will compute $50,000 of exchange gain with respect to the issue price. 
See Example 3. Under section 108(e)(10), Y is treated as having 
satisfied the $100,000 indebtedness with an amount of money equal to the 
fair market value of the stock ([pound]112,500 x $.50 = $56,250), 
resulting in a total gain on the exchange of $43,750. Accordingly, under 
paragraph (b)(13) of this section Y's realized (and recognized) exchange 
gain on the exchange is limited to $43,750. Also pursuant to paragraph 
(b)(13) of this section, for purposes of section 108 the amount of the 
indebtedness is considered to be reduced by the recognized exchange gain 
from $100,000 to $56,250. Accordingly, Y recognizes no discharge of 
indebtedness income on the exchange.

    (14) [Reserved]
    (15) Debt instruments and deposits denominated in hyperinflationary 
currencies--(i) In general. If a taxpayer issues, acquires, or otherwise 
enters into or holds a hyperinflationary debt instrument (as defined in 
paragraph (b)(15)(vi)(A) of this section) or a hyperinflationary deposit 
(as defined in paragraph (b)(15)(vi)(B) of this section) on which 
interest is paid or accrued that is denominated in (or determined by 
reference to) a nonfunctional currency of the taxpayer, then the 
taxpayer shall realize exchange gain or loss with respect to such 
instrument or deposit for its taxable year determined by reference to 
the change in exchange rates between--

[[Page 738]]

    (A) The later of the first day of the taxable year, or the date the 
instrument was entered into (or an amount deposited); and
    (B) The earlier of the last day of the taxable year, or the date the 
instrument (or deposit) is disposed of or otherwise terminated.
    (ii) Only exchange gain or loss is realized. No gain or loss is 
realized under paragraph (b)(15)(i) by reason of factors other than 
movement in exchange rates, such as the creditworthiness of the debtor.
    (iii) Special rule for synthetic, non-hyperinflationary currency 
debt instruments--(A) General rule. Paragraph (b)(15)(i) does not apply 
to a debt instrument that has interest and principal payments that are 
to be made by reference to a currency or item that does not reflect 
hyperinflationary conditions in a country (within the meaning of Sec. 
1.988-1(f)).
    (B) Example. Paragraph (b)(15)(iii)(A) is illustrated by the 
following example:

    Example. When the Turkish lira (TL) is a hyperinflationary currency, 
A, a U.S. corporation with the U.S. dollar as its functional currency, 
makes a 5 year, 100,000 TL-denominated loan to B, an unrelated 
corporation, at a 10% interest rate when 1,000 TL equals $1. Under the 
terms of the debt instrument, B must pay interest annually to A in 
amount of Turkish lira that is equal to $100. Also under the terms of 
the debt instrument, B must pay A upon maturity of the debt instrument 
an amount of Turkish lira that is equal to $1,000. Although the 
principal and interest are payable in a hyperinflationary currency, the 
debt instrument is a synthetic dollar debt instrument and is not subject 
to paragraph (b)(15)(i) of this section.

    (iv) Source and character of gain or loss--(A) General rule for 
hyperinflationary conditions. The rules of this paragraph (b)(15)(iv)(A) 
shall apply to any taxpayer that is either an issuer of (or obligor 
under) a hyperinflationary debt instrument or deposit and has currency 
gain on such debt instrument or deposit, or a holder of a 
hyperinflationary debt instrument or deposit and has currency loss on 
such debt instrument or deposit. For purposes of subtitle A of the 
Internal Revenue Code, any exchange gain or loss realized under 
paragraph (b)(15)(i) of this section is directly allocable to the 
interest expense or interest income, respectively, from the debt 
instrument or deposit (computed under this paragraph (b)), and therefore 
reduces or increases the amount of interest income or interest expense 
paid or accrued during that year with respect to that instrument or 
deposit. With respect to a debt instrument or deposit during a taxable 
year, to the extent exchange gain realized under paragraph (b)(15)(i) of 
this section exceeds interest expense of an issuer, or exchange loss 
realized under paragraph (b)(15)(i) of this section exceeds interest 
income of a holder or depositor, the character and source of such excess 
amount shall be determined under Sec. Sec. 1.988-3 and 1.988-4.
    (B) Special rule for subsiding hyperinflationary conditions. If the 
taxpayer is an issuer of (or obligor under) a hyperinflationary debt 
instrument or deposit and has currency loss, or if the taxpayer is a 
holder of a hyperinflationary debt instrument or deposit and has 
currency gain, then for purposes of subtitle A of the Internal Revenue 
Code, the character and source of the currency gain or loss is 
determined under Sec. Sec. 1.988-3 and 1.988-4. Thus, if an issuer has 
both interest expense and currency loss, the currency loss is sourced 
and characterized under section 988, and does not affect the 
determination of interest expense.
    (v) Adjustment to principal or basis. Any exchange gain or loss 
realized under paragraph (b)(15)(i) of this section is an adjustment to 
the functional currency principal amount of the issuer, functional 
currency basis of the holder, or the functional currency amount of the 
deposit. This adjusted amount or basis is used in making subsequent 
computations of exchange gain or loss, computing the basis of assets for 
purposes of allocating interest under Sec. Sec. 1.861-9T through 1.861-
12T and 1.882-5, or making other determinations that may be relevant for 
computing taxable income or loss.
    (vi) Definitions--(A) Hyperinflationary debt instrument. A 
hyperinflationary debt instrument is a debt instrument that provides 
for--
    (1) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in

[[Page 739]]

Sec. 1.988-1(f)) at the time the taxpayer enters into or otherwise 
acquires the debt instrument; or
    (2) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) during the 
taxable year, and the terms of the instrument provide for the adjustment 
of principal or interest payments in a manner that reflects 
hyperinflation. For example, a debt instrument providing for a variable 
interest rate based on local conditions and generally responding to 
changes in the local consumer price index will reflect hyperinflation.
    (B) Hyperinflationary deposit. A hyperinflationary deposit is a 
demand or time deposit or similar instrument issued by a bank or other 
financial institution that provides for--
    (1) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) at the time 
the taxpayer enters into or otherwise acquires the deposit; or
    (2) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) during the 
taxable year, and the terms of the deposit provide for the adjustment of 
the deposit amount or interest payments in a manner that reflects 
hyperinflation.
    (vii) Interaction with other provisions--(A) Interest allocation 
rules. In determining the amount of interest expense, this paragraph 
(b)(15) applies before Sec. Sec. 1.861-9T through 1.861-12T, and 1.882-
5.
    (B) DASTM. With respect to a qualified business unit that uses the 
United States dollar approximate separate transactions method of 
accounting described in Sec. 1.985-3, paragraph (b)(15)(i) of this 
section does not apply.
    (C) Interaction with section 988(a)(3)(C). Section 988(a)(3)(C) does 
not apply to a debt instrument subject to the rules of paragraph 
(b)(15)(i) of this section.
    (D) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply, the 
rules of paragraph (b)(15)(i) of this section will not apply. This 
paragraph (b)(15)(vii)(D) does not apply if the application of Sec. 
1.988-5 results in hyperinflationary debt instrument or deposit 
described in paragraph (b)(15)(vi)(A) or (B) of this section.
    (viii) Effective date. This paragraph (b)(15) applies to 
transactions entered into after February 14, 2000.
    (16) [Reserved] For further guidance, see Sec. 1.988-2T(b)(16).
    (17) Coordination with installment method under section 453. 
[Reserved]
    (18) Interaction of section 988 and Sec. 1.1275-2(g)--(i) In 
general. If a principal purpose of structuring a debt instrument subject 
to section 988 and any related hedges is to achieve a result that is 
unreasonable in light of the purposes of section 163(e), section 988, 
sections 1271 through 1275, or any related section of the Internal 
Revenue Code, the Commissioner can apply or depart from the regulations 
under the applicable sections as necessary or appropriate to achieve a 
reasonable result. For example, if this paragraph (b)(18) applies to a 
multicurrency debt instrument and a hedge or hedges, the Commissioner 
can wholly or partially integrate transactions or treat portions of the 
debt instrument as separate instruments where appropriate. See also 
Sec. 1.1275-2(g).
    (ii) Unreasonable result. Whether a result is unreasonable is 
determined based on all the facts and circumstances. In making this 
determination, a significant fact is whether the treatment of the debt 
instrument is expected to have a substantial effect on the issuer's or a 
holder's U.S. tax liability. Another significant fact is whether the 
result is obtainable without the application of Sec. 1.988-6 and any 
related provisions (e.g., if the debt instrument and the contingency 
were entered into separately). A result will not be considered 
unreasonable, however, in the absence of an expected substantial effect 
on the present value of a taxpayer's tax liability.
    (iii) Effective date. This paragraph (b)(18) shall apply to debt 
instruments issued on or after October 29, 2004.
    (c) Item of expense or gross income or receipts which is to be paid 
or received after the date accrued--(1) In general. Except as provided 
in Sec. 1.988-5, exchange gain or loss with respect to an item 
described in Sec. 1.988-1(a)(1)(ii) and (2)(ii) (other than accrued 
interest income or expense subject to paragraph

[[Page 740]]

(b) of this section) shall be realized on the date payment is made or 
received. Except as provided in the succeeding sentence, such exchange 
gain or loss shall be recognized in accordance with the applicable 
recognition provisions of the Internal Revenue Code. If the taxpayer's 
right to receive income, or obligation to pay an expense, is transferred 
or modified in a transaction in which gain or loss would otherwise be 
recognized, exchange gain or loss shall be realized and recognized only 
to the extent of the total gain or loss on the transaction.
    (2) Determination of exchange gain or loss with respect to an item 
of gross income or receipts. Exchange gain or loss realized on an item 
of gross income or receipts described in paragraph (c)(1) of this 
section shall be determined by multiplying the units of nonfunctional 
currency received by the spot rate on the payment date, and subtracting 
from such amount the amount determined by multiplying the units of 
nonfunctional currency received by the spot rate on the booking date. 
The term ``spot rate on the payment date'' means the spot rate 
determined under Sec. 1.988-1(d) on the date payment is received or 
otherwise taken into account. Pursuant to Sec. 1.988-1(d)(3), a 
taxpayer may use a spot rate convention for purposes of determining the 
spot rate on the payment date. The term ``spot rate on the booking 
date'' means the spot rate determined under Sec. 1.988-1(d) on the date 
the item of gross income or receipts is accrued or otherwise taken into 
account. Pursuant to Sec. 1.988-1(d)(3), a taxpayer may use a spot rate 
convention for purposes of determining the spot rate on the booking 
date.
    (3) Determination of exchange gain or loss with respect to an item 
of expense. Exchange gain or loss realized on an item of expense 
described in paragraph (c)(1) of this section shall be determined by 
multiplying the units of nonfunctional currency paid by the spot rate on 
the booking date and subtracting from such amount the amount determined 
by multiplying the units of nonfunctional currency paid by the spot rate 
on the payment date. The term ``spot rate on the booking date'' means 
the spot rate determined under Sec. 1.988-1(d) on the date the item of 
expense is accrued or otherwise taken into account. Pursuant to Sec. 
1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of 
determining the spot rate on the booking date. The term ``spot rate on 
the payment date'' means the spot rate determined under Sec. 1.988-1(d) 
on the date payment is made or otherwise taken into account. Pursuant to 
Sec. 1.988-1(d)(3), a taxpayer may use a spot rate convention for 
purposes of determining the spot rate on the date.
    (4) Examples. The following examples illustrate the application of 
paragraph (c) of this section.

    Example 1. X is a calendar year corporation with the dollar as its 
functional currency. X is on the accrual method of accounting. On 
January 15, 1989, X sells inventory for 10,000 Canadian dollars (C$). 
The spot rate on January 15, 1989, is C$1 = U.S. $.55. On February 23, 
1989, when X receives payment of the C$10,000, the spot rate is C$1 = 
U.S. $.50. On February 23, 1989, X will realize exchange loss. X's loss 
is computed by multiplying the C$10,000 by the spot rate on the date the 
C$10,000 are received (C$10,000 x .50 = U.S. $5,000) and subtracting 
from such amount, the amount computed by multiplying the C$10,000 by the 
spot rate on the booking date (C$10,000 x .55 = U.S. $5,500). Thus, X's 
exchange loss on the transaction is U.S. $500 (U.S. $5,000-U.S. $5,500).
    Example 2. The facts are the same as in Example 1 except that X uses 
a spot rate convention to determine the spot rate as provided in Sec. 
1.988-1(d)(3). Pursuant to X's spot rate convention, the spot rate at 
which a payable or receivable is booked is determined monthly for each 
nonfunctional currency payable or receivable by adding the spot rate at 
the beginning of the month and the spot rate at the end of the month and 
dividing by two. All payables and receivables in a nonfunctional 
currency booked during the month are translated into functional currency 
at the rate described in the preceding sentence. Further, the 
translation of nonfunctional currency paid with respect to a payable, 
and nonfunctional currency received with respect to a receivable, is 
also performed pursuant to the spot rate convention. Assume the spot 
rate determined under the spot rate convention for the month of January 
is C$1 = U.S. $.54 and for the month of February is C$1 = U.S. $.51. On 
the last date in February, X will realize exchange loss. X's loss is 
computed by multiplying the C$10,000 by the spot rate convention for the 
month of February (C$10,000 x U.S. $.51 = U.S. $5,100) and subtracting 
from such amount, the amount computed by multiplying the C$10,000 by the 
spot rate convention for the

[[Page 741]]

month of January (C$10,000 x U.S. $.54 = $5,400). Thus, X's exchange 
loss on the transaction is U.S. $300 (U.S. $5,100-U.S. $5,400). X's 
basis in the C$10,000 is U.S. $5,400.
    Example 3. The facts are the same as in Example 2 except that X has 
a standing order with X's bank for the bank to convert any nonfunctional 
currency received in satisfaction of a receivable into U.S. dollars on 
the day received and to deposit those U.S. dollars in X's U.S. dollar 
bank account. X may use its convention to translate the amount booked 
into U.S. dollars, but must use the U.S. dollar amounts received from 
the bank with respect to such receivables to determine X's exchange gain 
or loss. Thus, if X receives payment of the C$10,000 on February 23, 
1989, when the spot rate is C$1 = U.S.$ .50, X determines exchange gain 
or loss by subtracting the amount booked under X's convention 
(U.S.$5,400) from the amount of U.S. dollars received from the bank 
under the standing conversion order (assume $5,000). X's exchange loss 
is U.S.$400.

    (d) Exchange gain or loss with respect to forward contracts, futures 
contracts and option contracts--(1) Scope--(i) In general. This 
paragraph (d) applies to forward contracts, futures contracts and option 
contracts described in Sec. 1.988-1(a)(1)(ii) and (2)(iii). For rules 
applicable to currency swaps and notional principal contracts described 
in Sec. 1.988-1(a) (1)(ii) and (2)(iii), see paragraph (e) of this 
section.
    (ii) Treatment of spot contracts. Solely for purposes of this 
paragraph (d), a spot contract as defined in Sec. 1.988-1(b) to buy or 
sell nonfunctional currency is not considered a forward contract or 
similar transaction described in Sec. 1.988-1(a)(2)(iii) unless such 
spot contract is disposed of (or otherwise terminated) prior to making 
or taking delivery of the currency. For example, if a taxpayer with the 
dollar as its functional currency enters into a spot contract to 
purchase British pounds, and takes delivery of such pounds under the 
contract, the delivery of the pounds is not a realization event under 
section 988(c)(5) and paragraph (e)(4)(ii) of this section because the 
contract is not considered a forward contract or similar transaction 
described in Sec. 1.988-1(a)(2)(iii). However, if the taxpayer sells or 
otherwise terminates the contract before taking delivery of the pounds, 
exchange gain or loss shall be realized and recognized in accordance 
with paragraphs (d)(2) and (3) of this section.
    (2) Realization of exchange gain or loss--(i) In general. Except as 
provided in Sec. 1.988-5, exchange gain or loss on a contract described 
in Sec. 1.988-2(d)(1) shall be realized in accordance with the 
applicable realization section of the Internal Revenue Code (e.g., 
sections 1001, 1092, and 1256). See also section 988(c)(5). For purposes 
of determining the timing of the realization of exchange gain or loss, 
sections 1092 and 1256 shall take precedence over section 988(c)(5).
    (ii) Realization by offset--(A) In general. Except as provided in 
paragraphs (d)(2)(ii)(B) and (C) of this section, exchange gain or loss 
with respect to a transaction described in Sec. 1.988-1(a)(1)(ii) and 
(2)(iii) shall not be realized solely because such transaction is offset 
by another transaction (or transactions).
    (B) Exception where economic benefit is derived. If a transaction 
described in Sec. 1.988-1(a)(1)(ii) and (2)(iii) is offset by another 
transaction or transactions, exchange gain shall be realized to the 
extent the taxpayer derives, by pledge or otherwise, an economic benefit 
(e.g., cash, property or the proceeds from a borrowing) from any gain 
inherent in such offsetting positions. Proper adjustment shall be made 
in the amount of any gain or loss subsequently realized for gain taken 
into account by reason of the preceding sentence. This paragraph 
(d)(2)(ii)(B) shall apply to transactions creating an offset after 
September 21, 1989.
    (C) Certain contracts traded on an exchange. If a transaction 
described in Sec. 1.988-1(a)(1)(ii) and (2)(iii) is traded on an 
exchange and it is the general practice of the exchange to terminate 
offsetting contracts, entering into an offsetting contract shall be 
considered a termination of the contract being offset.
    (iii) Clarification of section 988(c)(5). If the delivery date of a 
contract subject to section 988(c)(5) and paragraph (d)(4)(ii) of this 
section is different than the date the contract expires, then for 
purposes of determining the date exchange gain or loss is realized, the 
term delivery date shall mean expiration date.

[[Page 742]]

    (iv) Examples. The following examples illustrate the rules of this 
paragraph (d)(1) and (2).

    Example 1. On August 1, 1989, X, a calendar year corporation with 
the dollar as its functional currency, enters into a forward contract 
with Bank A to buy 100 New Zealand dollars for $80 for delivery on 
January 31, 1990. (The forward purchase contract is not a section 1256 
contract.) On November 1, 1989, the market price for the purchase of 100 
New Zealand dollars for delivery on January 31, 1990, is $76. On 
November 1, 1989, X cancels its obligation under the forward purchase 
contract and pays Bank A $3.95 (the present value of $4 discounted at 
12% for the period) in cancellation of such contract. Under section 1001 
(a), X realizes an exchange loss of $3.95 on November 1, 1989, because 
cancellation of the forward purchase contract for cash results in the 
termination of X's contract.
    Example 2. X is a corporation with the dollar as its functional 
currency. On January 1, 1989, X enters into a currency swap contract 
with Bank A under which X is obligated to make a series of Japanese yen 
payments in exchange for a series of dollar payments. On February 21, 
1992, X has a gain of $100,000 inherent in such contract as a result of 
interest rate and exchange rate movements. Also on February 21, 1992, X 
enters into an offsetting swap with Bank A to lock in such gain. If on 
February 21, 1992, X pledges the gain inherent in such offsetting 
positions as collateral for a loan, X's initial swap contract is treated 
as being terminated on February 21, 1992, under paragraph (d)(2)(ii)(B) 
of this section. Proper adjustment is made in the amount of any gain or 
loss subsequently realized for the gain taken into account by reason of 
paragraph (d)(2)(ii)(B) of this section.
    Example 3. X is a calendar year corporation with the dollar as its 
functional currency. On October 1, 1989, X enters into a forward 
contract to buy 100,000 Swiss francs (Sf) for delivery on March l, 1990, 
for $51,220. Assume that the contract is a section 1256 contract under 
section 1256(g)(2) and that section 1256(e) does not apply. Pursuant to 
section 1256(a)(1), the forward contract is treated as sold for its fair 
market value on December 31, 1989. Assume that the fair market value of 
the contract is $1,000 determined under Sec. 1.988-1(g). Thus X will 
realize an exchange gain of $1,000 on December 31, 1989. Such gain is 
subject to the character rules of Sec. 1.988-3 and the source rules of 
Sec. 1.988-4.

    (v) Extension of the maturity date of certain contracts. An 
extension of time for making or taking delivery under a contract 
described in paragraph (d)(1) of this section (e.g., a historical rate 
rollover as defined in Sec. 1.988-5(b)(2)(iii)(C)) shall be considered 
a sale or exchange of the contract for its fair market value on the date 
of the extension and the establishment of a new contract on such date. 
If, under the terms of the extension, the time value of any gain or loss 
recognized pursuant to the preceding sentence adjusts the price of the 
currency to be bought or sold under the new contract, the amount 
attributable to such time value shall be treated as interest income or 
expense for all purposes of the Code. However, the preceding sentence 
shall not apply and the amount attributable to the time value of any 
gain or loss recognized shall be treated as exchange gain or loss if the 
period beginning on the first date the contract is rolled over and 
ending on the date payment is ultimately made or received with respect 
to such contract does not exceed 183 days.
    (3) Recognition of exchange gain or loss. Except as provided in 
Sec. 1.988-5 (relating to section 988 hedging transactions), exchange 
gain or loss realized with respect to a contract described in paragraph 
(d)(1) of this section shall be recognized in accordance with the 
applicable recognition provisions of the Internal Revenue Code. For 
example, a loss realized with respect to a contract described in 
paragraph (d)(1) of this section which is part of a straddle shall be 
recognized in accordance with the provisions of section 1092 to the 
extent such section is applicable.
    (4) Determination of exchange gain or loss--(i) In general. Exchange 
gain or loss with respect to a contract described in Sec. 1.988-2(d)(1) 
shall be determined by subtracting the amount paid (or deemed paid), if 
any, for or with respect to the contract (including any amount paid upon 
termination of the contract) from the amount received (or deemed 
received), if any, for or with respect to the contract (including any 
amount received upon termination of the contract). Any gain or loss 
determined according to the preceding sentence shall be treated as 
exchange gain or loss.
    (ii) Special rules where taxpayer makes or takes delivery. If the 
taxpayer makes or takes delivery in connection with a contract described 
in paragraph (d)(1)

[[Page 743]]

of this section, any gain or loss shall be realized and recognized in 
the same manner as if the taxpayer sold the contract (or paid another 
person to assume the contract) on the date on which he took or made 
delivery for its fair market value on such date. See paragraph 
(d)(2)(iii) of this section regarding the definition of the term 
``delivery date.'' This paragraph (d)(4)(ii) shall not apply in any case 
in which the taxpayer makes or takes delivery before June 11, 1987.
    (iii) Examples. The following examples illustrate the application of 
paragraph (d)(4) of this section.

    Example 1. X is a calendar year corporation with the dollar as its 
functional currency. On October 1, 1989, when the six month forward rate 
is $.4907, X enters into a forward contract to buy 100,000 New Zealand 
dollars (NZD) for delivery on March 1, 1990. On March 1, 1990, when X 
takes delivery of the 100,000 NZD, the spot rate is 1NZD equals $.48. 
Pursuant to section 988(c)(5) and paragraph (d)(4)(ii) of this section, 
a taxpayer that takes delivery of nonfunctional currency under a forward 
contract that is subject to section 988 is treated as if the taxpayer 
sold the contract for its fair market value on the date delivery is 
taken. If X sold the contract on March 1, 1990, the transferee would 
require a payment of $1,070 [($.48 x 100,000NZD)-($.4907 x 100,000NZD)] 
to compensate him for the loss in value of the 100,000NZD. Therefore, X 
realizes an exchange loss of $1,070. X has a basis in the 100,000NZD of 
$48,000.
    Example 2. Assume the same facts as in Example 1 except that the 
contract is for Swiss francs and is a section 1256 contract. Assume 
further that on December 31, 1989, the value to X of the contract as 
marked to market is $1,000. Pursuant to section 1256(a), X realizes an 
exchange gain of $1,000. Such gain, however, is characterized as 
ordinary income under Sec. 1.988-3 and will be sourced under Sec. 
1.988-4.
    Example 3. X is a calendar year corporation with the dollar as its 
functional currency. On May 2, 1989, X enters into an option contract 
with Bank A to purchase 50,000 Canadian dollars (C$) for U.S. $42,500 
(C$1 = U.S. $.85) for delivery on or before September 18, 1989. X pays a 
$285 premium to Bank A to obtain the option contract. On September 18, 
1989, when X exercises the option and takes delivery of the C$50,000, 
the spot rate is C$1 equals U.S. $.90. Pursuant to section 988(c)(5) and 
paragraph (d)(4)(ii) of this section, a taxpayer that takes delivery 
under an option contract that is subject to section 988 is treated as if 
the taxpayer sold the contract for its fair market value on the date 
delivery is taken. If X sold the contract for its fair market value on 
September 18, 1989, X would receive U.S. $2,500 [(C$50,000 x U.S. $.90)-
(C$50,000 x U.S. $.85)]. Accordingly, X is deemed to have received U.S. 
$2,500 on the sale of the contract at its fair market value. X will 
realize U.S. $2,215 ($2,500 deemed received less $285 paid) of exchange 
gain with respect to the delivery of Canadian dollars under the option 
contract. X's basis in the 50,000 Canadian dollars is U.S. $45,000.

    (5) Hyperinflationary contracts--(i) In general. If a taxpayer 
acquires or otherwise enters into a hyperinflationary contract (as 
defined in paragraph (d)(5)(ii) of this section) that has payments to be 
made or received that are denominated in (or determined by reference to) 
a nonfunctional currency of the taxpayer, then the taxpayer shall 
realize exchange gain or loss with respect to such contract for its 
taxable year determined by reference to the change in exchange rates 
between--
    (A) The later of the first day of the taxable year, or the date the 
contract was acquired or entered into; and
    (B) The earlier of the last day of the taxable year, or the date the 
contract is disposed of or otherwise terminated.
    (ii) Definition of hyperinflationary contract. A hyperinflationary 
contract is a contract described in paragraph (d)(1) of this section 
that provides for payments denominated in or determined by reference to 
a currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at 
the time the taxpayer acquires or otherwise enters into the contract.
    (iii) Interaction with other provisions--(A) DASTM. With respect to 
a qualified business unit that uses the United States dollar approximate 
separate transactions method of accounting described in Sec. 1.985-3, 
this paragraph (d)(5) does not apply.
    (B) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply, 
this paragraph (d)(5) does not apply.
    (C) Adjustment for subsequent transactions. Proper adjustments must 
be made in the amount of any gain or loss subsequently realized for gain 
or loss taken into account by reason of this paragraph (d)(5).
    (iv) Effective date. This paragraph (d) (5) is applicable to 
transactions acquired or otherwise entered into after February 14, 2000.

[[Page 744]]

    (e) Currency swaps and other notional principal contracts--(1) In 
general. Except as provided in paragraph (e)(2) of this section or in 
Sec. 1.988-5, the timing of income, deduction and loss with respect to 
a notional principal contract that is a section 988 transaction shall be 
governed by section 446 and the regulations thereunder. Such income, 
deduction and loss is characterized as exchange gain or loss (except as 
provided in another section of the Internal Revenue Code (or regulations 
thereunder), Sec. 1.988-5, or in paragraph (f) of this section).
    (2) Special rules for currency swaps--(i) In general. Except as 
provided in paragraph (e)(2)(iii)(B) of this section, the provisions of 
this paragraph (e)(2) shall apply solely for purposes of determining the 
realization, recognition and amount of exchange gain or loss with 
respect to a currency swap contract, and not for purposes of determining 
the source of such gain or loss, or characterizing such gain or loss as 
interest. Except as provided in Sec. 1.988-3(c), any income or loss 
realized with respect to a currency swap contract shall be characterized 
as exchange gain or loss (and not as interest income or expense). Any 
exchange gain or loss realized in accordance with this paragraph (e)(2) 
shall be recognized unless otherwise provided in an applicable section 
of the Code. For purposes of this paragraph (e)(2), a currency swap 
contract is a contract defined in paragraph (e)(2)(ii) of this section. 
With respect to a contract which requires the payment of swap principal 
prior to maturity of such contract, see paragraph (f) of this section. 
For purposes of this paragraph (e), the rules of paragraph (d)(2)(ii) of 
this section (regarding realization by offset) apply. See Example 2 of 
paragraph (d)(2)(iv) of this section.
    (ii) Definition of currency swap contract--(A) In general. A 
currency swap contract is a contract involving different currencies 
between two or more parties to--
    (1) Exchange periodic interim payments, as defined in paragraph 
(e)(2)(ii)(C) of this section, on or prior to maturity of the contract; 
and
    (2) Exchange the swap principal amount upon maturity of the 
contract.


A currency swap contract may also require an exchange of the swap 
principal amount upon commencement of the agreement.
    (B) Swap principal amount. The swap principal amount is an amount of 
two different currencies which, under the terms of the currency swap 
contract, is used to determine the periodic interim payments in each 
currency and which is exchanged upon maturity of the contract. If such 
amount is not clearly set forth in the contract, the Commissioner may 
determine the swap principal amount.
    (C) Exchange of periodic interim payments. An exchange of periodic 
interim payments is an exchange of one or more payments in one currency 
specified by the contract for one or more payments in a different 
currency specified by the contract where the payments in each currency 
are computed by reference to an interest index applied to the swap 
principal amount. A currency swap contract must clearly indicate the 
periodic interim payments, or the interest index used to compute the 
periodic interim payments, in each currency.
    (iii) Timing and computation of periodic interim payments--(A) In 
general. Except as provided in paragraph (e)(2)(iii)(B) of this section 
and Sec. 1.988-5, the timing and computation of the periodic interim 
payments provided in a currency swap agreement shall be determined by 
treating--
    (1) Payments made under the swap as payments made pursuant to a 
hypothetical borrowing that is denominated in the currency in which 
payments are required to be made (or are determined with reference to) 
under the swap, and
    (2) Payments received under the swap as payments received pursuant 
to a hypothetical loan that is denominated in the currency in which 
payments are received (or are determined with reference to) under the 
swap.


Except as provided in paragraph (e)(2)(v) of this section, the 
hypothetical issue price of such hypothetical borrowing and loan shall 
be the swap principal amount. The hypothetical stated redemption price 
at maturity is the total of all payments (excluding any exchange of the 
swap principal amount at the inception of the

[[Page 745]]

contract) provided under the hypothetical borrowing or loan other than 
periodic interest payments under the principles of section 1273. For 
purposes of determining economic accrual under the currency swap, the 
number of hypothetical interest compounding periods of such hypothetical 
borrowing and loan shall be determined pursuant to a semiannual 
compounding convention unless the currency swap contract indicates 
otherwise. For purposes of determining the timing and amount of the 
periodic interim payments, the principles regarding the amortization of 
interest (see generally, sections 1272 through 1275 and 163(e)) shall 
apply to the hypothetical interest expense and income of such 
hypothetical borrowing and loan. However, such principles shall not 
apply to determine the time when principal is deemed to be paid on the 
hypothetical borrowing and loan. See paragraph (d)(2)(iii) of this 
section and Example 2 of paragraph (d)(5) of this section with respect 
to the time when principal is deemed to be paid. With respect to the 
translation and computation of exchange gain or loss on any hypothetical 
interest income or expense, see Sec. 1.988-2(b). The amount treated as 
exchange gain or loss by the taxpayer with respect to the periodic 
interim payments for the taxable year shall be the amount of 
hypothetical interest income and exchange gain or loss attributable to 
such interest income from the hypothetical borrowing and loan for such 
year less the amount of hypothetical interest expense and exchange gain 
or loss attributable to the interest expense from such hypothetical 
borrowing and loan for such year.
    (B) Effect of prepayment for purposes of section 956. For purposes 
of section 956, the Commissioner may treat any prepayment of a currency 
swap as a loan.
    (iv) Timing and determination of exchange gain or loss with respect 
to the swap principal amount. Exchange gain or loss with respect to the 
swap principal amount shall be realized on the day the units of swap 
principal in each currency are exchanged. (See paragraph 
(e)(2)(ii)(A)(2) of this section which requires that the entire swap 
principal amount be exchanged upon maturity of the contract.) Such gain 
or loss shall be determined on the date of the exchange by subtracting 
the value (on such date) of the units of swap principal paid from the 
value of the units of swap principal received. This paragraph (e)(2)(iv) 
does not apply to an equal exchange of the swap principal amount at the 
commencement of the agreement at a market exchange rate.
    (v) Anti-abuse rules--(A) Method of accounting does not clearly 
reflect income. If the taxpayer's method of accounting for income, 
expense, gain or loss attributable to a currency swap does not clearly 
reflect income, or if the present value of the payments to be made is 
not equivalent to that of the payments to be received (including the 
swap premium or discount, as defined in paragraph (e)(3)(ii) of this 
section) on the day the taxpayer enters into or acquires the contract, 
the Commissioner may apply principles analogous to those of section 1274 
or such other rules as the Commissioner deems appropriate to clearly 
reflect income. For example, in order to clearly reflect income the 
Commissioner may determine the hypothetical issue price, the 
hypothetical stated redemption price at maturity, and the amounts 
required to be taken into account within a taxable year. Further, if the 
present value of the payments to be made is not equivalent to that of 
the payments to be received (including the swap premium or discount, as 
defined in paragraph (e)(3)(ii) of this section) on the day the taxpayer 
enters into or acquires the contract, the Commissioner may integrate the 
swap with another transaction (or transactions) in order to clearly 
reflect income.
    (B) Terms must be clearly stated. If the currency swap contract does 
not clearly set forth the swap principal amount in each currency, and 
the periodic interim payments in each currency (or the interest index 
used to compute the periodic interim payments in each currency), the 
Commissioner may defer any income, deduction, gain or loss with respect 
to such contract until termination of the contract.
    (3) Amortization of swap premium or discount in the case of off-
market currency swaps--(i) In general. An ``off-market currency swap'' 
is a currency

[[Page 746]]

swap contract under which the present value of the payments to be made 
is not equal to that of the payments to be received on the day the 
taxpayer enters into or acquires the contract (absent the swap premium 
or discount, as defined in paragraph (e)(3)(ii) of this section). 
Generally, such present values may not be equal if the swap exchange 
rate (as defined in paragraph (e)(3)(iii) of this section) is not the 
spot rate, or the interest indices used to compute the periodic interim 
payments do not reflect current values, on the day the taxpayer enters 
into or acquires the currency swap.
    (ii) Treatment of taxpayer entering into or acquiring an off-market 
currency swap. If a taxpayer that enters into or acquires a currency 
swap makes a payment (that is, the taxpayer pays a premium, ``swap 
premium,'' to enter into or acquire the currency swap) or receives a 
payment (that is, the taxpayer enters into or acquires the currency swap 
at a discount, ``swap discount'') in order to make the present value of 
the amounts to be paid equal the amounts to be received, such payment 
shall be amortized in a manner which places the taxpayer in the same 
position it would have been in had the taxpayer entered into a currency 
swap contract under which the present value of the amounts to be paid 
equal the amounts to be received (absent any swap premium or discount). 
Thus, swap premium or discount shall be amortized as follows--
    (A) The amount of swap premium or discount that is attributable to 
the difference between the swap exchange rate (as defined in paragraph 
(e)(3)(iii) of this section) and the spot rate on the date the contract 
is entered into or acquired shall be taken into account as income or 
expense on the date the swap principal amounts are taken into account; 
and
    (B) The amount of swap premium or discount attributable to the 
difference in values of the periodic interim payments shall be amortized 
in a manner consistent with the principles of economic accrual. Cf., 
section 171.


Any amount taken into account pursuant to this paragraph (e)(3)(ii) 
shall be treated as exchange gain or loss.
    (iii) Definition of swap exchange rate. The swap exchange rate is 
the single exchange rate set forth in the contract at which the swap 
principal amounts are determined. If the swap exchange rate is not 
clearly set forth in the contract, the Commissioner may determine such 
rate.
    (iv) Coordination with Sec. 1.446-3(g)(4) regarding swaps with 
significant nonperiodic payments. The rules of Sec. 1.446-3(g)(4) apply 
to any currency swap with a significant nonperiodic payment. Section 
1.446-3(g)(4) applies before this paragraph (e)(3). Thus, if Sec. 
1.446-3(g)(4) applies, currency gain or loss may be realized on the 
loan. This paragraph (e)(3)(iv) applies to transactions entered into 
after February 14, 2000.
    (4) Treatment of taxpayer disposing of a currency swap. Any gain or 
loss realized on the disposition or the termination of a currency swap 
is exchange gain or loss.
    (5) Examples. The following examples illustrate the application of 
this paragraph (e).

    Example 1. (i) C is an accrual method calendar year corporation with 
the dollar as its functional currency. On January 1, 1989, C enters into 
a currency swap with J with the following terms:
    (1) the principal amount is $150 and 100 British pounds ([pound]) 
(the equivalent of $150 on the effective date of the contract assuming a 
spot rate of [pound]1 = $1.50 on January 1, 1989);
    (2) C will make payments equal to 10% of the dollar principal amount 
on December 31, 1989, and December 31, 1990;
    (3) J will make payments equal to 12% of the pound principal amount 
on December 31, 1989, and December 31, 1990; and
    (4) on December 31, 1990, C will pay to J the $150 principal amount 
and J will pay to C the [pound]100 principal amount.


Assume that the spot rate is [pound]1 = $1.50 on January 1, 1989, 
[pound]1 = $1.40 on December 31, 1989, and [pound]1 = $1.30 on December 
31, 1990. Assume further that the average rate for 1989 is [pound]1 = 
$1.45 and for 1990 is [pound]1 = $1.35.
    (ii) Solely for determining the realization of gain or loss in 
accordance with paragraph (e)(2) of this section (and not for purposes 
of determining whether any payments are treated as interest), C will 
treat the dollar payments made by C as payments made pursuant to a 
dollar borrowing with an issue price of $150, a stated redemption price 
at maturity of $150, and yield to maturity of 10%. C will treat the 
pound payments received as payments received pursuant to a

[[Page 747]]

pound loan with an issue price of [pound]100, a stated redemption price 
at maturity of [pound]100, and a yield of 12% to maturity. Pursuant to 
Sec. 1.988-2(b), C is required to compute hypothetical accrued pound 
interest income at the average rate for the accrual period and then 
determine exchange gain or loss on the day payment is received with 
respect to such accrued amount. Accordingly, C will accrue $17.40 
([pound]12 x $1.45) in 1989 and $16.20 ([pound]12 x $1.35) in 1990. C 
also will compute hypothetical exchange loss of $.60 on December 31, 
1989 [([pound]12 x $1.40)-([pound]12 x $1.45)] and hypothetical exchange 
loss of $.60 on December 31, 1990 [([pound]12 x $1.30)-([pound]12 x 
$1.35)]. All such hypothetical interest income and exchange loss are 
characterized and sourced as exchange gain and loss. Further, C is 
treated as having paid $15 ($150 x 10%) of hypothetical interest on 
December 31, 1989, and again on December 31, 1990. Such hypothetical 
interest expense is characterized and sourced as exchange loss. Thus, C 
will have a net exchange gain of $1.80 ($17.40-$.60-$15.00) with respect 
to the periodic interim payments in 1989 and a net exchange gain of $.60 
($16.20-$.60-$15.00) with respect to the periodic interim payments in 
1990. Finally, C will realize an exchange loss on December 31, 1990, 
with respect to the exchange of the swap principal amount. This loss is 
determined by subtracting the value of the units of swap principal paid 
($150) from the value of the units of swap principal received 
([pound]100 x $1.30 = $130) resulting in a $20 exchange loss.
    Example 2. (i) C is an accrual method calendar year corporation with 
the dollar as its functional currency. On January 1, 1989, when the spot 
rate is [pound]1 = $1.50, C enters into a currency swap contract with J 
under which C agrees to make and receive the following payments:

------------------------------------------------------------------------
                     Date                          C pays       J pays
------------------------------------------------------------------------
December 31, 1989.............................       $15.00  [pound]12.0
                                                                       0
December 31, 1990.............................        41.04        12.00
December 31, 1991.............................         0.00        12.00
December 31, 1992.............................       150.00       112.00
------------------------------------------------------------------------

    (ii) Under paragraph (e)(2)(iii) of this section, C must treat the 
dollar periodic interim payments under the swap as made pursuant to a 
hypothetical dollar borrowing. The hypothetical issue price is $150 and 
the stated redemption price at maturity is $206.04. The amount of 
hypothetical interest expense must be amortized in accordance with 
economic accrual. Thus J must include and C must deduct periodic interim 
payment amounts as follows:

------------------------------------------------------------------------
                                                   Amount
                                                 taken into    Adjusted
                                                  account    issue price
------------------------------------------------------------------------
December 31, 1989.............................       $15.00       150.00
December 31, 1990.............................       $15.00       123.96
December 31, 1991.............................       $12.40       136.36
December 31, 1992.............................       $13.64
------------------------------------------------------------------------

    (iii) Gain or loss with respect to the periodic interim payments of 
the currency swap is determined under paragraph (e)(2)(iii)(A) of this 
section with respect to the dollar cash flow amortized as set forth 
above and the corresponding pound cash flow as stated in the currency 
swap contract. Gain or loss with respect to the principal payments 
(i.e., $150 and [pound]100) exchanged on December 31, 1992, is 
determined under paragraph (e)(2)(iv) of this section on December 31, 
1992, notwithstanding that under the principles regarding amortization 
of interest $26.04 would have been regarded as a payment of principal on 
December 31, 1990.
    Example 3. (i) X is a corporation on the accrual method of 
accounting with the dollar as its functional currency and the calendar 
year as its taxable year. On January 1, 1989, X enters into a three year 
currency swap contract with Y with the following terms. The swap 
principal amount is $100 and the Swiss franc (Sf) equivalent of such 
amount which equals Sf200 translated at the swap exchange rate of $1 = 
Sf2. There is no initial exchange of the swap principal amount. The 
interest rates used to compute the periodic interim payments are 10% 
compounded annually for U.S. dollar payments and 5% compounded annually 
for Swiss franc payments. Thus, under the currency swap, X agrees to pay 
Y $10 (10% x $100) on December 31st of 1989, 1990 and 1991 and to pay Y 
the swap principal amount of $100 on December 31, 1991. Y agrees to pay 
X Sf10 (5% x Sf200) on December 31st of 1989, 1990 and 1991 and to pay X 
the swap principal amount of Sf200 on December 31, 1991. Assume that the 
average rate for 1989 and the spot rate on December 31, 1989, is $1 = 
Sf2.5.
    (ii) Under paragraph (e)(2)(iii) of this section, on December 31, 
1989, X will realize an exchange loss of $6 (the sum of $10 of loss by 
reason of the $10 periodic interim payment paid to Y and $4.00 of gain, 
the value of Sf10 on December 31, 1989, from the receipt of Sf10 on such 
date).
    (iii) On January 1, 1990, X transfers its rights and obligations 
under the swap contract to Z, an unrelated corporation. Z has the dollar 
as its functional currency, is on the accrual method of accounting, and 
has the calendar year as its taxable year. On January 1, 1990, the 
exchange rate is $1 = Sf2.50. The relevant dollar interest rate is 8% 
compounded annually and the relevant Swiss franc interest rate is 5% 
compounded annually. Because of the movement in exchange and interest 
rates, the agreement between X and Z to transfer the currency swap 
requires

[[Page 748]]

X to pay Z $23.56 (the swap discount as determined under paragraph 
(e)(3) of this section).
    (iv) Pursuant to paragraph (e)(4) of this section, X may deduct the 
loss of $23.56 in 1990. The loss is characterized under Sec. 1.988-3 
and sourced under Sec. 1.988-4.
    (v) Pursuant to paragraph (e)(3)(ii) of this section, Z is required 
to amortize the $23.56 received as follows. The amount of the $23.56 
payment that is attributable to movements in exchange rates ($20) is 
taken into account on December 31, 1991, the date the swap principal 
amounts are exchanged, under paragraph (e)(3)(ii)(A) of this section. 
This amount is the present value (discounted at 10%, the rate under the 
currency swap contract used to compute the dollar periodic interim 
payments) of the financial asset required to compensate Z for the loss 
in value of the hypothetical Swiss franc loan resulting from movements 
in exchange rates between January 1, 1989, and January 1, 1990. This 
amount is determined by assuming that interest rates did not change from 
the date the swap originally was entered into (January 1, 1989), but 
that the exchange rate is $1 = Sf2.50. Under this assumption, a taxpayer 
undertaking the obligation to pay dollars under the currency swap on 
January 1, 1990, would only agree to pay $8 for Sf10 on December 31, 
1990, and $88 for Sf210 on December 31, 1991, because the exchange rates 
have moved from $1 = Sf2 to $1 = Sf2.50. Thus, Z requires $2 on December 
31, 1990, and $22 on December 31, 1991, to compensate for the amount of 
dollar payments Z is required to make in exchange for the Swiss francs 
received on December 31, 1990 and 1991. The present value of $2 on 
December 31, 1990, and $22 on December 31, 1991, discounted at the rate 
for U.S. dollar payments of 10% is $20 ($1.82 + $18.18). This amount is 
discounted at the rate for U.S. dollar payments (i.e., at the historic 
rate) because the amount of the $23.56 payment received by Z that is 
attributable to movements in interest rates is computed and amortized 
separately as provided in the following paragraph.
    (vi) Pursuant to paragraph (e)(3)(ii)(B) of this section, Z is 
required to amortize the portion of the $23.56 payment attributable to 
movements in interest rates under principles of economic accrual over 
the term of the currency swap agreement. The amount of the $23.56 
payment that is attributable to movements in interest rates (assuming 
that exchange rates have not changed) is the present value ($3.56) of 
the excess ($2.00 in 1990 and $2.00 in 1991) of the periodic interim 
payments Z is required to pay under the currency swap agreement ($10 in 
1990 and $10 in 1991) over the amount Z would be required to pay if the 
currency swap agreement reflected current interest rates on the day Z 
acquired the swap contract ($8 in 1990 and $8 in 1991) discounted at the 
appropriate dollar interest rate on January 1, 1990. Thus, under 
principles of economic accrual (e.g., see section 171 of the Code), Z 
will include in income $1.72 on December 31, 1990, the amount that, when 
added to the interest ($.28) on the $3.56 computed at the 8% rate on the 
date Z acquired the currency swap contract, will equal the $2.00 needed 
to compensate Z for the movement in interest rates between January 1, 
1989, and January 1, 1990. Z also will include in income $1.85 on 
December 31, 1991, the amount that, when added to the interest ($.15) on 
the $1.85 (the remaining balance of the $3.56 payment) computed at the 
8% rate on the date Z acquired the currency swap contract, will equal 
the $2.00 needed to compensate Z for the movement in interest rates 
between January 1, 1990, and January 1, 1991. This amount is computed 
assuming exchange rates have not changed because the amount attributable 
to movements in exchange rates is computed and amortized separately 
under the preceding paragraph.

    (6) Special effective date for rules regarding currency swaps. 
Paragraph (e)(3) of this section regarding amortization of swap premium 
or discount in the case of off-market currency swaps shall be effective 
for transactions entered into after September 21, 1989, unless such swap 
premium or discount was paid or received pursuant to a binding contract 
with an unrelated party that was entered into prior to such date. For 
transactions entered into prior to this date, see Notice 89-21, 1989-8 
I.R.B. 23.
    (7) Special rules for currency swap contracts in hyperinflationary 
currencies--(i) In general. If a taxpayer enters into a 
hyperinflationary currency swap (as defined in paragraph (e)(7)(iv) of 
this section), then the taxpayer realizes exchange gain or loss for its 
taxable year with respect to such instrument determined by reference to 
the change in exchange rates between--
    (A) The later of the first day of the taxable year, or the date the 
instrument was entered into (by the taxpayer); and
    (B) The earlier of the last day of the taxable year, or the date the 
instrument is disposed of or otherwise terminated.
    (ii) Adjustment to principal or basis. Proper adjustments are made 
in the amount of any gain or loss subsequently realized for gain or loss 
taken into account by reason of this paragraph (e)(7).

[[Page 749]]

    (iii) Interaction with DASTM. With respect to a qualified business 
unit that uses the United States dollar approximate separate 
transactions method of accounting described in Sec. 1.985-3, this 
paragraph (e)(7) does not apply.
    (iv) Definition of hyperinflationary currency swap contract. A 
hyperinflationary currency swap contract is a currency swap contract 
that provides for--
    (A) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) at the time 
the taxpayer enters into or otherwise acquires the currency swap; or
    (B) Payments that are adjusted to take into account the fact that 
the currency is hyperinflationary (as defined in Sec. 1.988-1(f)) 
during the current taxable year. A currency swap contract that provides 
for periodic payments determined by reference to a variable interest 
rate based on local conditions and generally responding to changes in 
the local consumer price index is an example of this latter type of 
currency swap contract.
    (v) Special effective date for nonfunctional hyperinflationary 
currency swap contracts. This paragraph (e)(7) applies to transactions 
entered into after February 14, 2000.
    (f) Substance over form--(1) In general. If the substance of a 
transaction described in Sec. 1.988-1(a)(1) differs from its form, the 
timing, source, and character of gains or losses with respect to such 
transaction may be recharacterized by the Commissioner in accordance 
with its substance. For example, if a taxpayer enters into a transaction 
that it designates a ``currency swap contract'' that requires the 
prepayment of all payments to be made or to be received (but not both), 
the Commissioner may recharacterize the contract as a loan. In applying 
the substance over form principle, separate transactions may be 
integrated where appropriate. See also Sec. 1.861-9T(b)(1).
    (2) Example. The following example illustrates the provisions of 
this paragraph (f).

    Example. (i) On January 1, 1990, X, a U.S. corporation with the 
dollar as its functional currency, enters into a contract with Y under 
which X will pay Y $100 and Y will pay X LC100 on January 1, 1990, and X 
will pay Y LC109.3 and Y will pay X $133 on December 31, 1992. On 
January 1, 1990, the spot exchange rate is LC1 = $1 and the 3 year 
forward rate is LC1 = $.8218. X's cash flows are summarized below:

------------------------------------------------------------------------
                         Date                            Dollar     LC
------------------------------------------------------------------------
1/1/90................................................    (100)      100
12/31/90..............................................        0        0
12/31/91..............................................        0        0
12/31/92..............................................      133  (109.3)
------------------------------------------------------------------------

    (ii) X and Y designate this contract as a ``currency swap.'' 
Notwithstanding this designation, for purposes of determining the 
timing, source, and character with respect to the transaction, the 
transaction is characterized by the Commissioner in accordance with its 
substance. Thus, the January 1, 1990, exchange by X of $100 for LC 100 
is treated as a spot purchase of LCs by X and the December 31, 1992, 
exchange by X at 109.3LC for $133 is treated as a forward sale of LCs by 
X. Under such treatment there would be no tax consequences to X under 
paragraph (e)(2) of this section in 1990, 1991, and 1992 with respect to 
this transaction other than the realization of exchange gain or loss on 
the sale of the LC109.3 on December 31, 1992. Calculation of such gain 
or loss would be governed by the rules of paragraph (d) of this section.

    (g) Effective date. Except as otherwise provided in this section, 
this section shall be effective for taxable years beginning after 
December 31, 1986. Thus, except as otherwise provided in this section, 
any payments made or received with respect to a section 988 transaction 
in taxable years beginning after December 31, 1986, are subject to this 
section.
    (h) Timing of income and deductions from notional principal 
contracts. Except as otherwise provided (e.g., in Sec. 1.988-5 or Sec. 
1.446-3(g)), income or loss from a notional principal contract described 
in Sec. 1.988-1(a)(2)(iii)(B) (other than a currency swap) is exchange 
gain or loss. For the rules governing the timing of income and 
deductions with respect to notional principal contracts, see Sec. 
1.446-3. See paragraph (e)(2) of this section with respect to currency 
swaps.
    (i) [Reserved] For further guidance, see Sec. 1.988-2T(i).

[T.D. 8400, 57 FR 9183, Mar. 17, 1992, as amended by T.D. 8491, 58 FR 
53135, Oct. 14, 1993; T.D. 8860, 65 FR 2028, Jan. 13, 2000; T.D. 9157, 
69 FR 52819, Aug. 30, 2004; T.D. 9795, 81 FR 88879, Dec. 8, 2016; T.D. 
9882, 84 FR 69123, Dec. 17, 2019]

[[Page 750]]



Sec. 1.988-2T  Recognition and computation of exchange gain or loss
(temporary).

    (a) through (b)(15) [Reserved] For further guidance, see Sec. 
1.988-2(a) through (b)(15).
    (16) Deferral of loss on certain related-party debt instruments--(i) 
Treatment of creditor. For rules applicable to a corporation included in 
a controlled group that is a creditor under a debt instrument see Sec. 
1.267(f)-1(e).
    (ii) Treatment of debtor--(A) In general. Exchange loss realized 
under Sec. 1.988-2(b)(4) or (b)(6) is deferred if--
    (1) The loss is realized by a debtor with respect to a loan from a 
person that has a relationship to the debtor described in section 267(b) 
or section 707(b); and
    (2) The transaction resulting in the realization of exchange loss 
has as a principal purpose the avoidance of Federal income tax.
    (B) Recognition of deferred loss. Any exchange loss that is deferred 
under paragraph (b)(16)(ii)(A) of this section is deferred until the end 
of the term of the loan, determined immediately prior to the 
transaction.
    (17) through (h) [Reserved] For further guidance, see Sec. 1.988-
2(b)(17) through (h).
    (i) Special rules for section 988 transactions of a section 987 QBU. 
For rules regarding section 988 transactions of a section 987 QBU, see 
Sec. 1.987-3T(b)(4) for section 987 QBUs in general and Sec. 1.987-
1T(b)(6) for dollar QBUs.
    (j) Effective/applicability date. Paragraph (b)(16) of this section 
applies to any exchange loss realized on or after December 7, 2016. 
Paragraph (i) of this section applies to taxable years beginning on or 
after one year after the first day of the first taxable year following 
December 7, 2016. Notwithstanding the preceding sentence, if a taxpayer 
makes an election under Sec. 1.987-11(b), then paragraph (i) of this 
section applies to taxable years to which Sec. Sec. 1.987-1 through 
1.987-10 apply as a result of such election.
    (k) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9795, 81 FR 88879, Dec. 8, 2016]



Sec. 1.988-3  Character of exchange gain or loss.

    (a) In general. The character of exchange gain or loss recognized on 
a section 988 transaction is governed by section 988 and this section. 
Except as otherwise provided in section 988(c)(1)(E), section 1092, 
Sec. 1.988-5 and this section, exchange gain or loss realized with 
respect to a section 988 transaction (including a section 1256 contract 
that is also a section 988 transaction) shall be characterized as 
ordinary gain or loss. Accordingly, unless a valid election is made 
under paragraph (b) of this section, any section providing special rules 
for capital gain or loss treatment, such as sections 1233, 1234, 1234A, 
1236 and 1256(f)(3), shall not apply.
    (b) Election to characterize exchange gain or loss on certain 
identified forward contracts, futures contracts and option contracts as 
capital gain or loss--(1) In general. Except as provided in paragraph 
(b)(2) of this section, a taxpayer may elect, subject to the 
requirements of paragraph (b)(3) of this section, to treat any gain or 
loss recognized on a contract described in Sec. 1.988-2(d)(1) as 
capital gain or loss, but only if the contract--
    (i) Is a capital asset in the hands of the taxpayer;
    (ii) Is not part of a straddle within the meaning of section 1092(c) 
(without regard to subsections (c)(4) or (e)); and
    (iii) Is not a regulated futures contract or nonequity option with 
respect to which an election under section 988(c)(1)(D)(ii) is in 
effect.


If a valid election under this paragraph (b) is made with respect to a 
section 1256 contract, section 1256 shall govern the character of any 
gain or loss recognized on such contract.
    (2) Special rule for contracts that become part of a straddle after 
an election is made. If a contract which is the subject of an election 
under paragraph (b)(1) of this section becomes part of a straddle within 
the meaning of section 1092(c) (without regard to subsections (c)(4) or 
(e)) after the date of the election, the election shall be invalid with 
respect to gains from such contract and the Commissioner, in his sole 
discretion,

[[Page 751]]

may invalidate the election with respect to losses.
    (3) Requirements for making the election. A taxpayer elects to treat 
gain or loss on a transaction described in paragraph (b)(1) of this 
section as capital gain or loss by clearly identifying such transaction 
on its books and records on the date the transaction is entered into. No 
specific language or account is necessary for identifying a transaction 
referred to in the preceding sentence. However, the method of 
identification must be consistently applied and must clearly identify 
the pertinent transaction as subject to the section 988(a)(1)(B) 
election. The Commissioner, in his sole discretion, may invalidate any 
purported election that does not comply with the preceding sentence.
    (4) Verification. A taxpayer that has made an election under Sec. 
1.988-3(b)(3) must attach to his income tax return a statement which 
sets forth the following:
    (i) A description and the date of each election made by the taxpayer 
during the taxpayer's taxable year;
    (ii) A statement that each election made during the taxable year was 
made before the close of the date the transaction was entered into;
    (iii) A description of any contract for which an election was in 
effect and the date such contract expired or was otherwise sold or 
exchanged during the taxable year;
    (iv) A statement that the contract was never part of a straddle as 
defined in section 1092; and
    (v) A statement that all transactions subject to the election are 
included on the statement attached to the taxpayer's income tax return.


In addition to any penalty that may otherwise apply, the Commissioner, 
in his sole discretion, may invalidate any or all elections made during 
the taxable year under Sec. 1.988-3(b)(1) if the taxpayer fails to 
verify each election as provided in this Sec. 1.988-3(b)(4). The 
preceding sentence shall not apply if the taxpayer's failure to verify 
each election was due to reasonable cause or bona fide mistake. The 
burden of proof to show reasonable cause or bona fide mistake made in 
good faith is on the taxpayer.
    (5) Independent verification--(i) Effect of independent 
verification. If the taxpayer receives independent verification of the 
election in paragraph (b)(3) of this section, the taxpayer shall be 
presumed to have satisfied the requirements of paragraphs (b)(3) and (4) 
of this section. A contract that is a part of a straddle as defined in 
section 1092 may not be independently verified and shall be subject to 
the rules of paragraph (b)(2) of this section.
    (ii) Requirements for independent verification. A taxpayer receives 
independent verification of the election in paragraph (b)(3) of this 
section if--
    (A) The taxpayer establishes a separate account(s) with an unrelated 
broker(s) or dealer(s) through which all transactions to be 
independently verified pursuant to this paragraph (b)(5) are conducted 
and reported.
    (B) Only transactions entered into on or after the date the taxpayer 
establishes such account may be recorded in the account.
    (C) Transactions subject to the election of paragraph (b)(3) of this 
section are entered into such account on the date such transactions are 
entered into.
    (D) The broker or dealer provides the taxpayer a statement detailing 
the transactions conducted through such account and includes on such 
statement the following: ``Each transaction identified in this account 
is subject to the election set forth in section 988(a)(1)(B).''
    (iii) Special effective date for independent verification. The rules 
of this paragraph (b)(5) shall be effective for transactions entered 
into after March 17, 1992.
    (6) Effective date. Except as otherwise provided, this paragraph (b) 
is effective for taxable years beginning on or after September 21, 1989. 
For prior taxable years, any reasonable contemporaneous election meeting 
the requirements of section 988(a)(1)(B) shall satisfy this paragraph 
(b).
    (c) Exchange gain or loss treated as interest--(1) In general. 
Except as provided in this paragraph (c)(1), exchange gain or loss 
realized on a section 988 transaction shall not be treated as interest 
income or expense. Exchange gain or

[[Page 752]]

loss realized on a section 988 transaction shall be treated as interest 
income or expense as provided in paragraph (c)(2) of this section with 
regard to tax exempt bonds, Sec. 1.988-2(e)(2)(ii)(B), Sec. 1.988-5, 
and in administrative pronouncements. See Sec. 1.861-9T(b), providing 
rules for the allocation of certain items of exchange gain or loss in 
the same manner as interest expense.
    (2) Exchange loss realized by the holder on nonfunctional currency 
tax exempt bonds. Exchange loss realized by the holder of a debt 
instrument the interest on which is excluded from gross income under 
section 103(a) or any similar provision of law shall be treated as an 
offset to and reduce total interest income received or accrued with 
respect to such instrument. Therefore, to the extent of total interest 
income, no exchange loss shall be recognized. This paragraph (c)(2) 
shall be effective with respect to debt instruments acquired on or after 
June 24, 1987.
    (d) Effective date. Except as otherwise provided in this section, 
this section shall be effective for taxable years beginning after 
December 31, 1986. Thus, except as otherwise provided in this section, 
any payments made or received with respect to a section 988 transaction 
in taxable years beginning after December 31, 1986, are subject to this 
section. Thus, for example, a payment made prior to January 1, 1987, 
under a forward contract that results in the deferral of a loss under 
section 1092 to a taxable year beginning after December 31, 1986, is not 
characterized as an ordinary loss by virtue of paragraph (a) of this 
section because payment was made prior to January 1, 1987.

[T.D. 8400, 57 FR 9197, Mar. 17, 1992]



Sec. 1.988-4  Source of gain or loss realized on a section 988 
transaction.

    (a) In general. Except as otherwise provided in Sec. 1.988-5 and 
this section, the source of exchange gain or loss shall be determined by 
reference to the residence of the taxpayer. This rule applies even if 
the taxpayer has made an election under Sec. 1.988-3(b) to characterize 
exchange gain or loss as capital gain or loss. This section takes 
precedence over section 865.
    (b) Qualified business unit--(1) In general. The source of exchange 
gain or loss shall be determined by reference to the residence of the 
qualified business unit of the taxpayer on whose books the asset, 
liability, or item of income or expense giving rise to such gain or loss 
is properly reflected.
    (2) Proper reflection on the books of the taxpayer or qualified 
business unit--(i) In general. For purposes of paragraph (b)(1) of this 
section, the principles of Sec. 1.987-2(b) shall apply in determining 
whether an asset, liability, or item of income or expense is reflected 
on the books and records of a qualified business unit.
    (ii) Effective/applicability date. Generally, paragraph (b)(2)(i) 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 
(b)(2)(i) of this section shall apply to taxable years of the taxpayer 
beginning on or after the first day of such prior taxable year.
    (c) Effectively connected exchange gain or loss. Notwithstanding 
paragraphs (a) and (b) of this section, exchange gain or loss that under 
principles similar to those set forth in Sec. 1.864-4(c) arises from 
the conduct of a United States trade or business shall be sourced in the 
United States and such gain or loss shall be treated as effectively 
connected to the conduct of a United States trade or business for 
purposes of sections 871(b) and 882 (a)(1).
    (d) Residence--(1) In general. Except as otherwise provided in this 
paragraph (d), for purposes of sections 985 through 989, the residence 
of any person shall be--
    (i) In the case of an individual, the country in which such 
individual's tax home (as defined in section 911(d)(3)) is located;
    (ii) In the case of a corporation, partnership, trust or estate 
which is a United States person (as defined in section 7701(a)(30)), the 
United States; and
    (iii) In the case of a corporation, partnership, trust or estate 
which is

[[Page 753]]

not a United States person, a country other than the United States.


If an individual does not have a tax home (as defined in section 
911(d)(3)), the residence of such individual shall be the United States 
if such individual is a United States citizen or a resident alien and 
shall be a country other than the United States if such individual is 
not a United States citizen or resident alien. If the taxpayer is a U.S. 
person and has no principal place of business outside the United States, 
the residence of the taxpayer is the United States. Notwithstanding 
paragraph (d)(1)(ii) of this section, if a partnership is formed or 
availed of to avoid tax by altering the source of exchange gain or loss, 
the source of such gain or loss shall be determined by reference to the 
residence of the partners rather than the partnership.
    (2) Exception. In the case of a qualified business unit of any 
taxpayer (including an individual), the residence of such unit shall be 
the country in which the principal place of business of such qualified 
business unit is located.
    (3) Partner in a partnership not engaged in a U.S. trade or business 
under section 864(b)(2). The determination of residence shall be made at 
the partner level (without regard to whether the partnership is a 
qualified business unit of the partners) in the case of partners in a 
partnership that are not engaged in a U.S. trade or business by reason 
of section 864(b)(2).
    (e) Special rule for certain related party loans--(1) In general. In 
the case of a loan by a United States person or a related person to a 10 
percent owned foreign corporation, or a corporation that meets the 80 
percent foreign business requirements test of section 861(c)(1), other 
than a corporation subject to Sec. 1.861-11T(e)(2)(i), which is 
denominated in, or determined by reference to, a currency other than the 
U.S. dollar and bears interest at a rate at least 10 percentage points 
higher than the Federal mid-term rate (as determined under section 
1274(d)) at the time such loan is entered into, the following rules 
shall apply--
    (i) For purposes of section 904 only, such loan shall be marked to 
market annually on the earlier of the last business day of the United 
States person's (or related person's) taxable year or the date the loan 
matures; and
    (ii) Any interest income earned with respect to such loan for the 
taxable year shall be treated as income from sources within the United 
States to the extent of any notional loss attributable to such loan 
under paragraph (d)(1)(i) of this section.
    (2) United States person. For purposes of this paragraph (e), the 
term ``United States person'' means a person described in section 
7701(a)(30).
    (3) Loans by related foreign persons--(i) In general. [Reserved]
    (ii) Definition of related person. For purposes of this paragraph 
(e), the term ``related person'' has the meaning given such term by 
section 954(d)(3) except that such section shall be applied by 
substituting ``United States person'' for ``controlled foreign 
corporation'' each place such term appears.
    (4) 10 percent owned foreign corporation. For purposes of this 
paragraph (e), the term ``10 percent owned foreign corporation'' means 
any foreign corporation in which the United States person owns directly 
or indirectly (within the meaning of section 318(a)) at least 10 percent 
of the voting stock.
    (f) Exchange gain or loss treated as interest under Sec. 1.988-3. 
Notwithstanding the provisions of this section, any gain or loss 
realized on a section 988 transaction that is treated as interest income 
or expense under Sec. 1.988-3(c)(1) shall be sourced or allocated and 
apportioned pursuant to section 861(a)(1), 862(a)(1), or 864(e) as the 
case may be.
    (g) Exchange gain or loss allocated in the same manner as interest 
under Sec. 1.861-9T. The allocation and apportionment of exchange gain 
or loss under Sec. 1.861-9T shall not affect the source of exchange 
gain or loss for purposes of sections 871(a), 881, 1441, 1442 and 6049.
    (h) Effective date. This section shall be effective for taxable 
years beginning after December 31, 1986. Thus, any payments made or 
received with respect to a section 988 transaction in taxable years 
beginning after December 31, 1986, are subject to this section.

[T.D. 8400, 57 FR 9199, Mar. 17, 1992, as amended by T.D. 9794, 81 FR 
88851, Dec. 8, 2016]

[[Page 754]]



Sec. 1.988-5  Section 988(d) hedging transactions.

    (a) Integration of a nonfunctional currency debt instrument and a 
Sec. 1.988-5(a) hedge--(1) In general. This paragraph (a) applies to a 
qualified hedging transaction as defined in this paragraph (a)(1). A 
qualified hedging transaction is an integrated economic transaction, as 
provided in paragraph (a)(5) of this section, consisting of a qualifying 
debt instrument as defined in paragraph (a)(3) of this section and a 
Sec. 1.988-5(a) hedge as defined in paragraph (a)(4) of this section. 
If a taxpayer enters into a transaction that is a qualified hedging 
transaction, no exchange gain or loss is recognized by the taxpayer on 
the qualifying debt instrument or on the Sec. 1.988-5(a) hedge for the 
period that either is part of a qualified hedging transaction, and the 
transactions shall be integrated as provided in paragraph (a)(9) of this 
section. However, if the qualified hedging transaction results in a 
synthetic nonfunctional currency denominated debt instrument, such 
instrument shall be subject to the rules of Sec. 1.988-2(b).
    (2) Exception. This paragraph (a) does not apply with respect to a 
qualified hedging transaction that creates a synthetic asset or 
liability denominated in, or determined by reference to, a currency 
other than the U.S. dollar if the rate that approximates the Federal 
short-term rate in such currency is at least 20 percentage points higher 
than the Federal short term rate (determined under section 1274(d)) on 
the date the taxpayer identifies the transaction as a qualified hedging 
transaction.
    (3) Qualifying debt instrument--(i) In general. A qualifying debt 
instrument is a debt instrument described in Sec. 1.988-1(a)(2)(i), 
regardless of whether denominated in, or determined by reference to, 
nonfunctional currency (including dual currency debt instruments, multi-
currency debt instruments and contingent payment debt instruments). A 
qualifying debt instrument does not include accounts payable, accounts 
receivable or similar items of expense or income.
    (ii) Special rule for debt instrument of which all payments are 
proportionately hedged. If a debt instrument satisfies the requirements 
of paragraph (a)(3)(i) of this section, and all principal and interest 
payments under the instrument are hedged in the same proportion, then 
for purposes of this paragraph (a), that portion of the instrument that 
is hedged is eligible to be treated as a qualifying debt instrument, and 
the rules of this paragraph (a) shall apply separately to such 
qualifying debt instrument. See Example 8 in paragraph (a)(9)(iv) of 
this section.
    (4) Section 1.988-5(a) hedge--(i) In general. A Sec. 1.988-5(a) 
hedge (hereinafter referred to in this paragraph (a) as a ``hedge'') is 
a spot contract, futures contract, forward contract, option contract, 
notional principal contract, currency swap contract, similar financial 
instrument, or series or combination thereof, that when integrated with 
a qualifying debt instrument permits the calculation of a yield to 
maturity (under principles of section 1272) in the currency in which the 
synthetic debt instrument is denominated (as determined under paragraph 
(a)(9)(ii)(A) of this section).
    (ii) Retroactive application of definition of currency swap 
contract. A taxpayer may apply the definition of currency swap contract 
set forth in Sec. 1.988-2(e)(2)(ii) in lieu of the definition of swap 
agreement in section 2(e)(5) of Notice 87-11, 1987-1 C.B. 423 to 
transactions entered into after December 31, 1986 and before September 
21, 1989.
    (5) Definition of integrated economic transaction. A qualifying debt 
instrument and a hedge are an integrated economic transaction if all of 
the following requirements are satisfied--
    (i) All payments to be made or received under the qualifying debt 
instrument (or amounts determined by reference to a nonfunctional 
currency) are fully hedged on the date the taxpayer identifies the 
transaction under paragraph (a) of this section as a qualified hedging 
transaction such that a yield to maturity (under principles of section 
1272) in the currency in which the synthetic debt instrument is 
denominated (as determined under paragraph (a)(9)(ii)(A) of this 
section) can be calculated. Any contingent payment features of the 
qualifying debt instrument must be fully offset by the hedge

[[Page 755]]

such that the synthetic debt instrument is not classified as a 
contingent payment debt instrument. See Examples 6 and 7 of paragraph 
(a)(9)(iv) of this section.
    (ii) The hedge is identified in accordance with paragraph (a)(8) of 
this section on or before the date the acquisition of the financial 
instrument (or instruments) constituting the hedge is settled or closed.
    (iii) None of the parties to the hedge are related. The term 
``related'' means the relationships defined in section 267(b) or section 
707(b).
    (iv) In the case of a qualified business unit with a residence, as 
defined in section 988(a)(3)(B), outside of the United States, both the 
qualifying debt instrument and the hedge are properly reflected on the 
books of such qualified business unit throughout the term of the 
qualified hedging transaction.
    (v) Subject to the limitations of paragraph (a)(5) of this section, 
both the qualifying debt instrument and the hedge are entered into by 
the same individual, partnership, trust, estate, or corporation. With 
respect to a corporation, the same corporation must enter into both the 
qualifying debt instrument and the hedge whether or not such corporation 
is a member of an affiliated group of corporations that files a 
consolidated return.
    (vi) With respect to a foreign person engaged in a U.S. trade or 
business that enters into a qualifying debt instrument or hedge through 
such trade or business, all items of income and expense associated with 
the qualifying debt instrument and the hedge (other than interest 
expense that is subject to Sec. 1.882-5), would have been effectively 
connected with such U.S. trade or business throughout the term of the 
qualified hedging transaction had this paragraph (a) not applied.
    (6) Special rules for legging in and legging out of integrated 
treatment--(i) Legging in. ``Legging in'' to integrated treatment under 
this paragraph (a) means that a hedge is entered into after the date the 
qualifying debt instrument is entered into or acquired, and the 
requirements of this paragraph (a) are satisfied on the date the hedge 
is entered into (``leg in date''). If a taxpayer legs into integrated 
treatment, the following rules shall apply--
    (A) Exchange gain or loss shall be realized with respect to the 
qualifying debt instrument determined solely by reference to changes in 
exchange rates between--
    (1) The date the instrument was acquired by the holder, or the date 
the obligor assumed the obligation to make payments under the 
instrument; and
    (2) The leg in date.
    (B) The recognition of such gain or loss will be deferred until the 
date the qualifying debt instrument matures or is otherwise disposed of.
    (C) The source and character of such gain or loss shall be 
determined on the leg in date as if the qualifying debt instrument was 
actually sold or otherwise terminated by the taxpayer.
    (ii) Legging out. With respect to a qualifying debt instrument and 
hedge that are properly identified as a qualified hedging transaction, 
``legging out'' of integrated treatment under this paragraph (a) means 
that the taxpayer disposes of or otherwise terminates all or any portion 
of the qualifying debt instrument or the hedge before maturity of the 
qualified hedging transaction. For purposes of the preceding sentence, 
if the taxpayer changes a material term of the qualifying debt 
instrument (for example, exercises an option to change the interest rate 
or index, or the maturity date) or the hedge (for example, changes the 
interest or exchange rates underlying the hedge, or the expiration date) 
before maturity of the qualified hedging transaction, the taxpayer will 
be deemed to have disposed of or otherwise terminated all or any portion 
of the qualifying debt instrument or the hedge, as applicable. A 
taxpayer that disposes of or terminates a qualified hedging transaction 
(that is, disposes of or terminates both the qualifying debt instrument 
and the hedge in their entirety on the same day) is considered to have 
disposed of or otherwise terminated the synthetic debt instrument rather 
than legging out. See paragraph (a)(9)(iv) of this section, Example 10 
for an illustration of this rule. If a taxpayer legs out of integrated 
treatment, the following rules apply:

[[Page 756]]

    (A) The transaction will be treated as a qualified hedging 
transaction during the time the requirements of this paragraph (a) were 
satisfied.
    (B) If all of the instruments comprising the hedge (each such 
instrument, a component) are disposed of or otherwise terminated, the 
qualifying debt instrument is treated as sold or otherwise terminated by 
the taxpayer for its fair market value on the date the hedge is disposed 
of or otherwise terminated (the leg-out date), and any gain or loss 
(including gain or loss resulting from factors other than movements in 
exchange rates) from the identification date to the leg-out date is 
realized and recognized on the leg-out date. The spot rate on the leg-
out date is used to determine exchange gain or loss on the debt 
instrument for the period beginning on the leg-out date and ending on 
the date such instrument matures or is disposed of or otherwise 
terminated. Proper adjustment must be made to reflect any gain or loss 
taken into account. The netting rule of Sec. 1.988-2(b)(8) applies. See 
paragraph (a)(9)(iv) of this section, Example 4 and Example 5 for an 
illustration of this rule.
    (C) If a hedge has more than one component (and such components have 
been properly identified as being part of the qualified hedging 
transaction) and at least one but not all of the components that 
comprise the hedge has been disposed of or otherwise terminated, or if 
part of any component of the hedge has been terminated (whether a hedge 
consists of a single or multiple components), the date such component 
(or part thereof) is disposed of or terminated is considered the leg-out 
date and the qualifying debt instrument is treated as sold or otherwise 
terminated by the taxpayer for its fair market value in accordance with 
the rules of paragraph (a)(6)(ii)(B) of this section on such leg-out 
date. In addition, all of the remaining components (or parts thereof) 
that have not been disposed of or otherwise terminated are treated as 
sold by the taxpayer for their fair market value on the leg-out date, 
and any gain or loss from the identification date to the leg-out date is 
realized and recognized on the leg-out date. To the extent relevant, the 
spot rate on the leg-out date is used to determine exchange gain or loss 
on the remaining components (or parts thereof) for the period beginning 
on the leg-out date and ending on the date such components (or parts 
thereof) are disposed of or otherwise terminated. See paragraph 
(a)(9)(iv) of this section, Example 11 for an illustration of this rule.
    (D) If the qualifying debt instrument is disposed of or otherwise 
terminated in whole or in part, the date of such disposition or 
termination is considered the leg-out date. Accordingly, the hedge 
(including all components making up the hedge in their entirety) that is 
part of the qualified hedging transaction is treated as sold by the 
taxpayer for its fair market value on the leg-out date, and any gain or 
loss from the identification date to the leg-out date is realized and 
recognized on the leg-out date. To the extent relevant, the spot rate on 
the leg-out date is used to determine exchange gain or loss on the hedge 
(including all components thereof) for the period beginning on the leg-
out date and ending on the date such hedge is disposed of or otherwise 
terminated.
    (E) Except as provided in paragraph (a)(8)(iii) of this section 
(regarding identification by the Commissioner), the part of the 
qualified hedging transaction that has not been disposed of or otherwise 
terminated (that is, the remaining debt instrument in its entirety even 
if partially hedged, or the remaining components of the hedge) cannot be 
part of a qualified hedging transaction for any period after the leg-out 
date.
    (F) If a taxpayer legs out of a qualified hedging transaction and 
realizes a net gain with respect to the debt instrument that is disposed 
of or otherwise terminated, then paragraph (a)(6)(ii)(B), (C), and (D) 
of this section, as appropriate, will not apply if during the period 
beginning 30 days before the leg-out date and ending 30 days after that 
date the taxpayer enters into another transaction that, taken together 
with any remaining components of the hedge, hedges at least 50 percent 
of the remaining currency flow with respect to the qualifying debt 
instrument that was part of the qualified hedging transaction or, if 
appropriate, an equivalent

[[Page 757]]

amount under the hedge (or any remaining components thereof) that was 
part of the qualified hedging transaction. Similarly, in a case in which 
a hedge has multiple components that are part of a qualified hedging 
transaction, if the taxpayer legs out of a qualified hedging transaction 
by terminating one such component or a part of one or more such 
components and realizes a net gain with respect to the terminated 
component, components, or portions thereof, then paragraphs 
(a)(6)(ii)(B), (C), and (D) of this section, as appropriate, will not 
apply if the remaining components of the hedge (including parts thereof) 
by themselves hedge at least 50 percent of the remaining currency flow 
with respect to the qualifying debt instrument that was part of the 
qualified hedging transaction. See paragraph (a)(9)(iv) of this section, 
Example 11 for an illustration of this rule.
    (7) Transactions part of a straddle. At the discretion of the 
Commissioner, a transaction shall not satisfy the requirements of 
paragraph (a)(5) of this section if the debt instrument making up the 
qualified hedging transaction is part of a straddle as defined in 
section 1092(c) prior to the time the qualified hedging transaction is 
identified.
    (8) Identification requirements--(i) Identification by the taxpayer. 
A taxpayer must establish a record and before the close of the date the 
hedge is entered into, the taxpayer must enter into the record for each 
qualified hedging transaction the following information--
    (A) The date the qualifying debt instrument and hedge were entered 
into;
    (B) The date the qualifying debt instrument and the hedge are 
identified as constituting a qualified hedging transaction;
    (C) The amount that must be deferred, if any, under paragraph (a)(6) 
of this section and the source and character of such deferred amount;
    (D) A description of the qualifying debt instrument and the hedge; 
and
    (E) A summary of the cash flow resulting from treating the 
qualifying debt instrument and the hedge as a qualified hedging 
transaction.
    (ii) Identification by trustee on behalf of beneficiary. A trustee 
of a trust that enters into a qualified hedging transaction may satisfy 
the identification requirements described in paragraph (a)(8)(i) of this 
section on behalf of a beneficiary of such trust.
    (iii) Identification by the Commissioner. If--
    (A) A taxpayer enters into a qualifying debt instrument and a hedge 
but fails to comply with one or more of the requirements of this 
paragraph (a), and
    (B) On the basis of all the facts and circumstances, the 
Commissioner concludes that the qualifying debt instrument and the hedge 
are, in substance, a qualified hedging transaction,


then the Commissioner may treat the qualifying debt instrument and the 
hedge as a qualified hedging transaction. The Commissioner may identify 
a qualifying debt instrument and a hedge as a qualified hedging 
transaction regardless of whether the qualifying debt instrument and the 
hedge are held by the same taxpayer.
    (9) Taxation of qualified hedging transactions--(i) In general--(A) 
General rule. If a transaction constitutes a qualified hedging 
transaction, the qualifying debt instrument and the hedge are integrated 
and treated as a single transaction with respect to the taxpayer that 
has entered into the qualified hedging transaction during the period 
that the transaction qualifies as a qualified hedging transaction. 
Neither the qualifying debt instrument nor the hedge that makes up the 
qualified hedging transaction shall be subject to section 263(g), 1092 
or 1256 for the period such transactions are integrated. However, the 
qualified hedging transaction may be subject to section 263(g) or 1092 
if such transaction is part of a straddle.
    (B) Special rule for income or expense of foreign persons 
effectively connected with a U.S. trade or business. Interest income of 
a foreign person resulting from a qualified hedging transaction entered 
into by such foreign person that satisfies the requirements of paragraph 
(a)(5)(vii) of this section shall be treated as effectively connected 
with a U.S. trade or business. Interest expense of a foreign person 
resulting from a qualified hedging transaction entered into by such 
foreign person that satisfies the requirements of paragraph

[[Page 758]]

(a)(5)(vii) of this section shall be allocated and apportioned under 
Sec. 1.882-5 of the regulations.
    (C) Special rule for foreign persons that enter into qualified 
hedging transactions giving rise to U.S. source income not effectively 
connected with a U.S. trade or business. If a foreign person enters into 
a qualified hedging transaction that gives rise to U.S. source interest 
income (determined under the source rules for synthetic asset 
transactions as provided in this section) not effectively connected with 
a U.S. trade or business of such foreign person, for purposes of 
sections 871(a), 881, 1441, 1442 and 6049, the provisions of this 
paragraph (a) shall not apply and such sections of the Internal Revenue 
Code shall be applied separately to the qualifying debt instrument and 
the hedge. To the extent relevant to any foreign person, if the 
requirements of this paragraph (a) are otherwise met, the provisions of 
this paragraph (a) shall apply for all other purposes of the Internal 
Revenue Code (e.g., for purposes of calculating the earnings and profits 
of a controlled foreign corporation that enters into a qualified hedging 
transaction through a qualified business unit resident outside the 
United States, income or expense with respect to such qualified hedging 
transaction shall be calculated under the provisions of this paragraph 
(a)).
    (ii) Income tax effects of integration. The effect of integrating 
and treating a transaction as a single transaction is to create a 
synthetic debt instrument for income tax purposes, which is subject to 
the original issue discount provisions of sections 1272 through 1288 and 
163(e), the terms of which are determined as follows:
    (A) Denomination of synthetic debt instrument. In the case where the 
qualifying debt instrument is a borrowing, the denomination of the 
synthetic debt instrument is the same as the currency paid under the 
terms of the hedge to acquire the currency used to make payments under 
the qualifying debt instrument. In the case where the qualifying debt 
instrument is a lending, the denomination of the synthetic debt 
instrument is the same as the currency received under the terms of the 
hedge in exchange for amounts received under the qualifying debt 
instrument. For example, if the hedge is a forward contract to acquire 
British pounds for dollars, and the qualifying debt instrument is a 
borrowing denominated in British pounds, the synthetic debt instrument 
is considered a borrowing in dollars.
    (B) Term and accrual periods. The term of the synthetic debt 
instrument shall be the period beginning on the identification date and 
ending on the date the qualifying debt instrument matures or such 
earlier date that the qualifying debt instrument or hedge is disposed of 
or otherwise terminated. Unless otherwise clearly indicated by the 
payment interval under the hedge, the accrual period shall be a six 
month period which ends on the dates determined under section 
1272(a)(5).
    (C) Issue price. The issue price of the synthetic debt instrument is 
the adjusted issue price of the qualifying debt instrument translated 
into the currency in which the synthetic debt instrument is denominated 
at the spot rate on the identification date.
    (D) Stated redemption price at maturity. In the case where the 
qualifying debt instrument is a borrowing, the stated redemption price 
at maturity shall be determined under section 1273(a)(2) on the 
identification date by reference to the amounts to be paid under the 
hedge to acquire the currency necessary to make interest and principal 
payments on the qualifying debt instrument. In the case where the 
qualifying debt instrument is a lending, the stated redemption price at 
maturity shall be determined under section 1273(a)(2) on the 
identification date by reference to the amounts to be received under the 
hedge in exchange for the interest and principal payments received 
pursuant to the terms of the qualifying debt instrument.
    (iii) Source of interest income and allocation of expense. Interest 
income from a synthetic debt instrument described in paragraph 
(a)(9)(ii) of this section shall be sourced by reference to the source 
of income under sections 861 (a)(1) and 862(a)(1) of the qualifying debt 
instrument. The character for purposes of section 904 of interest income 
from a synthetic debt instrument shall be determined by reference to the

[[Page 759]]

character of the interest income from qualifying debt instrument. 
Interest expense from a synthetic debt instrument described in paragraph 
(a)(9)(ii) of this section shall be allocated and apportioned under 
Sec. Sec. 1.861-8T through 1.861-12T or the successor sections thereof 
or under Sec. 1.882-5.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (a)(9).

    Example 1. (i) K is a U.S. corporation with the U.S. dollar as its 
functional currency. On December 24, 1989, K agrees to close the 
following transaction on December 31, 1989. K will borrow from an 
unrelated party on December 31, 1989, 100 British pounds ([pound]) for 3 
years at a 10 percent rate of interest, payable annually, with no 
principal payment due until the final installment. K will also enter 
into a currency swap contract with an unrelated counterparty under the 
terms of which--
    (a) K will swap, on December 31, 1989, the [pound]100 obtained from 
the borrowing for $100; and
    (b) K will exchange dollars for pounds pursuant to the following 
table in order to obtain the pounds necessary to make payments on the 
pound borrowing:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 1990.............................            8           10
December 31, 1991.............................            8           10
December 31, 1992.............................          108          110
------------------------------------------------------------------------

    (ii) The interest rate on the borrowing is set and the exchange 
rates on the swap are fixed on December 24, 1989. On December 31, 1989, 
K borrows the [pound]100 and swaps such pounds for $100. Assume x has 
satisfied the identification requirements of paragraph (a)(8) of this 
section.
    (iii) The pound borrowing (which constitutes a qualifying debt 
instrument under paragraph (a)(3) of this section) and the currency swap 
contract (which constitutes a hedge under paragraph (a)(4) of this 
section) are a qualified hedging transaction as defined in paragraph 
(a)(1) of this section. Accordingly, the pound borrowing and the swap 
are integrated and treated as one transaction with the following 
consequences:
    (A) The integration of the pound borrowing and the swap results in a 
synthetic dollar borrowing with an issue price of $100 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract (i.e., $8 in 1990, $8 in 1991, and $108 in 1992).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $100. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the annual interest payments of $8 under section 
163(a) (subject to any limitations on deductibility imposed by other 
provisions of the Code) according to its regular method of accounting. K 
has also paid $100 as a return of principal in 1992.
    (E) K must allocate and apportion its interest expense with respect 
to the synthetic dollar borrowing under the rules of Sec. Sec. 1.861-8T 
through 1.861-12T.
    Example 2. (i) K, a U.S. corporation, has the U.S. dollar as its 
functional currency. On December 24, 1989, when the spot rate for Swiss 
francs (Sf) is Sf1 = $1, K enters into a forward contract to purchase 
Sf100 in exchange for $100.04 for delivery on December 31, 1989. The 
Sf100 are to be used for the purchase of a franc denominated debt 
instrument on December 31, 1989. The instrument will have a term of 3 
years, an issue price of Sf100, and will bear interest at 6 percent, 
payable annually, with no repayment of principal until the final 
installment. On December 24, 1989, K also enters into a series of 
forward contracts to sell the franc interest and principal payments that 
will be received under the terms of the franc denominated debt 
instrument for dollars according to the following schedule:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Francs
------------------------------------------------------------------------
December 31, 1990.............................         6.12            6
December 31, 1991.............................         6.23            6
December 31, 1992.............................       112.16          106
------------------------------------------------------------------------

    (ii) On December 31, 1989, K takes delivery of the Sf100 and 
purchases the franc denominated debt instrument. Assume K satisfies the 
identification requirements of paragraph (a)(8) of this section. The 
purchase of the franc debt instrument (which constitutes a qualifying 
debt instrument under paragraph (a)(3) of this section) and the series 
of forward contracts (which constitute a hedge under paragraph (a)(4) of 
this section) are a qualified hedging transaction under paragraph (a)(1) 
of this section. Accordingly, the franc debt instrument and all the 
forward contracts are integrated and treated as one transaction with the 
following consequences:
    (A) The integration of the franc debt instrument and the forward 
contracts results in a synthetic dollar debt instrument in an amount 
equal to the dollars exchanged under the forward contract to purchase 
the francs necessary to acquire the franc debt instrument. Accordingly, 
the issue price is $100.04 (section 1273(b)(2) of the Code).
    (B) The total amount of interest and principal received by K with 
respect to the synthetic dollar debt instrument is equal to the dollars 
received under the forward sales contracts (i.e., $6.12 in 1990, $6.23 
in 1991, and $112.16 in 1992).

[[Page 760]]

    (C) The synthetic dollar debt instrument is an installment 
obligation and its stated redemption price at maturity is $106.15 (i.e., 
$6.12 of the payments in 1990, 1991, and 1992 are treated as periodic 
interest payments under the principles of section 1273). Because the 
stated redemption price at maturity exceeds the issue price, under 
section 1273(a)(1) the synthetic dollar debt instrument has OID of 
$6.11.
    (D) The yield to maturity of the synthetic dollar debt instrument is 
8.00 percent, compounded annually. Assuming K is a calendar year 
taxpayer, it must include interest income of $8.00 in 1990 (of which 
$1.88 constitutes OID), $8.15 in 1991 (of which $2.03 constitutes OID), 
and $8.32 in 1992 (of which $2.20 constitutes OID). The amount of the 
final payment received by K in excess of the interest income includible 
is a return of principal and a payment of previously accrued OID.
    (E) The source of the interest income shall be determined by 
applying sections 861(a)(1) and 862(a)(1) with reference to the franc 
interest income that would have been received had the transaction not 
been integrated.
    Example 3. (i) K is an accrual method U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 1992, K borrows 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. The spot rate on January 1, 1992, is [pound]1 = 
$1.50. On January 1, 1993, when the spot rate is [pound]1 = $1.60, K 
enters into a currency swap contract with an unrelated counterparty 
under the terms of which K will exchange dollars for pounds pursuant to 
the following table in order to obtain the pounds necessary to make the 
remaining payments on the pound borrowing:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 1993.............................        12.80           10
December 31, 1994.............................        12.80           10
December 31, 1994.............................       160.00          100
------------------------------------------------------------------------

    (ii) Assume that British pound interest rates are still 10% and that 
K properly identifies the pound borrowing and the currency swap contract 
as a qualified hedging transaction as provided in paragraph (a)(8) of 
this section. Under paragraph (a)(6)(i) of this section, K must realize 
exchange gain or loss with respect to the pound borrowing determined 
solely by reference to changes in exchange rates between January 1, 1992 
and January 1, 1993. (Thus, gain or loss from other factors such as 
movements in interest rates or changes in credit quality of K are not 
taken into account). Recognition of such gain or loss is deferred until 
K terminates its pound borrowing. Accordingly, K must defer exchange 
loss in the amount of $10 [([pound]100 x 1.50)-([pound]100 x 1.60)].
    (iii) Additionally, the qualified hedging transaction is treated as 
a synthetic U.S. dollar debt instrument with an issue date of January 1, 
1993, and a maturity date of December 31, 1994. The issue price of the 
synthetic debt instrument is $160 ([pound]100 x 1.60, the spot rate on 
January 1, 1993) and the total amount of interest and principal is 
$185.60. The accrual period is the one year period beginning on January 
1 and ending December 31 of each year. The stated redemption price at 
maturity is $160. Thus, K is treated as paying $12.80 of interest in 
1993, $12.80 of interest in 1994, and $160 of principal in 1994. The 
interest expense from the synthetic instrument is allocated and 
apportioned in accordance with the rules of Sec. Sec. 1.861-8T through 
1.861-12T. Sections 263(g), 1092, and 1256 do not apply to the positions 
comprising the synthetic dollar borrowing.
    Example 4. (i) K is an accrual method U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 2013, K borrows 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. The spot rate on January 1, 2013, is [pound]1 = 
$1.50. Also on January 1, 2013, K enters into a currency swap contract 
with an unrelated counterparty under the terms of which K will exchange 
dollars for pounds pursuant to the following table in order to obtain 
the pounds necessary to make the remaining payments on the pound 
borrowing:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 2013.............................        12.00           10
December 31, 2014.............................        12.00           10
December 31, 2015.............................       162.00          110
------------------------------------------------------------------------

    (ii) Assume that K properly identifies the pound borrowing and the 
currency swap contract as a qualified hedging transaction as provided in 
paragraph (a)(1) of this section.
    (iii) The pound borrowing (which constitutes a qualifying debt 
instrument under paragraph (a)(3) of this section) and the currency swap 
contract (which constitutes a hedge under paragraph (a)(4) of this 
section) are a qualified hedging transaction as defined in paragraph 
(a)(1) of this section. Accordingly, the pound borrowing and the swap 
are integrated and treated as one transaction with the following 
consequences:
    (A) The integration of the pound borrowing and the swap results in a 
synthetic dollar borrowing with an issue price of $150 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract (i.e., $12 in 2013, $12 in 2014, and $162 in 
2015).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $150. Because the stated redemption price equals the

[[Page 761]]

issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the annual interest payments of $12 under section 
163(a) (subject to any limitations on deductibility imposed by other 
provisions of the Code) according to its regular method of accounting. K 
has also paid $150 as a return of principal in 2015.
    (E) K must allocate and apportion its interest expense from the 
synthetic instrument under the rules of Sec. Sec. 1.861-8T through 
1.861-12T.
    (iv) Assume that on January 1, 2014, the spot exchange rate is 
[pound]1 = $1.60, interest rates have not changed since January 1, 2013, 
(accordingly, assume that the market value of K's bond in pounds has not 
changed) and that K transfers its rights and obligations under the 
currency swap contract in exchange for $10. Under Sec. 1.988-
2(e)(3)(iii), K will include in income as exchange gain $10 on January 
1, 2014. Pursuant to paragraph (a)(6)(ii) of this section, the pound 
borrowing and the currency swap contract are treated as a qualified 
hedging transaction for 2013. The loss inherent in the pound borrowing 
from January 1, 2013, to January 1, 2014, is realized and recognized on 
January 1, 2014. Such loss is exchange loss in the amount of $10.00 
[([pound]100 x $1.50, the spot rate on January 1, 2013)-([pound]100 x 
$1.60, the spot rate on January 1, 2014)]. For purposes of determining 
exchange gain or loss on the [pound]100 principal amount of the debt 
instrument for the period January 1, 2014, to December 31, 2015, the 
spot rate on January 1, 2014 is used rather than the spot rate on the 
issue date. Thus, assuming that the spot rate on December 31, 2015, the 
maturity date, is [pound]1 = $1.80, K realizes exchange loss in the 
amount of $20 [([pound]100 x $1.60)-([pound]100 x $1.80)]. Except as 
provided in paragraph (a)(8)(iii) (regarding identification by the 
Commissioner), the pound borrowing cannot be part of a qualified hedging 
transaction for any period subsequent to the leg out date.
    Example 5. (i) K, a U.S. corporation, has the U.S. dollar as its 
functional currency. On January 1, 2013, when the spot rate for Swiss 
francs (Sf) is Sf1 = $.50, K converts $100 to Sf200 and purchases a 
franc denominated debt instrument. The instrument has a term of 3 years, 
an adjusted issue price of Sf200, and will bear interest at 5 percent, 
payable annually, with no repayment of principal until the final 
installment. The U.S. dollar interest rate on an equivalent instrument 
is 8% on January 1, 2013, compounded annually. On January 1, 2013, K 
also enters into a series of forward contracts to sell the franc 
interest and principal payments that will be received under the terms of 
the franc denominated debt instrument for dollars according to the 
following schedule:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Francs
------------------------------------------------------------------------
December 31, 2013.............................         5.14           10
December 31, 2014.............................         5.29           10
December 31, 2015.............................       114.26          210
------------------------------------------------------------------------

    (ii) Assume K satisfies the identification requirements of paragraph 
(a)(8) of this section. Assume further that on January 1, 2014, the spot 
exchange rate is Sf1 = U.S.$.5143, the U.S. dollar interest rate is 10%, 
compounded annually, and the Swiss franc interest rate is the same as on 
January 1, 2013 (5%, compounded annually). On January 1, 2014, K 
disposes of the forward contracts that were to mature on December 31, 
2014, and December 31, 2015 and incurs a loss of $3.62 (the present 
value of $.10 with respect to the 2014 contract and $4.27 with respect 
to the 2015 contract).
    (iii) The purchase of the franc debt instrument (which constitutes a 
qualifying debt instrument under paragraph (a)(3) of this section) and 
the series of forward contracts (which constitute a hedge under 
paragraph (a)(4) of this section) are a qualified hedging transaction 
under paragraph (a)(1) of this section. Accordingly, the franc debt 
instrument and all the forward contracts are integrated for the period 
beginning January 1, 2013, and ending January 1, 2014.
    (A) The integration of the franc debt instrument and the forward 
contracts results in a synthetic dollar debt instrument with an issue 
price of $100.
    (B) The total amount of interest and principal to be received by K 
with respect to the synthetic dollar debt instrument is equal to the 
dollars to be received under the forward sales contracts (i.e., $5.14 in 
2013, $5.29 in 2014, and $114.26 in 2015).
    (C) The synthetic dollar debt instrument is an installment 
obligation and its stated redemption price at maturity is $109.27 (i.e., 
$5.14 of the payments in 2013, 2014, and 2015 is treated as periodic 
interest payments under the principles of section 1273). Because the 
stated redemption price at maturity exceeds the issue price, under 
section 1273(a)(1) the synthetic dollar debt instrument has OID of 
$9.27.
    (D) The yield to maturity of the synthetic dollar debt instrument is 
8.00 percent, compounded annually. Assuming K is a calendar year 
taxpayer, it must include interest income of $8.00 in 2013 (of which 
$2.86 constitutes OID).
    (E) The source of the interest income is determined by applying 
sections 861(a)(1) and 862(a)(1) with reference to the franc interest 
income that would have been received had the transaction not been 
integrated.
    (iv) Because K disposed of the forward contracts on January 1, 2014, 
the rules of paragraph (a)(6)(ii) of this section shall apply. 
Accordingly, the $3.62 loss from the disposition of the forward 
contracts is realized and recognized on January 1, 2014. Additionally,

[[Page 762]]

K is deemed to have sold the franc debt instrument for $102.86, its fair 
market value in dollars on January 1, 2014. K will compute gain or loss 
with respect to the deemed sale of the franc debt instrument by 
subtracting its adjusted basis in the instrument ($102.86--the value of 
the Sf200 issue price at the spot rate on the identification date plus 
$2.86 of original issue discount accrued on the synthetic dollar debt 
instrument for 2013) from the amount realized on the deemed sale of 
$102.86. Thus K realizes and recognizes no gain or loss from the deemed 
sale of the debt instrument. The dollar amount used to determine 
exchange gain or loss with respect to the franc debt instrument is the 
Sf200 issue price on January 1, 2014, translated into dollars at the 
spot rate on January 1, 2014, of Sf1 = U.S.$.5143. Except as provided in 
paragraph (a)(8)(iii) of this section (regarding identification by the 
Commissioner), the franc borrowing cannot be part of a qualified hedging 
transaction for any period subsequent to the leg out date.
    Example 6. (i) K is a U.S. corporation with the dollar as its 
functional currency. On January 1, 1992, K issues a debt instrument with 
the following terms: the issue price is $1,000, the instrument pays 
interest annually at a rate of 8% on the $1,000 principal amount, the 
instrument matures on December 31, 1996, and the amount paid at maturity 
is the greater of zero or $2,000 less the U.S. dollar value (determined 
on December 31, 1996) of 150,000 Japanese yen.
    (ii) Also on January 1, 1992, K enters into the following hedges 
with respect to the instrument described in the preceding paragraph: a 
forward contract under which K will sell 150,000 yen for $1,000 on 
December 31, 1996 (note that this forward rate assumes that interest 
rates in yen and dollars are equal); and an option contract that expires 
on December 31, 1996, under which K has the right (but not the 
obligation) to acquire 150,000 yen for $2,000. K will pay for the option 
by making payments to the writer of the option equal to $5 each December 
31 from 1992 through 1996.
    (iii) The net economic effect of these transactions is that K has 
created a liability with a principal amount and amount paid at maturity 
of $1,000, with an interest cost of 8.5% (8% on debt instrument, 0.5% 
option price) compounded annually. For example, if on December 31, 1996, 
the spot exchange rate is $1 = 100 yen, K pays $500 on the bond [$2,000-
(150,000 yen/$100)], and $500 in satisfaction of the forward contract 
[$1,000-(150,000 yen/$100)]. If instead the spot exchange rate on 
December 31, 1996 is $1 = 200 yen, K pays $1,250 on the bond [$2,000-
(150,000 yen/$200)] and K receives $250 in satisfaction of the forward 
contract [$1,000-(150,000 yen/$200)]. Finally, if the spot exchange rate 
on December 31, 1996 is $1 = 50 yen, K pays $0 on the bond [$2,000-
(150,000 yen/$50), but the bond holder is not required under the terms 
of the instrument to pay additional principal]; K exercises the option 
to buy 150,000 yen for $2,000; and K then delivers the 150,000 yen as 
required by the forward contract in exchange for $1,000.
    (iv) Assume K satisfies the identification requirements of paragraph 
(a)(8) of this section. The debt instrument described in paragraph (i) 
of this Example 6 (which constitutes a qualifying debt instrument under 
paragraph (a)(3) of this section) and the forward contract and option 
contract described in paragraph (ii) of this example (which constitute a 
hedge under paragraph (a)(4) of this section and are collectively 
referred to hereafter as ``the contracts'') together are a qualified 
hedging transaction under paragraph (a)(1) of this section. Accordingly, 
with respect to K, the debt instrument and the contracts are integrated, 
resulting in a synthetic dollar debt instrument with an issue price of 
$1000, a stated redemption price at maturity of $1000 and a yield to 
maturity of 8.5% compounded annually (with no original issue discount). 
K must allocate and apportion its annual interest expense of $85 under 
the rules of Sec. Sec. 1.861-8T through 1.861-12T.
    Example 7. (i) R is a U.S. corporation with the dollar as its 
functional currency. On January 1, 1995, R issues a debt instrument with 
the following terms: the issue price is 504 British pounds ([pound]), 
the instrument pays interest at a rate of 3.7% (compounded semi-
annually) on the [pound]504 principal amount, the instrument matures on 
December 31, 1999, with a repayment at maturity of the [pound]504 
principal plus the proportional gain, if any, in the ``Financial Times'' 
100 Stock Exchange (FTSE) index (determined by the excess of the value 
of the FTSE index on the maturity date over the value of the FTSE on the 
issue date, divided by the value of the FTSE index on the issue date, 
multiplied by the number of FTSE index contracts that could be purchased 
on the issue date for [pound]504).
    (ii) Also on January 1, 1995, R enters into a contract with a bank 
under which on January 1, 1995, R will swap the [pound]504 for $1,000 
(at the current spot rate). R will make U.S. dollar payments to the bank 
equal to 8.15% on the notional principal amount of $1,000 (compounded 
semi-annually) for the period beginning January 1, 1995 and ending 
December 31, 1999. R will receive pound payments from the bank equal to 
3.7% on the notional principal amount of [pound]504 (compounded semi-
annually) for the period beginning January 1, 1995 and ending December 
31, 1999. On December 31, 1999, R will swap with the bank $1,000 for 
[pound]504 plus the proportional gain, if any, in the FTSE index 
(computed as provided above).

[[Page 763]]

    (iii) Economically, both the indexed debt instrument and the hedging 
contract are hybrid instruments with the following components. The 
indexed debt instrument is composed of a par pound debt instrument that 
is assumed to have a 10.85% coupon (compounded semi-annually) plus an 
embedded FTSE equity index option for which the investor pays a premium 
of 7.15% (amortized semi-annually) on the pound principal amount. The 
combined effect is that the premium paid by the investor partially 
offsets the coupon payments resulting in a return of 3.7% (10.85%-
7.15%). Similarly, the dollar payments under the hedging contract to be 
made by R are computed by multiplying the dollar notional principal 
amount by an 8.00% rate (compounded semi-annually) which the facts 
assume would be the rate paid on a conventional currency swap plus a 
premium of 0.15% (amortized semi-annually) on the dollar notional 
principal amount for an embedded FTSE equity index option.
    (iv) Assume R satisfies the identification requirements of paragraph 
(a)(8) of this section. The indexed debt instrument described in 
paragraph (i) of this Example 7 constitutes a qualifying debt instrument 
under paragraph (a)(3) of this section. The hedging contract described 
in paragraph (ii) of this Example 7 constitutes a hedge under paragraph 
(a)(4) of this section. Since both the pound exposure of the indexed 
debt instrument and the exposure to movements of the FTSE embedded in 
the indexed debt instrument are hedged such that a yield to maturity can 
be determined in dollars, the transaction satisfies the requirement of 
paragraph (a)(5)(i) of this section. Assuming the transactions satisfy 
the other requirements of paragraph (a)(5) of this section, the indexed 
debt instrument and hedge are a qualified hedging transaction under 
paragraph (a)(1) of this section. Accordingly, with respect to R, the 
debt instrument and the contracts are integrated, resulting in a 
synthetic dollar debt instrument with an issue price of $1000, a stated 
redemption price at maturity of $1000 and a yield to maturity of 8.15% 
compounded semi-annually (with no original issue discount). K must 
allocate and apportion its interest expense from the synthetic 
instrument under the rules Sec. Sec. 1.861-8T through 1.861-12T.
    Example 8. (i) K is a U.S. corporation with the U.S. dollar as its 
functional currency. On December 24, 1992, K agrees to close the 
following transaction on December 31, 1992. K will borrow from an 
unrelated party on December 31, 1992, 200 British pounds ([pound]) for 3 
years at a 10 percent rate of interest, payable annually, with no 
principal payment due until the final installment. K will also enter 
into a currency swap contract with an unrelated counterparty under the 
terms of which--
    (A) K will swap, on December 31, 1992, [pound]100 obtained from the 
borrowing for $100; and
    (B) K will exchange dollars for pounds pursuant to the following 
table:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 1993.............................            8           10
December 31, 1994.............................            8           10
December 31, 1995.............................          108          110
------------------------------------------------------------------------

    (ii) The interest rate on the borrowing is set and the exchange 
rates on the swap are fixed on December 24, 1992. On December 31, 1992, 
K borrows the [pound]200 and swaps [pound]100 for $100. Assume K has 
satisfied the identification requirements of paragraph (a)(8) of this 
section.
    (iii) The [pound]200 debt instrument satisfies the requirements of 
paragraph (a)(3)(i) of this section. Because all principal and interest 
payments under the instrument are hedged in the same proportion (50% of 
all interest and principal payments are hedged), 50% of the payments 
under the [pound]200 instrument (principal amount of [pound]100 and 
annual interest of [pound]10) are treated as a qualifying debt 
instrument for purposes of paragraph (a) of this section. Thus, the 
distinct [pound]100 borrowing and the currency swap contract (which 
constitutes a hedge under paragraph (a)(4) of this section) are a 
qualified hedging transaction as defined in paragraph (a)(1) of this 
section. Accordingly, [pound]100 of the pound borrowing and the swap are 
integrated and treated as one synthetic dollar transaction with the 
following consequences:
    (A) The integration of [pound]100 of the pound borrowing and the 
swap results in a synthetic dollar borrowing with an issue price of $100 
under section 1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract (i.e., $8 in 1993, $8 in 1994, and $108 in 1995).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $100. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the annual interest payments of $8 under section 
163(a) (subject to any limitations on deductibility imposed by other 
provisions of the Code) according to its regular method of accounting. K 
has also paid $100 as a return of principal in 1995.
    (E) K must allocate and apportion its interest expense from the 
synthetic instrument under the rules of Sec. Sec. l.861-8T through 
1.861-12T.


That portion of the [pound]200 pound debt instrument that is not hedged 
(i.e., [pound]100) is treated as a separate debt instrument subject to 
the rules of Sec. 1.988-2 (b) and Sec. Sec. l.861-8T through 1.861-
12T.

[[Page 764]]

    Example 9. (i) K is an accrual method U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 1992, K borrows 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. On the same day, K enters into a currency swap 
agreement with an unrelated bank under which K agrees to the following:
    (A) On January 1, 1992, K will exchange the [pound]100 borrowed for 
$150.
    (B) For the period beginning January 1, 1992 and ending December 31, 
1994, K will pay at the end of each month an amount determined by 
multiplying $150 by one month LIBOR less 65 basis points and receive 
from the bank on December 31st of 1992, 1993, and 1994, [pound]10.
    (C) On December 31, 1994, K will exchange $150 for [pound]100.


Assume K satisfies the identification requirements of paragraph (a)(8) 
of this section.
    (ii) The pound borrowing (which constitutes a qualifying debt 
instrument under paragraph (a)(3) of this section) and the currency swap 
contract (which constitutes a hedge under paragraph (a)(4) of this 
section) are a qualified hedging transaction as defined in paragraph 
(a)(1) of this section. Accordingly, the pound borrowing and the swap 
are integrated and treated as one transaction with the following 
consequences:
    (A) The integration of the pound borrowing and the swap results in a 
synthetic dollar borrowing with an issue price of $150 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract.
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $150. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the monthly variable interest payments under 
section 163(a) (subject to any limitations on deductibility imposed by 
other provisions of the Code) according to its regular method of 
accounting. K has also paid $150 as a return of principal in 1994.
    (E) K must allocate and apportion its interest expense from the 
synthetic instrument under the rules of Sec. Sec. 1.861-8T through 
1.861-12T.
    Example 10. (i) K is an accrual method U.S. corporation with the 
U.S. dollar as its functional currency. On January 1, 1992, K loans 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. The spot rate on January 1, 1992, is [pound]1 = 
$1.50. Also on January 1, 1992, K enters into a currency swap contract 
with an unrelated counterparty under the terms of which K will exchange 
pounds for dollars pursuant to the following table:

------------------------------------------------------------------------
                     Date                          Pounds      Dollars
------------------------------------------------------------------------
December 31, 1992.............................           10           12
December 31, 1993.............................           10           12
December 31, 1994.............................          110          162
------------------------------------------------------------------------

    (ii) Assume that K properly identifies the pound borrowing and the 
currency swap contract as a qualified hedging transaction as provided in 
paragraph (a)(1) of this section.
    (iii) The pound loan (which constitutes a qualifying debt instrument 
under paragraph (a)(3) of this section) and the currency swap contract 
(which constitutes a hedge under paragraph (a)(4) of this section) are a 
qualified hedging transaction as defined in paragraph (a)(1) of this 
section. Accordingly, the pound loan and the swap are integrated and 
treated as one transaction with the following consequences:
    (A) The integration of the pound loan and the swap results in a 
synthetic dollar loan with an issue price of $150 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar loan is equal to the dollar payments received by K under the 
currency swap contract (i.e., $12 in 1992, $12 in 1993, and $162 in 
1994).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $150. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar loan.
    (D) K must include in income as interest $12 in 1992, 1993, and 
1994.
    (E) The source of the interest income shall be determined by 
applying sections 861(a)(1) and 862(a)(1) with reference to the pound 
interest income that would have been received had the transaction not 
been integrated.
    (iv) On January 1, 1993, K transfers both the pound loan and the 
currency swap to B, its wholly owned U.S. subsidiary, in exchange for B 
stock in a transfer that satisfies the requirements of section 351. 
Under paragraph (a)(6) of this section, the transfer of both instruments 
is not ``legging out.'' Rather, K is considered to have transferred the 
synthetic dollar loan to B in a transaction in which gain or loss is not 
recognized. B's basis in the loan under section 362 is $100.
    Example 11. (i) K is a domestic corporation with the U.S. dollar as 
its functional currency. On January 1, 2013, K borrows 100 British 
pounds ([pound]) for two years at a 10% rate of interest payable on 
December 31 of each year with no principal payment due until maturity on 
December 31, 2014. Assume that the spot rate on January 1, 2013, is 
[pound]1=$1. On the same date, K enters into two swap contracts with an 
unrelated counterparty that economically results in the transformation

[[Page 765]]

of the fixed rate [pound]100 borrowing to a floating rate dollar 
borrowing. The terms of the swaps are as follows:
    (A) Swap 1, Currency swap. On January 1, 2013, K will exchange 
[pound]100 for $100.
    (1) On December 31 of both 2013 and 2014, K will exchange $8 for 
[pound]10;
    (2) On December 31, 2014, K will exchange $100 for [pound]100.
    (B) Swap 2, Interest rate swap. On December 31 of both 2013 and 
2014, K will pay LIBOR times a notional principal amount of $100 and 
will receive 8% times the same $100 notional principal amount.
    (ii) Assume that K properly identifies the pound borrowing and the 
swap contracts as a qualified hedging transaction as provided in 
paragraph (a)(8)(i) of this section and that the other relevant 
requirements of paragraph (a) of this section are satisfied.
    (iii) On January 1, 2014, the spot exchange rate is [pound]1=$2; the 
U.S. dollar LIBOR rate of interest is 9%; the market value of K's note 
in pounds has not changed; and K terminates swap 2. Because interest 
rates have increased from 8% to 9%, K will incur a loss of ($.92) (the 
present value of the ($1) difference between the 8% and 9% interest 
payments discounted at the current interest rate of 9%) with respect to 
the termination of such swap on January 1, 2014. Pursuant to paragraph 
(a)(6)(ii)(C) of this section, K must treat swap 1 as having been sold 
for its fair market value on the leg-out date, which is the date swap 2 
is terminated. K must realize and recognize gain of $100.92 (the present 
value of [pound]110 discounted in pounds to equal [pound]100 x $2 ($200) 
less the present value of $108 ($99.08)). The loss inherent in the pound 
borrowing from January 1, 2013 to January 1, 2014 is realized and 
recognized on January 1, 2014. Such loss is exchange loss in the amount 
of $100 (the present value of [pound]110 that was to be paid at the end 
of the year discounted at pound interest rates to equal [pound]100 times 
the change in exchange rates: ([pound]100 x $1, the spot rate on January 
1, 2013)-([pound]100 x $2, the spot rate on January 1, 2014)). Pursuant 
to paragraph (a)(6)(ii)(E) of this section, except as provided in 
paragraph (a)(8)(iii) of this section (regarding identification by the 
Commissioner), the pound borrowing and currency swap cannot be part of a 
qualified hedging transaction for any period after the leg-out date.
    (iv) Assume the facts are the same as in paragraph (iii) of this 
Example except that on January 1, 2014, the U.S. dollar LIBOR rate of 
interest is 7% rather than 9%. When K terminates swap 2, K will realize 
gain of $0.93 (the present value of the ($1) difference between the 8% 
and 7% interest payments discounted at the current interest rate of 7%) 
received with respect to the termination on January 1, 2014. Fifty 
percent or more of the remaining pound cash flow of the pound borrowing 
remains hedged after the termination of swap 2. Accordingly, under 
paragraph (a)(6)(ii)(F) of this section, paragraphs (a)(6)(ii)(B) and 
(C) of this section do not apply, and the gain on swap 1 and the loss 
on the qualifying debt instrument are not taken into account. Thus, K 
will include in income $0.93 realized from the termination of swap 2.

    (10) Transition rules and effective dates for certain provisions--
(i) Coordination with Notice 87-11. Any transaction entered into prior 
to September 21, 1989, which satisfied the requirements of Notice 87-11, 
1987-1 C.B. 423, shall be deemed to satisfy the requirements of 
paragraph (a) of this section.
    (ii) Prospective application to contingent payment debt instruments. 
In the case of a contingent payment debt instrument, the definition of 
qualifying debt instrument set forth in paragraph (a)(3)(i) of this 
section applies to transactions entered into after March 17, 1992.
    (iii) Prospective application of partial hedging rule. Paragraph 
(a)(3)(ii) of this section is effective for transactions entered into 
after March 17, 1992.
    (iv) Effective/applicability dates for legging in and legging out 
rules. (A) The rules of paragraph (a)(6)(i) of this section are 
effective for qualified hedging transactions that are legged into after 
March 17, 1992.
    (B) The rules of paragraph (a)(6)(ii) and Example 11 of paragraph 
(a)(9)(iv) of this section apply to leg-outs that occur on or after 
September 6, 2012.
    (b) Hedged executory contracts--(1) In general. If the taxpayer 
enters into a hedged executory contract as defined in paragraph (b)(2) 
of this section, the executory contract and the hedge shall be 
integrated as provided in paragraph (b)(4) of this section.
    (2) Definitions--(i) Hedged executory contract. A hedged executory 
contract is an executory contract as defined in paragraph (b)(2)(ii) of 
this section that is the subject of a hedge as defined in paragraph 
(b)(2)(iii) of this section, provided that the following requirements 
are satisfied--
    (A) The executory contract and the hedge are identified as a hedged 
executory contract as provided in paragraph (b)(3) of this section.

[[Page 766]]

    (B) The hedge is entered into (i.e., settled or closed, or in the 
case of nonfunctional currency deposited in an account with a bank or 
other financial institution, such currency is acquired and deposited) on 
or after the date the executory contract is entered into and before the 
accrual date as defined in paragraph (b)(2)(iv) of this section.
    (C) The executory contract is hedged in whole or in part throughout 
the period beginning with the date the hedge is identified in accordance 
with paragraph (b)(3) of this section and ending on or after the accrual 
date.
    (D) None of the parties to the hedge are related. The term related 
means the relationships defined in section 267(b) and section 707(c)(1).
    (E) In the case of a qualified business unit with a residence, as 
defined in section 988(a)(3)(B), outside of the United States, both the 
executory contract and the hedge are properly reflected on the books of 
the same qualified business unit.
    (F) Subject to the limitations of paragraph (b)(2)(i)(E) of this 
section, both the executory contract and the hedge are entered into by 
the same individual, partnership, trust, estate, or corporation. With 
respect to a corporation, the same corporation must enter into both the 
executory contract and the hedge whether or not such corporation is a 
member of an affiliated group of corporations that files a consolidated 
return.
    (G) With respect to a foreign person engaged in a U.S. trade or 
business that enters into an executory contract or hedge through such 
trade or business, all items of income and expense associated with the 
executory contract and the hedge would have been effectively connected 
with such U.S. trade or business throughout the term of the hedged 
executory contract had this paragraph (b) not applied.
    (ii) Executory contract--(A) In general. Except as provided in 
paragraph (b)(2)(ii)(B) of this section, an executory contract is an 
agreement entered into before the accrual date to pay nonfunctional 
currency (or an amount determined with reference thereto) in the future 
with respect to the purchase of property used in the ordinary course of 
the taxpayer's business, or the acquisition of a service (or services), 
in the future, or to receive nonfunctional currency (or an amount 
determined with reference thereto) in the future with respect to the 
sale of property used or held for sale in the ordinary course of the 
taxpayer's business, or the performance of a service (or services), in 
the future. Notwithstanding the preceding sentence, a contract to buy or 
sell stock shall be considered an executory contract. (Thus, for 
example, a contract to sell stock of an affiliate is an executory 
contract for this purpose.) On the accrual date, such agreement ceases 
to be considered an executory contract and is treated as an account 
payable or receivable.
    (B) Exceptions. An executory contract does not include a section 988 
transaction. For example, a forward contract to purchase nonfunctional 
currency is not an executory contract. An executory contract also does 
not include a transaction described in paragraph (c) of this section.
    (C) Effective date for contracts to buy or sell stock. That part of 
paragraph (b)(2)(ii)(A) of this section which provides that a contract 
to buy or sell stock shall be considered an executory contract applies 
to contracts to buy or sell stock entered into on or after March 17, 
1992.
    (iii) Hedge--(A) In general. For purposes of this paragraph (b), the 
term hedge means a deposit of nonfunctional currency in a hedging 
account (as defined paragraph (b)(3)(iii)(D) of this section), a forward 
or futures contract described in Sec. 1.988-1(a)(1)(ii) and (2)(iii), 
or combination thereof, which reduces the risk of exchange rate 
fluctuations by reference to the taxpayer's functional currency with 
respect to nonfunctional currency payments made or received under an 
executory contract. The term hedge also includes an option contract 
described in Sec. 1.988-1(a)(1)(ii) and (2)(iii), but only if the 
option's expiration date is on or before the accrual date. The premium 
paid for an option that lapses shall be integrated with the executory 
contract.
    (B) Special rule for series of hedges. A series of hedges as defined 
in paragraph (b)(3)(iii)(A) of this section shall be considered a hedge 
if the executory contract is hedged in whole or in part

[[Page 767]]

throughout the period beginning with the date the hedge is identified in 
accordance with paragraph (b)(3)(i) of this section and ending on or 
after the accrual date. A taxpayer that enters into a series of hedges 
will be deemed to have satisfied the preceding sentence if the hedge 
that succeeds a hedge that has been terminated is entered into no later 
than the business day following such termination.
    (C) Special rules for historical rate rollovers--(1) Definition. A 
historical rate rollover is an extension of the maturity date of a 
forward contract where the new forward rate is adjusted on the rollover 
date to reflect the taxpayer's gain or loss on the contract as of the 
rollover date plus the time value of such gain or loss through the new 
maturity date.
    (2) Certain historical rate rollovers considered a hedge. A 
historical rate rollover is considered a hedge if the rollover date is 
before the accrual date.
    (3) Treatment of time value component of certain historical rate 
rollovers that are hedges. Interest income or expense determined under 
Sec. 1.988-2(d)(2)(v) with respect to a historical rate rollover shall 
be considered part of a hedge if the period beginning on the first date 
a hedging contract is rolled over and ending on the date payment is made 
or received under the executory contract does not exceed 183 days. Such 
interest income or expense shall not be recognized and shall be an 
adjustment to the income from, or expense of, the services performed or 
received under the executory contract, or to the amount realized or 
basis of the property sold or purchased under the executory contract. 
For the treatment of such interest income or expense that is not 
considered part of a hedge, see Sec. 1.988-2(d)(2)(v).
    (D) Special rules regarding deposits of nonfunctional currency in a 
hedging account. A hedging account is an account with a bank or other 
financial institution used exclusively for deposits of nonfunctional 
currency used to hedge executory contracts. For purposes of determining 
the basis of units in such account that comprise the hedge, only those 
units in the account as of the accrual date shall be taken into 
consideration. A taxpayer may adopt any reasonable convention 
(consistently applied to all hedging accounts) to determine which units 
comprise the hedge as of the accrual date and the basis of the units as 
of such date.
    (E) Interest income on deposit of nonfunctional currency in a 
hedging account. Interest income on a deposit of nonfunctional currency 
in a hedging account may be taken into account for purposes of 
determining the amount of a hedge if such interest is accrued on or 
before the accrual date. However, such interest income shall be included 
in income as provided in section 61. For example, if a taxpayer with the 
dollar as its functional currency enters into an executory contract for 
the purchase and delivery of a machine in one year for 100 British 
pounds ([pound]), and on such date deposits [pound]90.91 in a properly 
identified bank account that bears interest at the rate of 10%, the 
interest that accrues prior to the accrual date shall be included in 
income and may be considered a hedge.
    (iv) Accrual date. The accrual date is the date when the item of 
income or expense (including a capital expenditure) that relates to an 
executory contract is required to be accrued under the taxpayer's method 
of accounting.
    (v) Payment date. The payment date is the date when payment is made 
or received with respect to an executory contract or the subsequent 
corresponding account payable or receivable.
    (3) Identification rules--(i) Identification by the taxpayer. A 
taxpayer must establish a record and before the close of the date the 
hedge is entered into, the taxpayer must enter into the record a clear 
description of the executory contract and the hedge and indicate that 
the transaction is being identified in accordance with paragraph (b)(3) 
of this section.
    (ii) Identification by the Commissioner. If a taxpayer enters into 
an executory contract and a hedge but fails to satisfy one or more of 
the requirements of paragraph (b) of this section and, based on the 
facts and circumstances, the Commissioner concludes that the executory 
contract in substance is hedged, then the Commissioner may apply the 
provisions of paragraph (b) of this section as if the taxpayer had 
satisfied all

[[Page 768]]

of the requirements therein, and may make appropriate adjustments. The 
Commissioner may apply the provisions of paragraph (b) of this section 
regardless of whether the executory contract and the hedge are held by 
the same taxpayer.
    (4) Effect of hedged executory contract--(i) In general. If a 
taxpayer enters into a hedged executory contract, amounts paid or 
received under the hedge by the taxpayer are treated as paid or received 
by the taxpayer under the executory contract, or any subsequent account 
payable or receivable, or that portion to which the hedge relates. Also, 
the taxpayer recognizes no exchange gain or loss on the hedge. If an 
executory contract, on the accrual date, becomes an account payable or 
receivable, the taxpayer recognizes no exchange gain or loss on such 
payable or receivable for the period covered by the hedge.
    (ii) Partially hedged executory contracts. The effect of integrating 
an executory contract and a hedge that partially hedges such contract is 
to treat the amounts paid or received under the hedge as paid or 
received under the portion of the executory contract being hedged, or 
any subsequent account payable or receivable. The income or expense of 
services performed or received under the executory contract, or the 
amount realized or basis of property sold or purchased under the 
executory contract, that is attributable to that portion of the 
executory contract that is not hedged shall be translated into 
functional currency on the accrual date. Exchange gain or loss shall be 
realized when payment is made or received with respect to any payable or 
receivable arising on the accrual date with respect to such unhedged 
amount.
    (iii) Disposition of a hedge or executory contract prior to the 
accrual date--(A) In general. If a taxpayer identifies an executory 
contract as part of a hedged executory contract as defined in paragraph 
(b)(2) of this section, and disposes of (or otherwise terminates) the 
executory contract prior to the accrual date, the hedge shall be treated 
as sold for its fair market value on the date the executory contract is 
disposed of and any gain or loss shall be realized and recognized on 
such date. Such gain or loss shall be an adjustment to the amount 
received or expended with respect to the disposition or termination, if 
any. The spot rate on the date the hedge is treated as sold shall be 
used to determine subsequent exchange gain or loss on the hedge. If a 
taxpayer identifies a hedge as part of a hedged executory contract as 
defined in paragraph (b)(2) of this section, and disposes of the hedge 
prior to the accrual date, any gain or loss realized on such disposition 
shall not be recognized and shall be an adjustment to the income from, 
or expense of, the services performed or received under the executory 
contract, or to the amount realized or basis of the property sold or 
purchased under the executory contract.
    (B) Certain events in a series of hedges treated as a termination of 
the hedged executory contract. If the rules of paragraph (b)(2)(iii)(B) 
of this section are not satisfied, the hedged executory contract shall 
be terminated and the provisions of paragraph (b)(4)(iii)(A) of this 
section shall apply to any gain or loss previously realized with respect 
to such hedge. Any subsequent hedging contracts entered into to reduce 
the risk of exchange rate movements with respect to such executory 
contract shall not be considered a hedge as defined in paragraph 
(b)(2)(iii) of this section.
    (C) Executory contracts between related persons. If an executory 
contract is between related persons as defined in sections 267(b) and 
707(b), and the taxpayer disposes of the hedge or terminates the 
executory contract prior to the accrual date, the Commissioner may 
redetermine the timing, source, and character of gain or loss from the 
hedge or the executory contract if he determines that a significant 
purpose for disposing of the hedge or terminating the executory contract 
prior to the accrual date was to affect the timing, source, or character 
of income, gain, expense, or loss for Federal income tax purposes.
    (iv) Disposition of a hedge on or after the accrual date. If a 
taxpayer identifies a hedge as part of a hedged executory contract as 
defined in paragraph (b)(2) of this section, and disposes of the hedge 
on or after the accrual date, no gain or loss is recognized on the hedge

[[Page 769]]

and the booking date as defined in Sec. 1.988-2(c)(2) of the payable or 
receivable for purposes of computing exchange gain or loss shall be the 
date such hedge is disposed of. See Example 3 of paragraph (b)(4)(iv) of 
this section.
    (v) Sections 263(g), 1092, and 1256 do not apply. Sections 263(g), 
1092, and 1256 do not apply with respect to an executory contract or 
hedge which comprise a hedged executory contract as defined in paragraph 
(b)(2) of this section. However, sections 263(g), 1092 and 1256 may 
apply to the hedged executory contract if such transaction is part of a 
straddle.
    (vi) Examples. The principles set forth in paragraph (b) of this 
section are illustrated in the following examples. The examples assume 
that K is an accrual method, calendar year U.S. corporation with the 
dollar as its functional currency.

    Example 1. (i) On January 1, 1992, K enters into a contract with 
JPF, a Swiss machine manufacturer, to pay 500,000 Swiss francs for 
delivery of a machine on June 1, 1993. Also on January 1, 1992, K enters 
into a foreign currency forward agreement to purchase 500,000 Swiss 
francs for $250,000 for delivery on June 1, 1993. K properly identifies 
the executory contract and the hedge in accordance with paragraph 
(b)(3)(i) of this section. On June 1, 1993, K takes delivery of the 
500,000 Swiss francs (in exchange for $250,000) under the forward 
contract and makes payment of 500,000 Swiss francs to JPF in exchange 
for the machine. Assume that the accrual date is June 1, 1993.
    (ii) Under paragraph (b)(1) of this section, the hedge is integrated 
with the executory contract. Therefore, K is deemed to have paid 
$250,000 for the machine and there is no exchange gain or loss on the 
foreign currency forward contract. K's basis in the machine is $250,000. 
Section 1256 does not apply to the forward contract.
    Example 2. (i) On January 1, 1992, K enters into a contract with S, 
a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery 
of a machine on June 1, 1993. Under the contract, K is not obligated to 
pay for the machine until September 1, 1993. On February 1, 1992, K 
enters into a foreign currency forward agreement to purchase 500,000 
Swiss francs for $250,000 for delivery on September 1, 1993. K properly 
identifies the executory contract and the hedge in accordance with 
paragraph (b)(3) of this section. On June 1, 1993, K takes delivery of 
machine. Assume that under K's method of accounting the delivery date is 
the accrual date. On September 1, 1993, K takes delivery of the 500,000 
Swiss francs (in exchange for $250,000) under the forward contract and 
makes payment of 500,000 Swiss francs to S.
    (ii) Under paragraph (b)(1) of this section, the hedge is integrated 
with the executory contract. Therefore K is deemed to have paid $250,000 
for the machine and there is no exchange gain or loss on the foreign 
currency forward contract. Thus K's basis in the machine is $250,000. In 
addition, no exchange gain or loss is recognized on the payable in 
existence from June 1, 1993, to September 1, 1993. Section 1256 does not 
apply to the forward contract.
    Example 3. The facts are the same as in Example 2 except that K 
disposed of the forward contract on August 1, 1993 for $10,000. Pursuant 
to paragraph (b)(4)(iv) of this section, K does not recognize the 
$10,000 gain. K's basis in the machine is $250,000 (the amount fixed by 
the forward contract), regardless of the amount in dollars that K 
actually pays to acquire the Sf500,000 when K pays for the machine. K 
has a payable with a booking date of August 1, 1993, payable on 
September 1, 1993 for 500,000 Swiss francs. Thus, K will realize 
exchange gain or loss on the difference between the amount booked on 
August 1, 1993 and the amount paid on September 1, 1993 under Sec. 
1.988-2(c).
    Example 4. (i) On January 1, 1992, K enters into a contract with S, 
a Swiss machine repair firm, to pay 500,000 Swiss francs for repairs to 
be performed on June 1, 1992. Under the contract, K is not obligated to 
pay for the repairs until September 1, 1992. On February 1, 1992, K 
enters into a foreign currency forward agreement to purchase 500,000 
Swiss francs for $250,000 for delivery on August 1, 1992. K properly 
identifies the executory contract and the hedge in accordance with 
paragraph (b)(3) of this section. On June 1, 1992, S performs the repair 
services. Assume that under K's method of accounting this date is the 
accrual date. On August 1, 1992, K takes delivery of the 500,000 Swiss 
francs (in exchange for $250,000) under the forward contract. On the 
same day, K deposits the Sf500,000 in a separate account with a bank and 
properly identifies the transaction as a continuation of the hedged 
executory contract. On September 1, 1992, K makes payment of the 
Sf500,000 in the account to S.
    (ii) Under paragraph (b)(1) of this section, the hedge is integrated 
with the executory contract. Therefore K is deemed to have paid $250,000 
for the services and there is no exchange gain or loss on the foreign 
currency forward contract or on the disposition of Sf500,000 in the 
account. Any interest on the Swiss francs in the account is included in 
income but is not considered part of the hedge (because the amount paid 
for the services must be set on or before the accrual date). In 
addition, no exchange gain or loss is recognized on the payable in 
existence from June

[[Page 770]]

1, 1992, to September 1, 1992. Section 1256 does not apply to the 
forward contract.
    Example 5. (i) On January 1, 1992, K enters into a contract with S, 
a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery 
of a machine on June 1, 1993. Under the contract, K is not obligated to 
pay for the machine until September 1, 1993. On February 1, 1992, K 
enters into a foreign currency forward agreement to purchase 250,000 
Swiss francs for $125,000 for delivery on September 1, 1993. K properly 
identifies the executory contract and the hedge in accordance with 
paragraph (b)(3) of this section. On June 1, 1993, K takes delivery of 
the machine. Assume that under K's method of accounting the delivery 
date is the accrual date. Assume further that the exchange rate is Sf1 = 
$.50 on June 1, 1993. On August 30, 1993, K purchases Sf250,000 for 
$135,000. On September 1, 1993, K takes delivery of the 250,000 Swiss 
francs (in exchange for $125,000) under the forward contract and makes 
payment of 500,000 Swiss francs (the Sf250,000 received under the 
contract plus the Sf250,000 purchased on August 30, 1993) to S. Assume 
the spot rate on September 1, 1993, is 1 Sf = $.5420 (Sf250,000 equal 
$135,500).
    (ii) Under paragraph (b)(1) of this section, the partial hedge is 
integrated with the executory contract. K is deemed to have paid 
$250,000 for the machine [$125,000 on the hedged portion of the 
Sf500,000 and $125,000 ($.50, the spot rate on June 1, 1993, times 
Sf250,000) on the unhedged portion of the Sf500,000]. K's basis in the 
machine therefore is $250,000. K recognizes no exchange gain or loss on 
the foreign currency forward contract but K will realize exchange gain 
of $500 on the disposition of the Sf250,000 purchased on August 30, 1993 
under Sec. 1.988-2(a). In addition, exchange loss is realized on the 
unhedged portion of the payable in existence from June 1, 1993, to 
September 1, 1993. Thus, K will realize exchange loss of $10,500 
($125,000 booked less $135,500 paid) under Sec. 1.988-2(c) on the 
payable. Section 1256 does not apply to the forward contract.
    Example 6. (i) On January 1, 1990, K enters into a contract with S, 
a Swiss steel manufacturer, to buy steel for 1,000,000 Swiss francs (Sf) 
for delivery and payment on December 31, 1990. On January 1, 1990, the 
spot rate is Sf1 = $.50, the U.S. dollar interest rate is 10% compounded 
annually, and the Swiss franc rate is 5% compounded annually. Under K's 
method of accounting, the delivery date is the accrual date.
    (ii) Assume that on January 1, 1990, K enters into a foreign 
currency forward contract to buy Sf1,000,000 for $523,800 for delivery 
on December 31, 1990. K properly identifies the executory contract and 
the hedge in accordance with paragraph (b)(3) of this section. Pursuant 
to paragraph (b)(2)(iii) of this section, the forward contract 
constitutes a hedge. Assuming that the requirements of paragraph 
(b)(2)(i) of this section are satisfied, the executory contract to buy 
steel and the forward contract are integrated under paragraph (b)(1) of 
this section. Thus, K is deemed to have paid $523,800 for the steel and 
will have a basis in the steel of $523,800. No gain or loss is realized 
with respect to the forward contract and section 1256 does not apply to 
such contract.
    (iii) Assume instead that on January 1, 1990, K enters into a 
foreign currency forward contract to buy Sf1,000,000 for $512,200 for 
delivery on July 1, 1990. K properly identifies the executory contract 
and the hedge in accordance with paragraph (b)(3) of this section. On 
July 1, 1990, when the spot rate is Sf1 = $.53, K cancels the forward 
contract in exchange for $17,800 ($530,000-$512,200). On July 1, 1990, K 
enters into a second forward agreement to buy Sf1,000,000 for $542,900 
for delivery on December 31, 1990. K properly identifies the second 
forward agreement as a hedge in accordance with paragraph (b)(3) of this 
section. Pursuant to paragraph (b)(2)(iii) of this section, the forward 
contract entered into on January 1, 1990, and the forward contract 
entered into on July 1, 1990, constitute a hedge. Assuming that the 
requirements of paragraph (b)(2)(i) of this section are satisfied, the 
executory contract to buy steel and the forward agreements are 
integrated under paragraph (b)(1) of this section. Thus, K is deemed to 
have paid $525,100 for the steel (the forward price in the second 
forward agreement of $542,900 less the gain on the first forward 
agreement of $17,800) and will have a basis in the steel of $525,100. No 
gain is realized with respect to the forward contracts and section 1256 
does not apply to such contracts.
    (iv) Assume instead that on January 1, 1990, K enters into a foreign 
currency forward contract to buy Sf1,000,000 for $512,200 for delivery 
on July 1, 1990. K properly identifies the executory contract and the 
hedge in accordance with paragraph (b)(3) of this section. On July 1, 
1990, when the spot rate is Sf1 = $.53, K enters into a historical rate 
rollover of its $17,800 gain ($530,000-$512,200) on the forward 
agreement. Thus, K enters into a second foreign currency forward 
agreement to buy Sf1,000,000 for $524,210 for delivery on December 31, 
1990. (The forward price of $524,210 is the market forward price on July 
1, 1990, for the purchase of Sf1,000,000 for delivery on December 31, 
1990, of $542,900 less the $17,800 gain on January 1, 1990, contract and 
less the time value of such gain of $890.) K properly identifies the 
second forward agreement as a hedge in accordance with paragraph (b)(3) 
of this section. On December 31, 1990, when the spot rate is Sf1 = $.54, 
K takes delivery of the Sf1,000,000 (in exchange for $524,210) and 
purchases the steel for Sf1,000,000. Pursuant to paragraph (b)(2)(iii) 
of this section, the forward contract entered

[[Page 771]]

into on January 1, 1990, and the forward contract entered into on July 
1, 1990, which incorporates the rollover of K's gain on the January 1, 
1990, contract, constitute a hedge. Assuming that the requirements of 
paragraph (b)(2)(i) of this section are satisfied, the executory 
contract to buy steel and the forward agreements are integrated under 
paragraph (b)(1) of this section. Because the period from the rollover 
date to the date payment is made under the executory contract does not 
exceed 183 days, the $890 of interest income is considered part of the 
hedge and is not recognized. Thus, K is deemed to have paid $524,210 for 
the steel and will have a basis in the steel of $524,210. No gain is 
realized with respect to the forward contracts and section 1256 does not 
apply to such contracts.
    (v) Assume instead that on January 1, 1990, K purchases Sf952,380.95 
(the present value of Sf1,000,000 to be paid on December 31, 1990) for 
$476,190.48 and on the same day deposits the Swiss francs in a separate 
bank account that bears interest at a rate of 5%, compounded annually. K 
properly identifies the transaction as a hedged executory contract. Over 
the period beginning January 1, 1990, and ending December 31, 1990, K 
receives Sf47,619.05 in interest on the account that is included in 
income and that has a basis of $25,714.29. (Assume that under Sec. 
1.988-2(b)(1), K uses the spot rate of Sf1 = $.54 to translate the 
interest income). On December 31, 1990, K makes payment of the 
Sf1,000,000 principal and accrued interest in the account to S. Pursuant 
to paragraph (b)(2)(iii) of this section, the principal in the bank 
account and the interest constitute a hedge. Under paragraph (b)(1) of 
this section, the hedge is integrated with the executory contract. 
Therefore K is deemed to have paid $501,904.77 (the basis of the 
principal deposited plus the basis of the interest) for the steel and 
there is no exchange gain or loss on the disposition of the Sf1,000,000. 
K's basis in the steel therefore is $501,904.77.

    (5) References to this paragraph (b). If the rules of this paragraph 
(b) are referred to in another paragraph of this section (e.g., 
paragraph (c) of this section), then the rules of this paragraph (b) 
shall be applied for purposes of such other paragraph by substituting 
terms appropriate for such other paragraph. For example, paragraph 
(c)(2) of this section refers to the identification rules of paragraph 
(b)(3) of this section. Accordingly, for purposes of paragraph (c)(2), 
the rules of paragraph (b)(3) will be applied by substituting the term 
``stock or security'' for ``executory contract''.
    (c) Hedges of period between trade date and settlement date on 
purchase or sale of publicly traded stock or security. If a taxpayer 
purchases or sells stocks or securities which are traded on an 
established securities market and--
    (1) Hedges all or part of such purchase or sale for any part of the 
period beginning on the trade date and ending on the settlement date; 
and
    (2) Identifies the hedge and the underlying stock or securities as 
an integrated transaction under the rules of paragraph (b)(3) of this 
section;


then any gain or loss on the hedge shall be an adjustment to the amount 
realized or the adjusted basis of the stock or securities sold or 
purchased (and shall not be taken into account as exchange gain or 
loss). The term hedge means a deposit of nonfunctional currency in a 
hedging account (within the meaning of paragraph (b)(2)(iii)(D) of this 
section), or a forward or futures contract described in Sec. 1.988-
1(a)(1)(ii) and (2)(iii), or combination thereof, which reduces the risk 
of exchange rate fluctuations for any portion of the period beginning on 
the trade date and ending on the settlement date. The provisions of 
paragraphs (b)(2)(i)(D) through (G), and (b)(2)(iii)(D) and (E) of this 
section shall apply. Sections 263(g), 1092, and 1256 do not apply with 
respect to stock or securities and a hedge which are subject to this 
paragraph (c).
    (d) [Reserved]
    (e) Advance rulings regarding net hedging and anticipatory hedging 
systems. In his sole discretion, the Commissioner may issue an advance 
ruling addressing the income tax consequences of a taxpayer's system of 
hedging either its net nonfunctional currency exposure or anticipated 
nonfunctional currency exposure. The ruling may address the character, 
source, and timing of both the section 988 transaction(s) making up the 
hedge and the underlying transactions being hedged. The procedures for 
obtaining a ruling shall be governed by such pertinent revenue 
procedures and revenue rulings as the Commissioner may provide. The 
Commissioner will not issue a ruling regarding hedges of a taxpayer's 
investment in a foreign subsidiary.
    (f) [Reserved]

[[Page 772]]

    (g) General effective date. Except as otherwise provided in this 
section, the rules of this section shall apply to qualified hedging 
transactions, hedged executory contracts and transactions described in 
paragraph (c) of this section entered into on or after September 21, 
1989. This section shall apply even if the transaction being hedged 
(e.g., the debt instrument) was entered into or acquired prior to such 
date. The effective date regarding advance rulings for net and 
anticipatory hedging shall be governed by such revenue procedures that 
the Commissioner may publish.

[T.D. 8400, 57 FR 9199, Mar. 17, 1992, as amended at T.D. 9598, 77 FR 
54809, Sept. 6, 2012; T.D. 9736, 80 FR 53733, 53735, Sept. 8, 2015]



Sec. 1.988-6  Nonfunctional currency contingent payment debt 
instruments.

    (a) In general--(1) Scope. This section determines the accrual of 
interest and the amount, timing, source, and character of any gain or 
loss on nonfunctional currency contingent payment debt instruments 
described in this paragraph (a)(1) and to which Sec. 1.1275-4(a) would 
otherwise apply if the debt instrument were denominated in the 
taxpayer's functional currency. Except as provided by the rules in this 
section, the rules in Sec. 1.1275-4 (relating to contingent payment 
debt instruments) apply to the following instruments--
    (i) A debt instrument described in Sec. 1.1275-4(b)(1) for which 
all payments of principal and interest are denominated in, or determined 
by reference to, a single nonfunctional currency and which has one or 
more non-currency related contingencies;
    (ii) A debt instrument described in Sec. 1.1275-4(b)(1) for which 
payments of principal or interest are denominated in, or determined by 
reference to, more than one currency and which has no non-currency 
related contingencies;
    (iii) A debt instrument described in Sec. 1.1275-4(b)(1) for which 
payments of principal or interest are denominated in, or determined by 
reference to, more than one currency and which has one or more non-
currency related contingencies; and
    (iv) A debt instrument otherwise described in paragraph (a)(1)(i), 
(ii) or (iii) of this section, except that the debt instrument is 
described in Sec. 1.1275-4(c)(1) rather than Sec. 1.1275-4(b)(1) 
(e.g., the instrument is issued for non-publicly traded property).
    (2) Exception for hyperinflationary currencies--(i) In general. 
Except as provided in paragraph (a)(2)(ii) of this section, this section 
shall not apply to an instrument described in paragraph (a)(1) of this 
section if any payment made under such instrument is determined by 
reference to a hyperinflationary currency, as defined in Sec. 1.985-
1(b)(2)(ii)(D). In such case, the amount, timing, source and character 
of interest, principal, foreign currency gain or loss, and gain or loss 
relating to a non-currency contingency shall be determined under the 
method that reflects the instrument's economic substance.
    (ii) Discretion as to method. If a taxpayer does not account for an 
instrument described in paragraph (a)(2)(i) of this section in a manner 
that reflects the instrument's economic substance, the Commissioner may 
apply the rules of this section to such an instrument or apply the 
principles of Sec. 1.988-2(b)(15), reasonably taking into account the 
contingent feature or features of the instrument.
    (b) Instruments described in paragraph (a)(1)(i) of this section--
(1) In general. Paragraph (b)(2) of this section provides rules for 
applying the noncontingent bond method (as set forth in Sec. 1.1275-
4(b)) in the nonfunctional currency in which a debt instrument described 
in paragraph (a)(1)(i) of this section is denominated, or by reference 
to which its payments are determined (the denomination currency). 
Paragraph (b)(3) of this section describes how amounts determined in 
paragraph (b)(2) of this section shall be translated from the 
denomination currency of the instrument into the taxpayer's functional 
currency. Paragraph (b)(4) of this section describes how gain or loss 
(other than foreign currency gain or loss) shall be determined and 
characterized with respect to the instrument. Paragraph (b)(5) of this 
section describes how foreign currency gain or loss shall be determined 
with respect to accrued interest and principal on the instrument. 
Paragraph (b)(6) of this section provides rules for determining

[[Page 773]]

the source and character of any gain or loss with respect to the 
instrument. Paragraph (b)(7) of this section provides rules for 
subsequent holders of an instrument who purchase the instrument for an 
amount other than the adjusted issue price of the instrument. Paragraph 
(c) of this section provides examples of the application of paragraph 
(b) of this section. See paragraph (d) of this section for the 
determination of the denomination currency of an instrument described in 
paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of this 
section for the treatment of an instrument described in paragraph 
(a)(1)(iv) of this section.
    (2) Application of noncontingent bond method--(i) Accrued interest. 
Interest accruals on an instrument described in paragraph (a)(1)(i) of 
this section are initially determined in the denomination currency of 
the instrument by applying the noncontingent bond method, set forth in 
Sec. 1.1275-4(b), to the instrument in its denomination currency. 
Accordingly, the comparable yield, projected payment schedule, and 
comparable fixed rate debt instrument, described in Sec. 1.1275-
4(b)(4), are determined in the denomination currency. For purposes of 
applying the noncontingent bond method to instruments described in this 
paragraph, the applicable Federal rate described in Sec. 1.1275-
4(b)(4)(i) shall be the rate described in Sec. 1.1274-4(d) with respect 
to the denomination currency.
    (ii) Net positive and negative adjustments. Positive and negative 
adjustments, and net positive and net negative adjustments, with respect 
to an instrument described in paragraph (a)(1)(i) of this section are 
determined by applying the rules of Sec. 1.1275-4(b)(6) (and Sec. 
1.1275-4(b)(9)(i) and (ii), if applicable) in the denomination currency. 
Accordingly, a net positive adjustment is treated as additional interest 
(in the denomination currency) on the instrument. A net negative 
adjustment first reduces interest that otherwise would be accrued by the 
taxpayer during the current tax year in the denomination currency. If a 
net negative adjustment exceeds the interest that would otherwise be 
accrued by the taxpayer during the current tax year in the denomination 
currency, the excess is treated as ordinary loss (if the taxpayer is a 
holder of the instrument) or ordinary income (if the taxpayer is the 
issuer of the instrument). The amount treated as ordinary loss by a 
holder with respect to a net negative adjustment is limited, however, to 
the amount by which the holder's total interest inclusions on the debt 
instrument (determined in the denomination currency) exceed the total 
amount of the holder's net negative adjustments treated as ordinary loss 
on the debt instrument in prior taxable years (determined in the 
denomination currency). Similarly, the amount treated as ordinary income 
by an issuer with respect to a net negative adjustment is limited to the 
amount by which the issuer's total interest deductions on the debt 
instrument (determined in the denomination currency) exceed the total 
amount of the issuer's net negative adjustments treated as ordinary 
income on the debt instrument in prior taxable years (determined in the 
denomination currency). To the extent a net negative adjustment exceeds 
the current year's interest accrual and the amount treated as ordinary 
loss to a holder (or ordinary income to the issuer), the excess is 
treated as a negative adjustment carryforward, within the meaning of 
Sec. 1.1275-4(b)(6)(iii)(C), in the denomination currency.
    (iii) Adjusted issue price. The adjusted issue price of an 
instrument described in paragraph (a)(1)(i) of this section is 
determined by applying the rules of Sec. 1.1275-4(b)(7) in the 
denomination currency. Accordingly, the adjusted issue price is equal to 
the debt instrument's issue price in the denomination currency, 
increased by the interest previously accrued on the debt instrument 
(determined without regard to any net positive or net negative 
adjustments on the instrument) and decreased by the amount of any 
noncontingent payment and the projected amount of any contingent payment 
previously made on the instrument. All adjustments to the adjusted issue 
price are calculated in the denomination currency.
    (iv) Adjusted basis. The adjusted basis of an instrument described 
in paragraph (a)(1)(i) of this section is determined by applying the 
rules of Sec. 1.1275-4(b)(7) in the taxpayer's functional currency. In 
accordance with those rules,

[[Page 774]]

a holder's basis in the debt instrument is increased by the interest 
previously accrued on the debt instrument (translated into functional 
currency), without regard to any net positive or net negative 
adjustments on the instrument (except as provided in paragraph (b)(7) or 
(8) of this section, if applicable), and decreased by the amount of any 
noncontingent payment and the projected amount of any contingent payment 
previously made on the instrument to the holder (translated into 
functional currency). See paragraph (b)(3)(iii) of this section for 
translation rules.
    (v) Amount realized. The amount realized by a holder and the 
repurchase price paid by the issuer on the scheduled or unscheduled 
retirement of a debt instrument described in paragraph (a)(1)(i) of this 
section are determined by applying the rules of Sec. 1.1275-4(b)(7) in 
the denomination currency. For example, with regard to a scheduled 
retirement at maturity, the holder is treated as receiving the projected 
amount of any contingent payment due at maturity, reduced by the amount 
of any negative adjustment carryforward. For purposes of translating the 
amount realized by the holder into functional currency, the rules of 
paragraph (b)(3)(iv) of this section shall apply.
    (3) Treatment and translation of amounts determined under 
noncontingent bond method--(i) Accrued interest. The amount of accrued 
interest, determined under paragraph (b)(2)(i) of this section, is 
translated into the taxpayer's functional currency at the average 
exchange rate, as described in Sec. 1.988-2(b)(2)(iii)(A), or, at the 
taxpayer's election, at the appropriate spot rate, as described in Sec. 
1.988-2(b)(2)(iii)(B).
    (ii) Net positive and negative adjustments--(A) Net positive 
adjustments. A net positive adjustment, as referenced in paragraph 
(b)(2)(ii) of this section, is translated into the taxpayer's functional 
currency at the spot rate on the last day of the taxable year in which 
the adjustment is taken into account under Sec. 1.1275-4(b)(6), or, if 
earlier, the date the instrument is disposed of or otherwise terminated.
    (B) Net negative adjustments. A net negative adjustment is treated 
and, where necessary, is translated from the denomination currency into 
the taxpayer's functional currency under the following rules:
    (1) The amount of a net negative adjustment determined in the 
denomination currency that reduces the current year's interest in that 
currency shall first reduce the current year's accrued but unpaid 
interest, and then shall reduce the current year's interest which was 
accrued and paid. No translation is required.
    (2) The amount of a net negative adjustment treated as ordinary 
income or loss under Sec. 1.1275-4(b)(6)(iii)(B) first is attributable 
to accrued but unpaid interest accrued in prior taxable years. For this 
purpose, the net negative adjustment shall be treated as attributable to 
any unpaid interest accrued in the immediately preceding taxable year, 
and thereafter to unpaid interest accrued in each preceding taxable 
year. The amount of the net negative adjustment applied to accrued but 
unpaid interest is translated into functional currency at the same rate 
used, in each of the respective prior taxable years, to translate the 
accrued interest.
    (3) Any amount of the net negative adjustment remaining after the 
application of paragraphs (b)(3)(ii)(B)(1) and (2) of this section is 
attributable to interest accrued and paid in prior taxable years. The 
amount of the net negative adjustment applied to such amounts is 
translated into functional currency at the spot rate on the date the 
debt instrument was issued or, if later, acquired.
    (4) Any amount of the net negative adjustment remaining after 
application of paragraphs (b)(3)(ii)(B)(1), (2) and (3) of this section 
is a negative adjustment carryforward, within the meaning of Sec. 
1.1275-4(b)(6)(iii)(C). A negative adjustment carryforward is carried 
forward in the denomination currency and is applied to reduce interest 
accruals in subsequent years. In the year in which the instrument is 
sold, exchanged or retired, any negative adjustment carryforward not 
applied to interest reduces the holder's amount realized on the 
instrument (in the denomination currency). An issuer of a debt 
instrument described in paragraph (a)(1)(i) of this section who takes 
into income a negative adjustment

[[Page 775]]

carryforward (that is not applied to interest) in the year the 
instrument is retired, as described in Sec. 1.1275-4(b)(6)(iii)(C), 
translates such income into functional currency at the spot rate on the 
date the instrument was issued.
    (iii) Adjusted basis--(A) In general. Except as otherwise provided 
in this paragraph and paragraph (b)(7) or (8) of this section, a holder 
determines and maintains adjusted basis by translating the denomination 
currency amounts determined under Sec. 1.1275-4(b)(7)(iii) into 
functional currency as follows:
    (1) The holder's initial basis in the instrument is determined by 
translating the amount paid by the holder to acquire the instrument (in 
the denomination currency) into functional currency at the spot rate on 
the date the instrument was issued or, if later, acquired.
    (2) An increase in basis attributable to interest accrued on the 
instrument is translated at the rate applicable to such interest under 
paragraph (b)(3)(i) of this section.
    (3) Any noncontingent payment and the projected amount of any 
contingent payments determined in the denomination currency that 
decrease the holder's basis in the instrument under Sec. 1.1275-
4(b)(7)(iii) are translated as follows:
    (i) The payment first is attributable to the most recently accrued 
interest to which prior amounts have not already been attributed. The 
payment is translated into functional currency at the rate at which the 
interest was accrued.
    (ii) Any amount remaining after the application of paragraph 
(b)(3)(iii)(A)(3)(i) of this section is attributable to principal. Such 
amounts are translated into functional currency at the spot rate on the 
date the instrument was issued or, if later, acquired.
    (B) Exception for interest reduced by a negative adjustment 
carryforward. Solely for purposes of this Sec. 1.988-6, any amounts of 
accrued interest income that are reduced as a result of a negative 
adjustment carryforward shall be treated as principal and translated at 
the spot rate on the date the instrument was issued or, if later, 
acquired.
    (iv) Amount realized--(A) Instrument held to maturity--(1) In 
general. With respect to an instrument held to maturity, a holder 
translates the amount realized by separating such amount in the 
denomination currency into the component parts of interest and principal 
that make up adjusted basis prior to translation under paragraph 
(b)(3)(iii) of this section, and translating each of those component 
parts of the amount realized at the same rate used to translate the 
respective component parts of basis under paragraph (b)(3)(iii) of this 
section. The amount realized first shall be translated by reference to 
the component parts of basis consisting of accrued interest during the 
taxpayer's holding period as determined under paragraph (b)(3)(iii) of 
this section and ordering such amounts on a last in first out basis. Any 
remaining portion of the amount realized shall be translated by 
reference to the rate used to translate the component of basis 
consisting of principal as determined under paragraph (b)(3)(iii) of 
this section.
    (2) Subsequent purchases at discount and fixed but deferred 
contingent payments. For purposes of this paragraph (b)(3)(iv) of this 
section, any amount which is required to be added to adjusted basis 
under paragraph (b)(7) or (8) of this section shall be treated as 
additional interest which was accrued on the date the amount was added 
to adjusted basis. To the extent included in amount realized, such 
amounts shall be translated into functional currency at the same rates 
at which they were translated for purposes of determining adjusted 
basis. See paragraphs (b)(7)(iv) and (b)(8) of this section for rules 
governing the rates at which the amounts are translated for purposes of 
determining adjusted basis.
    (B) Sale, exchange, or unscheduled retirement--(1) Holder. In the 
case of a sale, exchange, or unscheduled retirement, application of the 
rule stated in paragraph (b)(3)(iv)(A) of this section shall be as 
follows. The holder's amount realized first shall be translated by 
reference to the principal component of basis as determined under 
paragraph (b)(3)(iii) of this section, and then to the component of 
basis consisting of accrued interest as

[[Page 776]]

determined under paragraph (b)(3)(iii) of this section and ordering such 
amounts on a first in first out basis. Any gain recognized by the holder 
(i.e., any excess of the sale price over the holder's basis, both 
expressed in the denomination currency) is translated into functional 
currency at the spot rate on the payment date.
    (2) Issuer. In the case of an unscheduled retirement of the debt 
instrument, any excess of the adjusted issue price of the debt 
instrument over the amount paid by the issuer (expressed in denomination 
currency) shall first be attributable to accrued unpaid interest, to the 
extent the accrued unpaid interest had not been previously offset by a 
negative adjustment, on a last-in-first-out basis, and then to 
principal. The accrued unpaid interest shall be translated into 
functional currency at the rate at which the interest was accrued. The 
principal shall be translated at the spot rate on the date the debt 
instrument was issued.
    (C) Effect of negative adjustment carryforward with respect to the 
issuer. Any amount of negative adjustment carryforward treated as 
ordinary income under Sec. 1.1275-4(b)(6)(iii)(C) shall be translated 
at the exchange rate on the day the debt instrument was issued.
    (4) Determination of gain or loss not attributable to foreign 
currency. A holder of a debt instrument described in paragraph (a)(1)(i) 
of this section shall recognize gain or loss upon sale, exchange, or 
retirement of the instrument equal to the difference between the amount 
realized with respect to the instrument, translated into functional 
currency as described in paragraph (b)(3)(iv) of this section, and the 
adjusted basis in the instrument, determined and maintained in 
functional currency as described in paragraph (b)(3)(iii) of this 
section. The amount of any gain or loss so determined is characterized 
as provided in Sec. 1.1275-4(b)(8), and sourced as provided in 
paragraph (b)(6) of this section.
    (5) Determination of foreign currency gain or loss--(i) In general. 
Other than in a taxable disposition of the debt instrument, foreign 
currency gain or loss is recognized with respect to a debt instrument 
described in paragraph (a)(1)(i) of this section only when payments are 
made or received. No foreign currency gain or loss is recognized with 
respect to a net positive or negative adjustment, as determined under 
paragraph (b)(2)(ii) of this section (except with respect to a positive 
adjustment described in paragraph (b)(8) of this section). As described 
in this paragraph (b)(5), foreign currency gain or loss is determined in 
accordance with the rules of Sec. 1.988-2(b).
    (ii) Foreign currency gain or loss attributable to accrued interest. 
The amount of foreign currency gain or loss recognized with respect to 
payments of interest previously accrued on the instrument is determined 
by translating the amount of interest paid or received into functional 
currency at the spot rate on the date of payment and subtracting from 
such amount the amount determined by translating the interest paid or 
received into functional currency at the rate at which such interest was 
accrued under the rules of paragraph (b)(3)(i) of this section. For 
purposes of this paragraph, the amount of any payment that is treated as 
accrued interest shall be reduced by the amount of any net negative 
adjustment treated as ordinary loss (to the holder) or ordinary income 
(to the issuer), as provided in paragraph (b)(2)(ii) of this section. 
For purposes of determining whether the payment consists of interest or 
principal, see the payment ordering rules in paragraph (b)(5)(iv) of 
this section.
    (iii) Principal. The amount of foreign currency gain or loss 
recognized with respect to payment or receipt of principal is determined 
by translating the amount paid or received into functional currency at 
the spot rate on the date of payment or receipt and subtracting from 
such amount the amount determined by translating the principal into 
functional currency at the spot rate on the date the instrument was 
issued or, in case of the holder, if later, acquired. For purposes of 
determining whether the payment consists of interest or principal, see 
the payment ordering rules in paragraph (b)(5)(iv) of this section.

[[Page 777]]

    (iv) Payment ordering rules--(A) In general. Except as provided in 
paragraph (b)(5)(iv)(B) of this section, payments with respect to an 
instrument described in paragraph (a)(1)(i) of this section shall be 
treated as follows:
    (1) A payment shall first be attributable to any net positive 
adjustment on the instrument that has not previously been taken into 
account.
    (2) Any amount remaining after applying paragraph (b)(5)(iv)(A)(1) 
of this section shall be attributable to accrued but unpaid interest, 
remaining after reduction by any net negative adjustment, and shall be 
attributable to the most recent accrual period to the extent prior 
amounts have not already been attributed to such period.
    (3) Any amount remaining after applying paragraphs (b)(5)(iv)(A)(1) 
and (2) of this section shall be attributable to principal. Any interest 
paid in the current year that is reduced by a net negative adjustment 
shall be considered a payment of principal for purposes of determining 
foreign currency gain or loss.
    (B) Special rule for sale or exchange or unscheduled retirement. 
Payments made or received upon a sale or exchange or unscheduled 
retirement shall first be applied against the principal of the debt 
instrument (or in the case of a subsequent purchaser, the purchase price 
of the instrument in denomination currency) and then against accrued 
unpaid interest (in the case of a holder, accrued while the holder held 
the instrument).
    (C) Subsequent purchaser that has a positive adjustment allocated to 
a daily portion of interest. A positive adjustment that is allocated to 
a daily portion of interest pursuant to paragraph (b)(7)(iv) of this 
section shall be treated as interest for purposes of applying the 
payment ordering rule of this paragraph (b)(5)(iv).
    (6) Source of gain or loss. The source of foreign currency gain or 
loss recognized with respect to an instrument described in paragraph 
(a)(1)(i) of this section shall be determined pursuant to Sec. 1.988-4. 
Consistent with the rules of Sec. 1.1275-4(b)(8), all gain (other than 
foreign currency gain) on an instrument described in paragraph (a)(1)(i) 
of this section is treated as interest income for all purposes. The 
source of an ordinary loss (other than foreign currency loss) with 
respect to an instrument described in paragraph (a)(1)(i) of this 
section shall be determined pursuant to Sec. 1.1275-4(b)(9)(iv). The 
source of a capital loss with respect to an instrument described in 
paragraph (a)(1)(i) of this section shall be determined pursuant to 
Sec. 1.865-1(b)(2).
    (7) Basis different from adjusted issue price--(i) In general. The 
rules of Sec. 1.1275-4(b)(9)(i), except as set forth in this paragraph 
(b)(7), shall apply to an instrument described in paragraph (a)(1)(i) of 
this section purchased by a subsequent holder for more or less than the 
instrument's adjusted issue price.
    (ii) Determination of basis. If an instrument described in paragraph 
(a)(1)(i) of this section is purchased by a subsequent holder, the 
subsequent holder's initial basis in the instrument shall equal the 
amount paid by the holder to acquire the instrument, translated into 
functional currency at the spot rate on the date of acquisition.
    (iii) Purchase price greater than adjusted issue price. If the 
purchase price of the instrument (determined in the denomination 
currency) exceeds the adjusted issue price of the instrument, the holder 
shall, consistent with the rules of Sec. 1.1275-4(b)(9)(i)(B), 
reasonably allocate such excess to the daily portions of interest 
accrued on the instrument or to a projected payment on the instrument. 
To the extent attributable to interest, the excess shall be reasonably 
allocated over the remaining term of the instrument to the daily 
portions of interest accrued and shall be a negative adjustment on the 
dates the daily portions accrue. On the date of such adjustment, the 
holder's adjusted basis in the instrument is reduced by the amount 
treated as a negative adjustment under this paragraph (b)(7)(iii), 
translated into functional currency at the rate used to translate the 
interest which is offset by the negative adjustment. To the extent 
related to a projected payment, such excess shall be treated as a 
negative adjustment on the date the payment is made. On the date of such 
adjustment, the holder's

[[Page 778]]

adjusted basis in the instrument is reduced by the amount treated as a 
negative adjustment under this paragraph (b)(7)(iii), translated into 
functional currency at the spot rate on the date the instrument was 
acquired.
    (iv) Purchase price less than adjusted issue price. If the purchase 
price of the instrument (determined in the denomination currency) is 
less than the adjusted issue price of the instrument, the holder shall, 
consistent with the rules of Sec. 1.1275-4(b)(9)(i)(C), reasonably 
allocate the difference to the daily portions of interest accrued on the 
instrument or to a projected payment on the instrument. To the extent 
attributable to interest, the difference shall be reasonably allocated 
over the remaining term of the instrument to the daily portions of 
interest accrued and shall be a positive adjustment on the dates the 
daily portions accrue. On the date of such adjustment, the holder's 
adjusted basis in the instrument is increased by the amount treated as a 
positive adjustment under this paragraph (b)(7)(iv), translated into 
functional currency at the rate used to translate the interest to which 
it relates. For purposes of determining adjusted basis under paragraph 
(b)(3)(iii) of this section, such increase in adjusted basis shall be 
treated as an additional accrual of interest during the period to which 
the positive adjustment relates. To the extent related to a projected 
payment, such difference shall be treated as a positive adjustment on 
the date the payment is made. On the date of such adjustment, the 
holder's adjusted basis in the instrument is increased by the amount 
treated as a positive adjustment under this paragraph (b)(7)(iv), 
translated into functional currency at the spot rate on the date the 
adjustment is taken into account. For purposes of determining the amount 
realized on the instrument in functional currency under paragraph 
(b)(3)(iv) of this section, amounts attributable to the excess of the 
adjusted issue price of the instrument over the purchase price of the 
instrument shall be translated into functional currency at the same rate 
at which the corresponding adjustments are taken into account under this 
paragraph (b)(7)(iv) for purposes of determining the adjusted basis of 
the instrument.
    (8) Fixed but deferred contingent payments. In the case of an 
instrument with a contingent payment that becomes fixed as to amount 
before the payment is due, the rules of Sec. 1.1275-4(b)(9)(ii) shall 
be applied in the denomination currency of the instrument. For this 
purpose, foreign currency gain or loss shall be recognized on the date 
payment is made or received with respect to the instrument under the 
principles of paragraph (b)(5) of this section. Any increase or decrease 
in basis required under Sec. 1.1275-4(b)(9)(ii)(D) shall be taken into 
account at the same exchange rate as the corresponding net positive or 
negative adjustment is taken into account.
    (c) Examples. The provisions of paragraph (b) of this section may be 
illustrated by the following examples. In each example, assume that the 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the 
instrument is a debt instrument for federal income tax purposes. The 
examples are as follows:

    Example 1. Treatment of net positive adjustment. (i) Facts. On 
December 31, 2004, Z, a calendar year U.S. resident taxpayer whose 
functional currency is the U.S. dollar, purchases from a foreign 
corporation, at original issue, a zero-coupon debt instrument with a 
non-currency contingency for [pound]1000. All payments of principal and 
interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the British 
pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it 
were denominated in dollars. The debt instrument's comparable yield, 
determined in British pounds under paragraph (b)(2)(i) of this section 
and Sec. 1.1275-4(b), is 10 percent, compounded annually, and the 
projected payment schedule, as constructed under the rules of Sec. 
1.1275-4(b), provides for a single payment of [pound]1210 on December 
31, 2006 (consisting of a noncontingent payment of [pound]975 and a 
projected payment of [pound]235). The debt instrument is a capital asset 
in the hands of Z. Z does not elect to use the spot-rate convention 
described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on 
December 31, 2006, is [pound]1300. The relevant pound/dollar spot rates 
over the term of the instrument are as follows:

[[Page 779]]



------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2004.......................  [pound]1.00 = $1.00
Dec. 31, 2005.......................  [pound]1.00 = $1.10
Dec. 31, 2006.......................  [pound]1.00 = $1.20
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
2005................................  [pound]1.00 = $1.05
2006................................  [pound]1.00 = $1.15
------------------------------------------------------------------------

    (ii) Treatment in 2005--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]100 of interest on the debt instrument for 2005 (issue 
price of [pound]1000 x 10 percent). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]100 at the average exchange rate for 
the accrual period ($1.05 x [pound]100 = $105). Accordingly, Z has 
interest income in 2005 of $105.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued in 2005. Thus, on 
January 1, 2006, the adjusted issue price of the debt instrument is 
[pound]1100. For purposes of determining Z's dollar basis in the debt 
instrument, the $1000 basis ($1.00 x [pound]1000 original cost basis) is 
increased by the [pound]100 of accrued interest, translated at the rate 
at which interest was accrued for 2005. See paragraph (b)(3)(iii) of 
this section. Accordingly, Z's adjusted basis in the debt instrument as 
of January 1, 2006, is $1105.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the comparable 
yield, Z accrues [pound]110 of interest on the debt instrument for 2006 
(adjusted issue price of [pound]1100 x 10 percent). Under paragraph 
(b)(3)(i) of this section, Z translates the [pound]110 at the average 
exchange rate for the accrual period ($1.15 x [pound]110 = $126.50). 
Accordingly, Z has interest income in 2006 of $126.50.
    (B) Effect of net positive adjustment. The payment actually made on 
December 31, 2006, is [pound]1300, rather than the projected 
[pound]1210. Under paragraph (b)(2)(ii) of this section, Z has a net 
positive adjustment of [pound]90 on December 31, 2006, attributable to 
the difference between the amount of the actual payment and the amount 
of the projected payment. Under paragraph (b)(3)(ii)(A) of this section, 
the [pound]90 net positive adjustment is treated as additional interest 
income and is translated into dollars at the spot rate on the last day 
of the year ($1.20 x [pound]90 = $108). Accordingly, Z has a net 
positive adjustment of $108 resulting in a total interest inclusion for 
2006 of $234.50 ($126.50 + $108 = $234.50).
    (C) Adjusted issue price and basis. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument immediately 
before the payment at maturity is [pound]1210 ([pound]1100 plus 
[pound]110 of accrued interest for 2006). Z's adjusted basis in dollars, 
based only on the noncontingent payment and the projected amount of the 
contingent payment to be received, is $1231.50 ($1105 plus $126.50 of 
accrued interest for 2006).
    (D) Amount realized. Even though Z receives [pound]1300 at maturity, 
for purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected amount of 
the contingent payment on December 31, 2006. Therefore, Z is treated as 
receiving [pound]1210 on December 31, 2006. Under paragraph (b)(3)(iv) 
of this section, Z translates its amount realized into dollars and 
computes its gain or loss on the instrument (other than foreign currency 
gain or loss) by breaking the amount realized into its component parts. 
Accordingly, [pound]100 of the [pound]1210 (representing the interest 
accrued in 2005) is translated at the rate at which it was accrued 
([pound]1 = $1.05), resulting in an amount realized of $105; [pound]110 
of the [pound]1210 (representing the interest accrued in 2006) is 
translated into dollars at the rate at which it was accrued ([pound]1 = 
$1.15), resulting in an amount realized of $126.50; and [pound]1000 of 
the [pound]1210 (representing a return of principal) is translated into 
dollars at the spot rate on the date the instrument was purchased 
([pound]1 = $1), resulting in an amount realized of $1000. Z's total 
amount realized is $1231.50, the same as its basis, and Z recognizes no 
gain or loss (before consideration of foreign currency gain or loss) on 
retirement of the instrument.
    (E) Foreign currency gain or loss. Under paragraph (b)(5) of this 
section Z recognizes foreign currency gain under section 988 on the 
instrument with respect to the consideration actually received at 
maturity (except for the net positive adjustment), [pound]1210. The 
amount of recognized foreign currency gain is determined based on the 
difference between the spot rate on the date the instrument matures and 
the rates at which the principal and interest were taken into account. 
With respect to the portion of the payment attributable to interest 
accrued in 2005, the foreign currency gain is $15 [[pound]100 x ($1.20-
$1.05)]. With respect to interest accrued in 2006, the foreign currency 
gain equals $5.50 [[pound]110 x ($1.20-$1.15)]. With respect to 
principal, the foreign currency gain is $200 [[pound]1000 x ($1.20-
$1.00)]. Thus, Z recognizes a total foreign currency gain on December 
31, 2006, of $220.50.
    (F) Source. Z has interest income of $105 in 2005, interest income 
of $234.50 in 2006 (attributable to [pound]110 of accrued interest and 
the [pound]90 net positive adjustment), and a foreign currency gain of 
$220.50 in 2006. Under paragraph (b)(6) of this section and section 
862(a)(1), the interest income is sourced by reference to the residence 
of the payor and is therefore from sources without the United States.

[[Page 780]]

Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign 
currency gain of $220.50 is sourced by reference to Z's residence and is 
therefore from sources within the United States.
    Example 2. Treatment of net negative adjustment. (i) Facts. Assume 
the same facts as in Example 1, except that Z receives [pound]975 at 
maturity instead of [pound]1300.
    (ii) Treatment in 2005. The treatment of the debt instrument in 2005 
is the same as in Example 1. Thus, Z has interest income in 2005 of 
$105. On January 1, 2006, the adjusted issue price of the debt 
instrument is [pound]1100, and Z's adjusted basis in the instrument is 
$1105.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section and based on the comparable 
yield, Z's accrued interest for 2006 is [pound]110 (adjusted issue price 
of [pound]1100 x 10 percent). Under paragraph (b)(3)(i) of this section, 
the [pound]110 of accrued interest is translated at the average exchange 
rate for the accrual period ($1.15 x [pound]110 = $126.50).
    (B) Effect of net negative adjustment. The payment actually made on 
December 31, 2006, is [pound]975, rather than the projected [pound]1210. 
Under paragraph (b)(2)(ii) of this section, Z has a net negative 
adjustment of [pound]235 on December 31, 2006, attributable to the 
difference between the amount of the actual payment and the amount of 
the projected payment. Z's accrued interest income of [pound]110 in 2006 
is reduced to zero by the net negative adjustment. Under paragraph 
(b)(3)(ii)(B)(1) of this section the net negative adjustment which 
reduces the current year's interest is not translated into functional 
currency. Under paragraph (b)(2)(ii) of this section, Z treats the 
remaining [pound]125 net negative adjustment as an ordinary loss to the 
extent of the [pound]100 previously accrued interest in 2005. This 
[pound]100 ordinary loss is attributable to interest accrued but not 
paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) 
of this section, Z translates the loss into dollars at the average rate 
for such year ([pound]1 = $1.05). Accordingly, Z has an ordinary loss of 
$105 in 2006. The remaining [pound]25 of net negative adjustment is a 
negative adjustment carryforward under paragraph (b)(2)(ii) of this 
section.
    (C) Adjusted issue price and basis. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument immediately 
before the payment at maturity is [pound]1210 ([pound]1100 plus 
[pound]110 of accrued interest for 2006). Z's adjusted basis in dollars, 
based only on the noncontingent payments and the projected amount of the 
contingent payments to be received, is $1231.50 ($1105 plus $126.50 of 
accrued interest for 2006).
    (D) Amount realized. Even though Z receives [pound]975 at maturity, 
for purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected amount of 
the contingent payment on December 31, 2006, reduced by the amount of 
Z's negative adjustment carryforward of [pound]25. Therefore, Z is 
treated as receiving [pound]1185 ([pound]1210-[pound]25) on December 31, 
2006. Under paragraph (b)(3)(iv) of this section, Z translates its 
amount realized into dollars and computes its gain or loss on the 
instrument (other than foreign currency gain or loss) by breaking the 
amount realized into its component parts. Accordingly, [pound]100 of the 
[pound]1185 (representing the interest accrued in 2005) is translated at 
the rate at which it was accrued ([pound]1 = $1.05), resulting in an 
amount realized of $105; [pound]110 of the [pound]1185 (representing the 
interest accrued in 2006) is translated into dollars at the rate at 
which it was accrued ([pound]1 = $1.15), resulting in an amount realized 
of $126.50; and [pound]975 of the [pound]1185 (representing a return of 
principal) is translated into dollars at the spot rate on the date the 
instrument was purchased ([pound]1 = $1), resulting in an amount 
realized of $975. Z's amount realized is $1206.50 ($105 + $126.50 + $975 
= $1206.50), and Z recognizes a capital loss (before consideration of 
foreign currency gain or loss) of $25 on retirement of the instrument 
($1206.50-$1231.50 = -$25).
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to the consideration actually received at maturity, 
[pound]975. Under paragraph (b)(5)(ii) of this section, no foreign 
currency gain or loss is recognized with respect to unpaid accrued 
interest reduced to zero by the net negative adjustment resulting in 
2006. In addition, no foreign currency gain or loss is recognized with 
respect to unpaid accrued interest from 2005, also reduced to zero by 
the ordinary loss. Accordingly, Z recognizes foreign currency gain with 
respect to principal only. Thus, Z recognizes a total foreign currency 
gain on December 31, 2006, of $195 [[pound]975 x ($1.20-$1.00)].
    (F) Source. In 2006, Z has an ordinary loss of $105, a capital loss 
of $25, and a foreign currency gain of $195. Under paragraph (b)(6) of 
this section and Sec. 1.1275-4(b)(9)(iv), the $105 ordinary loss 
generally reduces Z's foreign source passive income under section 904(d) 
and the regulations thereunder. Under paragraph (b)(6) of this section 
and Sec. 1.865-1(b)(2), the $25 capital loss is sourced by reference to 
how interest income on the instrument would have been sourced. 
Therefore, the $25 capital loss generally reduces Z's foreign source 
passive income under section 904(d) and the regulations thereunder. 
Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign 
currency gain of $195 is sourced by reference to Z's residence and is 
therefore from sources within the United States.
    Example 3. Negative adjustment and periodic interest payments. (i) 
Facts. On December 31, 2004, Z, a calendar year U.S. resident taxpayer 
whose functional currency is the U.S. dollar, purchases from a foreign 
corporation, at original issue, a two-year debt instrument

[[Page 781]]

with a non-currency contingency for [pound]1000. All payments of 
principal and interest with respect to the instrument are denominated 
in, or determined by reference to, a single nonfunctional currency (the 
British pound). The debt instrument would be subject to Sec. 1.1275-
4(b) if it were denominated in dollars. The debt instrument's comparable 
yield, determined in British pounds under Sec. Sec. 1.988-2(b)(2) and 
1.1275-4(b), is 10 percent, compounded semiannually. The debt instrument 
provides for semiannual interest payments of [pound]30 payable each June 
30, and December 31, and a contingent payment at maturity on December 
31, 2006, which is projected to equal [pound]1086.20 (consisting of a 
noncontingent payment of [pound]980 and a projected payment of 
[pound]106.20) in addition to the interest payable at maturity. The debt 
instrument is a capital asset in the hands of Z. Z does not elect to use 
the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The 
payment actually made on December 31, 2006, is [pound]981.00. The 
relevant pound/dollar spot rates over the term of the instrument are as 
follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2004.......................  [pound]1.00 = $1.00
June 30, 2005.......................  [pound]1.00 = $1.20
Dec. 31, 2005.......................  [pound]1.00 = $1.40
June 30, 2006.......................  [pound]1.00 = $1.60
Dec. 31, 2006.......................  [pound]1.00 = $1.80
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
Jan.-June 2005......................  [pound]1.00 = $1.10
July-Dec. 2005......................  [pound]1.00 = $1.30
Jan.-June 2006......................  [pound]1.00 = $1.50
July-Dec. 2006......................  [pound]1.00 = $1.70
------------------------------------------------------------------------

    (ii) Treatment in 2005--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]50 of interest on the debt instrument for the January-
June accrual period (issue price of [pound]1000 x 10 percent/2). Under 
paragraph (b)(3)(i) of this section, Z translates the [pound]50 at the 
average exchange rate for the accrual period ($1.10 x [pound]50 = 
$55.00). Similarly, Z accrues [pound]51 of interest in the July-December 
accrual period [([pound]1000 + [pound]50-[pound]30) x 10 percent/2], 
which is translated at the average exchange rate for the accrual period 
($1.30 x [pound]51 = $66.30). Accordingly, Z accrues $121.30 of interest 
income in 2005.
    (B) Adjusted issue price and basis--(1) January-June accrual period. 
Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted 
issue price of the debt instrument determined in pounds and Z's adjusted 
basis in dollars in the debt instrument are increased by the interest 
accrued, and decreased by the interest payment made, in the January-June 
accrual period. Thus, on July 1, 2005, the adjusted issue price of the 
debt instrument is [pound]1020 ([pound]1000 + [pound]50 - [pound]30 = 
[pound]1020). For purposes of determining Z's dollar basis in the debt 
instrument, the $1000 basis is increased by the [pound]50 of accrued 
interest, translated, under paragraph (b)(3)(iii) of this section, at 
the rate at which interest was accrued for the January-June accrual 
period ($1.10 x [pound]50 = $55). The resulting amount is reduced by the 
[pound]30 payment of interest made during the accrual period, 
translated, under paragraph (b)(3)(iii) of this section and Sec. 1.988-
2(b)(7), at the rate applicable to accrued interest ($1.10 x [pound]30 = 
$33). Accordingly, Z's adjusted basis as of July 1, 2005, is $1022 
($1000 + $55 - $33).
    (2) July-December accrual period. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued, and decreased by the 
interest payment made, in the July-December accrual period. Thus, on 
January 1, 2006, the adjusted issue price of the instrument is 
[pound]1041 ([pound]1020 + [pound]51 - [pound]30 = [pound]1041). For 
purposes of determining Z's dollar basis in the debt instrument, the 
$1022 basis is increased by the [pound]51 of accrued interest, 
translated, under paragraph (b)(3)(iii) of this section, at the rate at 
which interest was accrued for the July-December accrual period ($1.30 x 
[pound]51 = $66.30). The resulting amount is reduced by the [pound]30 
payment of interest made during the accrual period, translated, under 
paragraph (b)(3)(iii) of this section and Sec. 1.988-2(b)(7), at the 
rate applicable to accrued interest ($1.30 x [pound]30 = $39). 
Accordingly, Z's adjusted basis as of January 1, 2006, is $1049.30 
($1022 + $66.30 - $39).
    (C) Foreign currency gain or loss. Z will recognize foreign currency 
gain on the receipt of each [pound]30 payment of interest actually 
received during 2005. The amount of foreign currency gain in each case 
is determined, under paragraph (b)(5)(ii) of this section, by reference 
to the difference between the spot rate on the date the [pound]30 
payment was made and the average exchange rate for the accrual period 
during which the interest accrued. Accordingly, Z recognizes $3 of 
foreign currency gain on the January-June interest payment [[pound]30 x 
($1.20 - $1.10)], and $3 of foreign currency gain on the July-December 
interest payment [[pound]30 x ($1.40 - $1.30)]. Z recognizes in 2005 a 
total of $6 of foreign currency gain.
    (D) Source. Z has interest income of $121.30 and a foreign currency 
gain of $6. Under paragraph (b)(6) of this section and section 
862(a)(1), the interest income is sourced by reference to the residence 
of the payor and is therefore from sources without the United States. 
Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign 
currency gain of $6 is sourced by reference to Z's residence and is 
therefore from sources within the United States.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of

[[Page 782]]

this section, and based on the comparable yield, Z's accrued interest 
for the January-June accrual period is [pound]52.05 (adjusted issue 
price of [pound]1041 x 10 percent/2). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]52.05 at the average exchange rate for 
the accrual period ($1.50 x [pound]52.05 = $78.08). Similarly, Z accrues 
[pound]53.15 of interest in the July-December accrual period 
[([pound]1041 + [pound]52.05-[pound]30) x 10 percent/2], which is 
translated at the average exchange rate for the accrual period ($1.70 x 
[pound]53.15 = $90.35). Accordingly, Z accrues [pound]105.20, or 
$168.43, of interest income in 2006.
    (B) Effect of net negative adjustment. The payment actually made on 
December 31, 2006, is [pound]981.00, rather than the projected 
[pound]1086.20. Under paragraph (b)(2)(ii)(B) of this section, Z has a 
net negative adjustment of [pound]105.20 on December 31, 2006, 
attributable to the difference between the amount of the actual payment 
and the amount of the projected payment. Z's accrued interest income of 
[pound]105.20 in 2006 is reduced to zero by the net negative adjustment. 
Elimination of the 2006 accrued interest fully utilizes the net negative 
adjustment.
    (C) Adjusted issue price and basis--(1) January-June accrual period. 
Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted 
issue price of the debt instrument determined in pounds and Z's adjusted 
basis in dollars in the debt instrument are increased by the interest 
accrued, and decreased by the interest payment made, in the January-June 
accrual period. Thus, on July 1, 2006, the adjusted issue price of the 
debt instrument is [pound]1063.05 ([pound]1041 + [pound]52.05 - 
[pound]30 = [pound]1063.05). For purposes of determining Z's dollar 
basis in the debt instrument, the $1049.30 adjusted basis is increased 
by the [pound]52.05 of accrued interest, translated, under paragraph 
(b)(3)(iii) of this section, at the rate at which interest was accrued 
for the January-June accrual period ($1.50 x [pound]52.05 = $78.08). The 
resulting amount is reduced by the [pound]30 payment of interest made 
during the accrual period, translated, under paragraph (b)(3)(iii) of 
this section and Sec. 1.988-2(b)(7), at the rate applicable to accrued 
interest ($1.50 x [pound]30 = $45). Accordingly, Z's adjusted basis as 
of July 1, 2006, is $1082.38 ($1049.30 + $78.08 - $45).
    (2) July-December accrual period. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued, and decreased by the 
interest payment made, in the July-December accrual period. Thus, 
immediately before maturity on December 31, 2006, the adjusted issue 
price of the instrument is [pound]1086.20 ([pound]1063.05 + [pound]53.15 
- [pound]30 = [pound]1086.20). For purposes of determining Z's dollar 
basis in the debt instrument, the $1082.38 adjusted basis is increased 
by the [pound]53.15 of accrued interest, translated, under paragraph 
(b)(3)(iii) of this section, at the rate at which interest was accrued 
for the July-December accrual period ($1.70 x [pound]53.15 = $90.36). 
The resulting amount is reduced by the [pound]30 payment of interest 
made during the accrual period, translated, under paragraph (b)(3)(iii) 
of this section and Sec. 1.988-2(b)(7), at the rate applicable to 
accrued interest ($1.70 x [pound]30 = $51). Accordingly, Z's adjusted 
basis on December 31, 2006, immediately prior to maturity is $1121.74 
($1082.38 + $90.36 - $51).
    (D) Amount realized. Even though Z receives [pound]981.00 at 
maturity, for purposes of determining the amount realized, Z is treated 
under paragraph (b)(2)(v) of this section as receiving the projected 
amount of the contingent payment on December 31, 2006. Therefore, Z is 
treated as receiving [pound]1086.20 on December 31, 2006. Under 
paragraph (b)(3)(iv) of this section, Z translates its amount realized 
into dollars and computes its gain or loss on the instrument (other than 
foreign currency gain or loss) by breaking the amount realized into its 
component parts. Accordingly, [pound]20 of the [pound]1086.20 
(representing the interest accrued in the January-June 2005 accrual 
period, less [pound]30 interest paid) is translated into dollars at the 
rate at which it was accrued ([pound]1 = $1.10), resulting in an amount 
realized of $22; [pound]21 of the [pound]1086.20 (representing the 
interest accrued in the July-December 2005 accrual period, less 
[pound]30 interest paid) is translated into dollars at the rate at which 
it was accrued ([pound]1 = $1.30), resulting in an amount realized of 
$27.30; [pound]22.05 of the [pound]1086.20 (representing the interest 
accrued in the January-June 2006 accrual period, less [pound]30 interest 
paid) is translated into dollars at the rate at which it was accrued 
([pound]1 = $1.50), resulting in an amount realized of $33.08; 
[pound]23.15 of the [pound]1086.20 (representing the interest accrued in 
the July 1-December 31, 2006 accrual period, less the [pound]30 interest 
payment) is translated into dollars at the rate at which it was accrued 
([pound]1 = $1.70), resulting in an amount realized of $39.36; and 
[pound]1000 (representing principal) is translated into dollars at the 
spot rate on the date the instrument was purchased ([pound]1 = $1), 
resulting in an amount realized of $1000. Accordingly, Z's total amount 
realized is $1121.74 ($22 + $27.30 + $33.08 + $39.36 + $1000), the same 
as its basis, and Z recognizes no gain or loss (before consideration of 
foreign currency gain or loss) on retirement of the instrument.
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to each [pound]30 payment actually received during 
2006. These payments, however, are treated as payments of principal for 
this purpose because all 2006 accrued interest is reduced to zero by the 
net negative adjustment. See paragraph (b)(5)(iv)(A)(3) of this section. 
The amount of foreign currency gain in each case is determined, under 
paragraph (b)(5)(iii) of this section, by reference to the difference

[[Page 783]]

between the spot rate on the date the [pound]30 payment is made and the 
spot rate on the date the debt instrument was issued. Accordingly, Z 
recognizes $18 of foreign currency gain on the January-June 2006 
interest payment [[pound]30 x ($1.60 - $1.00)], and $24 of foreign 
currency gain on the July-December 2006 interest payment [[pound]30 x 
($1.80 - $1.00)]. Z separately recognizes foreign currency gain with 
respect to the consideration actually received at maturity, 
[pound]981.00. The amount of such gain is determined based on the 
difference between the spot rate on the date the instrument matures and 
the rates at which the principal and interest were taken into account. 
With respect to the portion of the payment attributable to interest 
accrued in January-June 2005 (other than the [pound]30 payments), the 
foreign currency gain is $14 [[pound]20 x ($1.80 - $1.10)]. With respect 
to the portion of the payment attributable to interest accrued in July-
December 2005 (other than the [pound]30 payments), the foreign currency 
gain is $10.50 [[pound]21 x ($1.80 - $1.30)]. With respect to the 
portion of the payment attributable to interest accrued in 2006 (other 
than the [pound]30 payments), no foreign currency gain or loss is 
recognized under paragraph (b)(5)(ii) of this section because such 
interest was reduced to zero by the net negative adjustment. With 
respect to the portion of the payment attributable to principal, the 
foreign currency gain is $752 [[pound]940 x ($1.80 - $1.00)]. Thus, Z 
recognizes a foreign currency gain of $42 on receipt of the two 
[pound]30 payments in 2006, and $776.50 ($14 + $10.50 + $752) on receipt 
of the payment at maturity, for a total 2006 foreign currency gain of 
$818.50.
    (F) Source. Under paragraph (b)(6) of this section and Sec. 1.988-
4, Z's foreign currency gain of $818.50 is sourced by reference to Z's 
residence and is therefore from sources within the United States.
    Example 4. Purchase price greater than adjusted issue price. (i) 
Facts. On July 1, 2005, Z, a calendar year U.S. resident taxpayer whose 
functional currency is the U.S. dollar, purchases a debt instrument with 
a non-currency contingency for [pound]1405. All payments of principal 
and interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the British 
pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it 
were denominated in dollars. The debt instrument was originally issued 
by a foreign corporation on December 31, 2003, for an issue price of 
[pound]1000, and matures on December 31, 2006. The debt instrument's 
comparable yield, determined in British pounds under Sec. Sec. 1.988-
2(b)(2) and 1.1275-4(b), is 10.25 percent, compounded semiannually, and 
the projected payment schedule for the debt instrument (determined as of 
the issue date under the rules of Sec. 1.1275-4(b)) provides for a 
single payment at maturity of [pound]1349.70 (consisting of a 
noncontingent payment of [pound]1000 and a projected payment of 
[pound]349.70). At the time of the purchase, the adjusted issue price of 
the debt instrument is [pound]1161.76, assuming semiannual accrual 
periods ending on June 30 and December 31 of each year. The increase in 
the value of the debt instrument over its adjusted issue price is due to 
an increase in the expected amount of the contingent payment. The debt 
instrument is a capital asset in the hands of Z. Z does not elect to use 
the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The 
payment actually made on December 31, 2006, is [pound]1400. The relevant 
pound/dollar spot rates over the term of the instrument are as follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
July 1, 2005........................  [pound]1.00 = $1.00
Dec. 31, 2006.......................  [pound]1.00 = $2.00
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
July 1-Dec. 31, 2005................  [pound]1.00 = $1.50
Jan. 1-June 30, 2006................  [pound]1.00 = $1.50
July 1-Dec. 31, 2006................  [pound]1.00 = $1.50
------------------------------------------------------------------------

    (ii) Initial basis. Under paragraph (b)(7)(ii) of this section, Z's 
initial basis in the debt instrument is $1405, Z's purchase price of 
[pound]1405, translated into functional currency at the spot rate on the 
date the debt instrument was purchased ([pound]1 = $1).
    (iii) Allocation of purchase price differential. Z purchased the 
debt instrument for [pound]1405 when its adjusted issue price was 
[pound]1161.76. Under paragraph (b)(7)(iii) of this section, Z allocates 
the [pound]243.24 excess of purchase price over adjusted issue price to 
the contingent payment at maturity. This allocation is reasonable 
because the excess is due to an increase in the expected amount of the 
contingent payment and not, for example, to a decrease in prevailing 
interest rates.
    (iv) Treatment in 2005--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]59.54 of interest on the debt instrument for the July-
December 2005 accrual period (issue price of [pound]1161.76 x 10.25 
percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 
[pound]59.54 of interest at the average exchange rate for the accrual 
period ($1.50 x [pound]59.54 = $89.31). Accordingly, Z has interest 
income in 2005 of $89.31.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued in July-December 2005. 
Thus, on January 1, 2006, the adjusted issue price of the debt 
instrument is

[[Page 784]]

[pound]1221.30 ([pound]1161.76 + [pound]59.54). For purposes of 
determining Z's dollar basis in the debt instrument on January 1, 2006, 
the $1405 basis is increased by the [pound]59.54 of accrued interest, 
translated at the rate at which interest was accrued for the July-
December 2005 accrual period. Paragraph (b)(3)(iii) of this section. 
Accordingly, Z's adjusted basis in the instrument, as of January 1, 
2006, is $1494.31 [$1405 + ([pound]59.54 x $1.50)].
    (v) Treatment in 2006--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]62.59 of interest on the debt instrument for the 
January-June 2006 accrual period (issue price of [pound]1221.30 x 10.25 
percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 
[pound]62.59 of accrued interest at the average exchange rate for the 
accrual period ($1.50 x [pound]62.59 = $93.89). Similarly, Z accrues 
[pound]65.80 of interest in the July-December 2006 accrual period 
[([pound]1221.30 + [pound]62.59) x 10.25 percent/2], which is translated 
at the average exchange rate for the accrual period ($1.50 x 
[pound]65.80 = $98.70). Accordingly, Z accrues [pound]128.39, or 
$192.59, of interest income in 2006.
    (B) Effect of positive and negative adjustments--(1) Offset of 
positive adjustment. The payment actually made on December 31, 2006, is 
[pound]1400, rather than the projected [pound]1349.70. Under paragraph 
(b)(2)(ii) of this section, Z has a positive adjustment of [pound]50.30 
on December 31, 2006, attributable to the difference between the amount 
of the actual payment and the amount of the projected payment. Under 
paragraph (b)(7)(iii) of this section, however, Z also has a negative 
adjustment of [pound]243.24, attributable to the excess of Z's purchase 
price for the debt instrument over its adjusted issue price. 
Accordingly, Z will have a net negative adjustment of [pound]192.94 
([pound]50.30-[pound]243.24 = [pound]192.94) for 2006.
    (2) Offset of accrued interest. Z's accrued interest income of 
[pound]128.39 in 2006 is reduced to zero by the net negative adjustment. 
The net negative adjustment which reduces the current year's interest is 
not translated into functional currency. Under paragraph (b)(2)(ii) of 
this section, Z treats the remaining [pound]64.55 net negative 
adjustment as an ordinary loss to the extent of the [pound]59.54 
previously accrued interest in 2005. This [pound]59.54 ordinary loss is 
attributable to interest accrued but not paid in the preceding year. 
Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z 
translates the loss into dollars at the average rate for such year 
([pound]1 = $1.50). Accordingly, Z has an ordinary loss of $89.31 in 
2006. The remaining [pound]5.01 of net negative adjustment is a negative 
adjustment carryforward under paragraph (b)(2)(ii) of this section.
    (C) Adjusted issue price and basis--(1) January-June accrual period. 
Under paragraph (b)(2)(iii) of this section, the adjusted issue price of 
the debt instrument on July 1, 2006, is [pound]1283.89 ([pound]1221.30 + 
[pound]62.59 = [pound]1283.89). Under paragraphs (b)(2)(iv) and 
(b)(3)(iii) of this section, Z's adjusted basis as of July 1, 2006, is 
$1588.20 ($1494.31 + $93.89).
    (2) July-December accrual period. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument immediately 
before the payment at maturity is [pound]1349.70 ([pound]1283.89 + 
[pound]65.80 accrued interest for July-December). Z's adjusted basis in 
dollars, based only on the noncontingent payments and the projected 
amount of the contingent payments to be received, is $1686.90 ($1588.20 
plus $98.70 of accrued interest for July-December).
    (3) Adjustment to basis upon contingent payment. Under paragraph 
(b)(7)(iii) of this section, Z's adjusted basis in the debt instrument 
is reduced at maturity by [pound]243.24, the excess of Z's purchase 
price for the debt instrument over its adjusted issue price. For this 
purpose, the adjustment is translated into functional currency at the 
spot rate on the date the instrument was acquired ([pound]1 = $1). 
Accordingly, Z's adjusted basis in the debt instrument at maturity is 
$1443.66 ($1686.90-$243.24).
    (D) Amount realized. Even though Z receives [pound]1400 at maturity, 
for purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected amount of 
the contingent payment on December 31, 2006, reduced by the amount of 
Z's negative adjustment carryforward of [pound]5.01. Therefore, Z is 
treated as receiving [pound]1344.69 ([pound]1349.70-[pound]5.01) on 
December 31, 2006. Under paragraph (b)(3)(iv) of this section, Z 
translates its amount realized into dollars and computes its gain or 
loss on the instrument (other than foreign currency gain or loss) by 
breaking the amount realized into its component parts. Accordingly, 
[pound]59.54 of the [pound]1344.69 (representing the interest accrued in 
2005) is translated at the rate at which it was accrued ([pound]1 = 
$1.50), resulting in an amount realized of $89.31; [pound]62.59 of the 
[pound]1344.69 (representing the interest accrued in January-June 2006) 
is translated into dollars at the rate at which it was accrued ([pound]1 
= $1.50), resulting in an amount realized of $93.89; [pound]65.80 of the 
[pound]1344.69 (representing the interest accrued in July-December 2006) 
is translated into dollars at the rate at which it was accrued ([pound]1 
= $1.50), resulting in an amount realized of $98.70; and [pound]1156.76 
of the [pound]1344.69 (representing a return of principal) is translated 
into dollars at the spot rate on the date the instrument was purchased 
([pound]1 = $1), resulting in an amount realized of $1156.76. Z's amount 
realized is $1438.66 ($89.31 + $93.89 + $98.70 + $1156.76), and Z 
recognizes a capital loss (before consideration of foreign currency gain 
or loss) of $5 on retirement of the instrument ($1438.66 - $1443.66 = -
$5).
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain under section 988

[[Page 785]]

on the instrument with respect to the entire consideration actually 
received at maturity, [pound]1400. While foreign currency gain or loss 
ordinarily would not have arisen with respect to [pound]50.30 of the 
[pound]1400, which was initially treated as a positive adjustment in 
2006, the larger negative adjustment in 2006 reduced this positive 
adjustment to zero. Accordingly, foreign currency gain or loss is 
recognized with respect to the entire [pound]1400. Under paragraph 
(b)(5)(ii) of this section, however, no foreign currency gain or loss is 
recognized with respect to unpaid accrued interest reduced to zero by 
the net negative adjustment resulting in 2006, and no foreign currency 
gain or loss is recognized with respect to unpaid accrued interest from 
2005, also reduced to zero by the ordinary loss. Therefore, the entire 
[pound]1400 is treated as a return of principal for the purpose of 
determining foreign currency gain or loss, and Z recognizes a total 
foreign currency gain on December 31, 2001, of $1400 [[pound]1400 x 
($2.00-$1.00)].
    (F) Source. Z has an ordinary loss of $89.31, a capital loss of $5, 
and a foreign currency gain of $1400. Under paragraph (b)(6) of this 
section and Sec. 1.1275-4(b)(9)(iv), the $89.31 ordinary loss generally 
reduces Z's foreign source passive income under section 904(d) and the 
regulations thereunder. Under paragraph (b)(6) of this section and Sec. 
1.865-1(b)(2), the $5 capital loss is sourced by reference to how 
interest income on the instrument would have been sourced. Therefore, 
the $5 capital loss generally reduces Z's foreign source passive income 
under section 904(d) and the regulations thereunder. Under paragraph 
(b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of 
$1400 is sourced by reference to Z's residence and is therefore from 
sources within the United States.
    Example 5. Sale of an instrument with a negative adjustment 
carryforward. (i) Facts. On December 31, 2003, Z, a calendar year U.S. 
resident taxpayer whose functional currency is the U.S. dollar, 
purchases at original issue a debt instrument with non-currency 
contingencies for [pound]1000. All payments of principal and interest 
with respect to the instrument are denominated in, or determined by 
reference to, a single nonfunctional currency (the British pound). The 
debt instrument would be subject to Sec. 1.1275-4(b) if it were 
denominated in dollars. The debt instrument's comparable yield, 
determined in British poundsunder Sec. Sec. 1.988-2(b)(2) and 1.1275-
4(b), is 10 percent, compounded annually, and the projected payment 
schedule for the debt instrument provides for payments of [pound]310 on 
December 31, 2005 (consisting of a noncontingent payment of [pound]50 
and a projected amount of [pound]260) and [pound]990 on December 31, 
2006 (consisting of a noncontingent payment of [pound]940 and a 
projected amount of [pound]50). The debt instrument is a capital asset 
in the hands of Z. Z does not elect to use the spot-rate convention 
described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on 
December 31, 2005, is [pound]50. On December 30, 2006, Z sells the debt 
instrument for [pound]940. The relevant pound/dollar spot rates over the 
term of the instrument are as follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2003.......................  [pound]1.00 = $1.00
Dec. 31, 2005.......................  [pound]1.00 = $2.00
Dec. 30, 2006.......................  [pound]1.00 = $2.00
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
Jan. 1-Dec. 31, 2004................  [pound]1.00 = $2.00
Jan. 1-Dec. 31, 2005................  [pound]1.00 = $2.00
Jan. 1-Dec. 31, 2006................  [pound]1.00 = $2.00
------------------------------------------------------------------------

    (ii) Treatment in 2004--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]100 of interest on the debt instrument for 2004 (issue 
price of [pound]1000 x 10 percent). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]100 at the average exchange rate for 
the accrual period ($2.00 x [pound]100 = $200). Accordingly, Z has 
interest income in 2004 of $200.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued in 2004. Thus, on 
January 1, 2005, the adjusted issue price of the debt instrument is 
[pound]1100. For purposes of determining Z's dollar basis in the debt 
instrument, the $1000 basis ($1.00 x [pound]1000 original cost basis) is 
increased by the [pound]100 of accrued interest, translated at the rate 
at which interest was accrued for 2004. See paragraph (b)(3)(iii) of 
this section. Accordingly, Z's adjusted basis in the debt instrument as 
of January 1, 2005, is $1200 ($1000 + $200).
    (iii) Treatment in 2005--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the comparable 
yield, Z's accrued interest for 2005 is [pound]110 (adjusted issue price 
of [pound]1100 x 10 percent). Under paragraph (b)(3)(i) of this section, 
the [pound]110 of accrued interest is translated at the average exchange 
rate for the accrual period ($2.00 x [pound]110 = $220).
    (B) Effect of net negative adjustment. The payment actually made on 
December 31, 2005, is [pound]50, rather than the projected [pound]310. 
Under paragraph (b)(2)(ii) of this section, Z has a net negative 
adjustment of [pound]260 on December 31, 2005, attributable to the 
difference between the amount of the actual payment and the amount of 
the projected payment. Z's accrued interest income of [pound]110 in 2005 
is reduced to zero by the net negative adjustment. Under paragraph 
(b)(3)(ii)(B)(1) of this section, the net negative adjustment which

[[Page 786]]

reduces the current year's interest is not translated into functional 
currency. Under paragraph (b)(2)(ii) of this section, Z treats the 
remaining [pound]150 net negative adjustment as an ordinary loss to the 
extent of the [pound]100 previously accrued interest in 2004. This 
[pound]100 ordinary loss is attributable to interest accrued but not 
paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) 
of this section, Z translates the loss into dollars at the average rate 
for such year ([pound]1 = $2.00). Accordingly, Z has an ordinary loss of 
$200 in 2005. The remaining [pound]50 of net negative adjustment is a 
negative adjustment carryforward under paragraph (b)(2)(ii) of this 
section.
    (C) Adjusted issue price and basis. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument on January 1, 
2006 is [pound]900, i.e., the adjusted issue price of the debt 
instrument on January 1, 2005 ([pound]1100), increased by the interest 
accrued in 2005 ([pound]110), and decreased by the projected amount of 
the December 31, 2005, payment ([pound]310). See paragraph (b)(2)(iii) 
of this section. Z's adjusted basis on January 1, 2006 is Z's adjusted 
basis on January 1, 2005 ($1200), increased by the functional currency 
amount of interest accrued in 2005 ($220), and decreased by the amount 
of the payments made in 2005, based solely on the projected payment 
schedule, ([pound]310). The amount of the projected payment is first 
attributable to the interest accrued in 2005 ([pound]110), and then to 
the interest accrued in 2004 ([pound]100), and the remaining amount to 
principal ([pound]100). The interest component of the projected payment 
is translated into functional currency at the rates at which it was 
accrued, and the principal component of the projected payment is 
translated into functional currency at the spot rate on the date the 
instrument was issued. See paragraph (b)(3)(iii) of this section. 
Accordingly, Z's adjusted basis in the debt instrument, following the 
increase of adjusted basis for interest accrued in 2005 ($1200 + $220 = 
$1420), is decreased by $520 ($220 + $200 + $100 = $520). Z's adjusted 
basis on January 1, 2006 is therefore, $900.
    (D) Foreign currency gain or loss. Z will recognize foreign currency 
gain on the receipt of the [pound]50 payment actually received on 
December 31, 2005. Based on paragraph (b)(5)(iv) of this section, the 
[pound]50 payment is attributable to principal since the accrued unpaid 
interest was completely eliminated by the net negative adjustment. The 
amount of foreign currency gain is determined, under paragraph 
(b)(5)(iii) of this section, by reference to the difference between the 
spot rate on the date the [pound]50 payment was made and the spot rate 
on the date the debt instrument was issued. Accordingly, Z recognizes 
$50 of foreign currency gain on the [pound]50 payment. [($2.00--$1.00) x 
[pound]50 = $50]. Under paragraph (b)(6) of this section and Sec. 
1.988-4, Z's foreign currency gain of $50 is sourced by reference to Z's 
residence and is therefore from sources within the United States.
    (iv) Treatment in 2006--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]90 of interest on the debt instrument for 2006 
(adjusted issue price of [pound]900 x 10 percent). Under paragraph 
(b)(3)(i) of this section, Z translates the [pound]90 at the average 
exchange rate for the accrual period ($2.00 x [pound]90 = $180). 
Accordingly, prior to taking into account the 2005 negative adjustment 
carryforward, Z has interest income in 2006 of $180.
    (B) Effect of net negative adjustment. The [pound]50 negative 
adjustment carryforward from 2005 is a negative adjustment for 2006. 
Since there are no other positive or negative adjustments, there is a 
[pound]50 negative adjustment in 2006 which reduces Z's accrued interest 
income by [pound]50. Accordingly, after giving effect to the [pound]50 
negative adjustment carryforward, Z will accrue $80 of interest income. 
[([pound]90-[pound]50) x $2.00 = $80]
    (C) Adjusted issue price. Under paragraph (b)(2)(iii) of this 
section, the adjusted issue price of the debt instrument determined in 
pounds is increased by the interest accrued in 2006 (prior to taking 
into account the negative adjustment carryforward). Thus, on December 
30, 2006, the adjusted issue price of the debt instrument is [pound]990.
    (D) Adjusted basis. For purposes of determining Z's dollar basis in 
the debt instrument, Z's $900 adjusted basis on January 1, 2006, is 
increased by the accrued interest, translated at the rate at which 
interest was accrued for 2006. See paragraph (b)(3)(iii)(A) of this 
section. Note, however, that under paragraph (b)(3)(iii)(B) of this 
section the amount of accrued interest which is reduced as a result of 
the negative adjustment carryforward, i.e., [pound]50, is treated for 
purposes of this section as principal, and is translated at the spot 
rate on the date the instrument was issued, i.e., [pound]1.00 = $1.00. 
Accordingly, Z's adjusted basis in the debt instrument as of December 
30, 2006, is $1030 ($900 + $50 + $80).
    (E) Amount realized. Z's amount realized in denomination currency is 
[pound]940, i.e., the amount of pounds Z received on the sale of the 
debt instrument. Under paragraph (b)(3)(iv)(B)(1) of this section, Z's 
amount realized is first translated by reference to the principal 
component of basis (including the amount which is treated as principal 
under paragraph (b)(3)(iii)(B) of this section) and then the remaining 
amount realized, if any, is translated by reference to the accrued 
unpaid interest component of adjusted basis. Thus, [pound]900 of Z's 
amount realized is translated by reference to the principal component of 
adjusted basis. The remaining [pound]40 of Z's amount realized is 
treated as principal under paragraph (b)(3)(iii)(B) of this section, and 
is also translated by reference to the

[[Page 787]]

principal component of adjusted basis. Accordingly, Z's amount realized 
in functional currency is $940. (No part of Z's amount realized is 
attributable to the interest accrued on the debt instrument.) Z realizes 
a loss of $90 on the sale of the debt instrument ($1030 basis-$940 
amount realized). Under paragraph (b)(4) of this section and Sec. 
1.1275-4(b)(8), $80 of the loss is characterized as ordinary loss, and 
the remaining $10 of loss is characterized as capital loss. Under 
Sec. Sec. 1.988-6(b)(6) and 1.1275-4(b)(9)(iv) the $80 ordinary loss is 
treated as a deduction that is definitely related to the interest income 
accrued on the debt instrument. Similarly, under Sec. Sec. 1.988-
6(b)(6) and 1.865-1(b)(2) the $10 capital loss is also allocated to the 
interest income from the debt instrument.
    (F) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to the [pound]940 he received on the sale of the debt 
instrument. Under paragraph (b)(5)(iv) of this section, the [pound]940 Z 
received is attributable to principal (and the amount which is treated 
as principal under paragraph (b)(3)(iii)(B) of this section). Thus, Z 
recognizes foreign currency gain on December 31, 2006, of $940. [($2.00-
$1.00) x [pound]940]. Under paragraph (b)(6) of this section and Sec. 
1.988-4, Z's foreign currency gain of $940 is sourced by reference to 
Z's residence and is therefore from sources within the United States.

    (d) Multicurrency debt instruments--(1) In general. Except as 
provided in this paragraph (d), a multicurrency debt instrument 
described in paragraph (a)(1)(ii) or (iii) of this section shall be 
treated as an instrument described in paragraph (a)(1)(i) of this 
section and shall be accounted for under the rules of paragraph (b) of 
this section. Because payments on an instrument described in paragraph 
(a)(1)(ii) or (iii) of this section are denominated in, or determined by 
reference to, more than one currency, the issuer and holder or holders 
of the instrument are required to determine the denomination currency of 
the instrument under paragraph (d)(2) of this section before applying 
the rules of paragraph (b) of this section.
    (2) Determination of denomination currency--(i) In general. The 
denomination currency of an instrument described in paragraph (a)(1)(ii) 
or (iii) of this section shall be the predominant currency of the 
instrument. Except as otherwise provided in paragraph (d)(2)(ii) of this 
section, the predominant currency of the instrument shall be the 
currency with the greatest value determined by comparing the functional 
currency value of the noncontingent and projected payments denominated 
in, or determined by reference to, each currency on the issue date, 
discounted to present value (in each relevant currency), and translated 
(if necessary) into functional currency at the spot rate on the issue 
date. For this purpose, the applicable discount rate may be determined 
using any method, consistently applied, that reasonably reflects the 
instrument's economic substance. If a taxpayer does not determine a 
discount rate using such a method, the Commissioner may choose a method 
for determining the discount rate that does reflect the instrument's 
economic substance. The predominant currency is determined as of the 
issue date and does not change based on subsequent events (e.g., changes 
in value of one or more currencies).
    (ii) Difference in discount rate of greater than 10 percentage 
points. This Sec. 1.988-6(d)(2)(ii) applies if no currency has a value 
determined under paragraph (d)(2)(i) of this section that is greater 
than 50% of the total value of all payments. In such a case, if the 
difference between the discount rate in the denomination currency 
otherwise determined under (d)(2)(i) of this section and the discount 
rate determined under paragraph (d)(2)(i) of this section with respect 
to any other currency in which payments are made (or determined by 
reference to) pursuant to the instrument is greater than 10 percentage 
points, then the Commissioner may determine the predominant currency 
under any reasonable method.
    (3) Issuer/holder consistency. The issuer determines the 
denomination currency under the rules of paragraph (d)(2) of this 
section and provides this information to the holders of the instrument 
in a manner consistent with the issuer disclosure rules of Sec. 1.1275-
2(e). If the issuer does not determine the denomination currency of the 
instrument, or if the issuer's determination is unreasonable, the holder 
of the instrument must determine the denomination currency under the 
rules of paragraph (d)(2) of this section. A holder that determines the 
denomination currency itself must explicitly disclose this fact on a 
statement attached to

[[Page 788]]

the holder's timely filed federal income tax return for the taxable year 
that includes the acquisition date of the instrument.
    (4) Treatment of payments in currencies other than the denomination 
currency. For purposes of applying the rules of paragraph (b) of this 
section to debt instruments described in paragraph (a)(1)(ii) or (iii) 
of this section, payments not denominated in (or determined by reference 
to) the denomination currency shall be treated as non-currency-related 
contingent payments. Accordingly, if the denomination currency of the 
instrument is determined to be the taxpayer's functional currency, the 
instrument shall be accounted for under Sec. 1.1275-4(b) rather than 
under this section.
    (e) Instruments issued for nonpublicly traded property--(1) 
Applicability. This paragraph (e) applies to debt instruments issued for 
nonpublicly traded property that would be described in paragraph 
(a)(1)(i), (ii), or (iii) of this section, but for the fact that such 
instruments are described in Sec. 1.1275-4(c)(1) rather than Sec. 
1.1275-4(b)(1). For example, this paragraph (e) generally applies to a 
contingent payment debt instrument denominated in a nonfunctional 
currency that is issued for non-publicly traded property. Generally the 
rules of Sec. 1.1275-4(c) apply except as set forth by the rules of 
this paragraph (e).
    (2) Separation into components. An instrument described in this 
paragraph (e) is not accounted for using the noncontingent bond method 
of Sec. 1.1275-4(b) and paragraph (b) of this section. Rather, the 
instrument is separated into its component payments. Each noncontingent 
payment or group of noncontingent payments which is denominated in a 
single currency shall be considered a single component treated as a 
separate debt instrument denominated in the currency of the payment or 
group of payments. Each contingent payment shall be treated separately 
as provided in paragraph (e)(4) of this section.
    (3) Treatment of components consisting of one or more noncontingent 
payments in the same currency. The issue price of each component treated 
as a separate debt instrument which consists of one or more 
noncontingent payments is the sum of the present values of the 
noncontingent payments contained in the separate instrument. The present 
value of any noncontingent payment shall be determined under Sec. 
1.1274-2(c)(2), and the test rate shall be determined under Sec. 
1.1274-4 with respect to the currency in which each separate instrument 
is considered denominated. No interest payments on the separate debt 
instrument are qualified stated interest payments (within the meaning of 
Sec. 1.1273-1(c)) and the de minimis rules of section 1273(a)(3) and 
Sec. 1.1273-1(d) do not apply to the separate debt instrument. Interest 
income or expense is translated, and exchange gain or loss is recognized 
on the separate debt instrument as provided in Sec. 1.988-2(b)(2), if 
the instrument is denominated in a nonfunctional currency.
    (4) Treatment of components consisting of contingent payments--(i) 
General rule. A component consisting of a contingent payment shall 
generally be treated in the manner provided in Sec. 1.1275-4(c)(4). 
However, except as provided in paragraph (e)(4)(ii) of this section, the 
test rate shall be determined by reference to the U.S. dollar unless the 
dollar does not reasonably reflect the economic substance of the 
contingent component. In such case, the test rate shall be determined by 
reference to the currency which most reasonably reflects the economic 
substance of the contingent component. Any amount received in 
nonfunctional currency from a component consisting of a contingent 
payment shall be translated into functional currency at the spot rate on 
the date of receipt. Except in the case when the payment becomes fixed 
more than six months before the payment is due, no foreign currency gain 
or loss shall be recognized on a contingent payment component.
    (ii) Certain delayed contingent payments--(A) Separate debt 
instrument relating to the fixed component. The rules of Sec. 1.1275-
4(c)(4)(iii) shall apply to a contingent component the payment of which 
becomes fixed more than 6 months before the payment is due. For this 
purpose, the denomination currency of the separate debt instrument 
relating to the fixed payment shall be the currency in which payment is 
to be

[[Page 789]]

made and the test rate for such separate debt instrument shall be 
determined in the currency of that instrument. If the separate debt 
instrument relating to the fixed payment is denominated in nonfunctional 
currency, the rules of Sec. 1.988-2(b)(2) shall apply to that 
instrument for the period beginning on the date the payment is fixed and 
ending on the payment date.
    (B) Contingent component. With respect to the contingent component, 
the issue price considered to have been paid by the issuer to the holder 
under Sec. 1.1275-4(c)(4)(iii)(A) shall be translated, if necessary, 
into the functional currency of the issuer or holder at the spot rate on 
the date the payment becomes fixed.
    (5) Basis different from adjusted issue price. The rules of Sec. 
1.1275-4(c)(5) shall apply to an instrument subject to this paragraph 
(e).
    (6) Treatment of a holder on sale, exchange, or retirement. The 
rules of Sec. 1.1275-4(c)(6) shall apply to an instrument subject to 
this paragraph (e).
    (f) Rules for nonfunctional currency tax exempt obligations 
described in Sec. 1.1275-4(d)--(1) In general. Except as provided in 
paragraph (f)(2) of this section, section 1.988-6 shall not apply to a 
debt instrument the interest on which is excluded from gross income 
under section 103(a).
    (2) Operative rules. [Reserved]
    (g) Effective date. This section shall apply to debt instruments 
issued on or after October 29, 2004.

[T.D. 9157, 69 FR 52819, Aug. 30, 2004]



Sec. 1.989(a)-1  Definition of a qualified business unit.

    (a) Applicability--(1) In general. This section provides rules 
relating to the definition of the term ``qualified business unit'' (QBU) 
within the meaning of section 989.
    (2) Effective date. These rules shall apply to taxable years 
beginning after December 31, 1986. However, any person may apply on a 
consistent basis Sec. 1.989(a)-1T (c) of the Temporary Income Tax 
Regulations in lieu of Sec. 1.989(a)-1 (c) to all taxable years 
beginning after December 31, 1986, and on or before February 5, 1990. 
For the text of the temporary regulation, see 53 FR 20612 (June 8, 
1988).
    (b) Definition of a qualified business unit--(1) In general. A QBU 
is any separate and clearly identified unit of a trade or business of a 
taxpayer provided that separate books and records are maintained.
    (2) Application of the QBU definition--(i) Persons--(A) 
Corporations. A corporation is a QBU.
    (B) Individuals. An individual is not a QBU.
    (C) Partnerships. A partnership, other than a section 987 aggregate 
partnership as defined in Sec. 1.987-1(b)(5), is a QBU.
    (D) Trusts and estates. A trust or estate is a QBU of a beneficiary.
    (ii) Activities. Activities of a corporation, partnership, trust, 
estate, or individual qualify as a QBU if--
    (A) The activities constitute a trade or business; and
    (B) A separate set of books and records is maintained with respect 
to the activities.
    (3) Special rule. Any activity (wherever conducted and regardless of 
its frequency) that produces income or loss that is, or is treated as, 
effectively connected with the conduct of a trade or business within the 
United States shall be treated as a separate QBU, provided the books and 
records requirement of paragraph (d)(2) of this section is satisfied.
    (4) Effective/applicability date. Generally, the revisions to 
paragraph (b)(2)(i) 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 the effective date of the revisions to paragraph 
(b)(2)(i) of this section with respect to the taxpayer shall apply to 
taxable years of the taxpayer beginning on or after the first day of 
such prior taxable year.
    (c) Trade or business. The determination as to whether activities 
constitute a trade or business is ultimately dependent upon an 
examination of all the facts and circumstances. Generally, a trade or 
business for purposes of section 989(a) is a specific unified group of 
activities that constitutes (or could

[[Page 790]]

constitute) an independent economic enterprise carried on for profit, 
the expenses related to which are deductible under section 162 or 212 
(other than that part of section 212 dealing with expenses incurred in 
connection with taxes). To constitute a trade or business, a group of 
activities must ordinarily include every operation which forms a part 
of, or a step in, a process by which an enterprise may earn income or 
profit. Such group of activities must ordinarily include the collection 
of income and the payment of expenses. It is not necessary that the 
activities carried out by a QBU constitute a different trade or business 
from those carried out by other QBUs of the taxpayer. A vertical, 
functional, or geographic division of the same trade or business may be 
a trade or business for this purpose provided that the activities 
otherwise qualify as trade or business under this paragraph (c). 
However, activities that are merely ancillary to a trade or business 
will not constitute a trade or business under this paragraph (c). 
Activities of an individual as an employee are not considered by 
themselves to constitute a trade or business under this paragraph (c).
    (d) Separate books and records--(1) General rule. Except as provided 
in paragraph (d)(2) of this section, a separate set of books and records 
shall include books of original entry and ledger accounts, both general 
and subsidiary, or similar records. For example, in the case of a 
taxpayer using the cash receipts and disbursements method of accounting, 
the books of original entry include a cash receipts and disbursements 
journal where each receipt and each disbursement is recorded. Similarly, 
in the case of a taxpayer using an accrual method of accounting, the 
books of original entry include a journal to record sales (accounts 
receivable) and a journal to record expenses incurred (accounts 
payable). In general, a journal represents a chronological account of 
all transactions entered into by an entity for an accounting period. A 
ledger account, on the other hand, chronicles the impact during an 
accounting period of the specific transactions recorded in the journal 
for that period upon the various items shown on the entity's balance 
sheet (i.e., assets, liabilities, and capital accounts) and income 
statement (i.e., revenues and expenses).
    (2) Special rule. For purposes of paragraph (b)(3) of this section, 
books and records include books and records used to determine income or 
loss that is, or is treated as, effectively connected with the conduct 
of a trade or business within the United States.
    (3) Proper reflection on the books of the taxpayer or qualified 
business unit. The principles of Sec. 1.987-2(b) shall apply in 
determining whether an asset, liability, or item of income or expense is 
reflected on the books of a qualified business unit (and therefore is 
attributable to such unit).
    (4) Effective/applicability date. Generally, the revisions to 
paragraph (d)(3) 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 
the revisions to paragraph (b)(2)(i) of this section shall apply with 
respect to taxable years of the taxpayer beginning on or after the first 
day of such prior taxable year.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. Corporation X is a domestic corporation. Corporation X 
manufactures widgets in the U.S. for export. Corporation X sells widgets 
in the United Kingdom through a branch office in London. The London 
office has its own employees and solicits and processes orders. 
Corporation X maintains in the U.S. a separate set of books and records 
for all transactions conducted by the London office. Corporation X is a 
QBU under paragraph (b)(2)(i) of this section because of its corporate 
status. The London branch office is a QBU under paragraph (b)(2)(ii) of 
this section because (1) the sale of widgets is a trade or business as 
defined in paragraph (c) of this section; and (2) a complete and 
separate set of books and records (as described in paragraph (d) of this 
section) is maintained with respect to its sales operations.
    Example 2. A domestic corporation incorporates a wholly-owned 
subsidiary in Switzerland. The domestic corporation is a manufacturer 
that markets its product abroad primarily through the Swiss subsidiary. 
To facilitate sales of the parent's product in Europe, the Swiss 
subsidiary has branch offices

[[Page 791]]

in France and West Germany that are responsible for all marketing 
operations in those countries. Each branch has its own employees, 
solicits and processes orders, and maintains a separate set of books and 
records. The domestic corporation and the Swiss subsidiary are both QBUs 
under paragraph (b)(2)(i) of this section because of their corporate 
status. The French and West German branches are QBUs of the Swiss 
subsidiary. They satisfy paragraph (b)(2)(ii) because each constitutes a 
trade or business (as defined in paragraph (c) of this section) and 
because separate sets of books and records (as described in paragraph 
(d) of this section) of their respective operations is maintained. Each 
branch is considered to have a trade or business although each is a 
geographical division of the same trade or business.
    Example 3. W is a domestic corporation that manufactures product X 
in the United States for sale worldwide. All of W's sales functions are 
conducted exclusively in the United States. W employs individual Q to 
work in France. Q's sole function is to act as a courier to deliver 
sales documents to customers in France. With respect to Q's activities 
in France, a separate set of books and records as described in paragraph 
(d) is maintained. Under paragraph (c) of this section, Q's activities 
in France do not constitute a QBU since they are merely ancillary to W's 
manufacturing and selling business. Q is not considered to have a QBU 
because an individual's activities as an employee are not considered to 
constitute a trade or business of the individual under paragraph (c).
    Example 4. The facts are the same as in example (3) except that the 
courier function is the sole activity of a wholly-owned French 
subsidiary of W. Under paragraph (b)(2)(i) of this section, the French 
subsidiary is considered to be a QBU.
    Example 5. A corporation incorporated in the Netherlands is a 
subsidiary of a domestic corporation and a holding company for the stock 
of one or more subsidiaries incorporated in other countries. The Dutch 
corporation's activities are limited to paying its directors and its 
administrative expenses, receiving capital contributions from its United 
States parent corporation, contributing capital to its subsidiaries, 
receiving dividend distributions from its subsidiaries, and distributing 
dividends to its domestic parent corporation. Under paragraph (b)(2)(i) 
of this section, the Netherlands corporation is considered to be a QBU.
    Example 6. Taxpayer A, an individual resident of the United States, 
is engaged in a trade or business wholly unrelated to any type of 
investment activity. A also maintains a portfolio of foreign currency-
denominated investments through a foreign broker. The broker is 
responsible for all activities necessary to the management of A's 
investments and maintains books and records as described in paragraph 
(d) of this section, with respect to all investment activities of A. A's 
investment activities qualify as a QBU under paragraph (b)(2)(ii) of 
this section to the extent the activities engaged in by A generate 
expenses that are deductible under section 212 (other than that part of 
section 212 dealing with expenses incurred in connection with taxes).
    Example 7. Taxpayer A, an individual resident of the United States, 
is the sole shareholder of foreign corporation (FC) whose activities are 
limited to trading in stocks and securities. FC is a QBU under paragraph 
(b)(2)(i) of this section.
    Example 8. Taxpayer A, an individual resident of the United States, 
markets and sells in Spain and in the United States various products 
produced by other United States manufacturers. A has an office and 
employs a salesman to manage A's activities in Spain, maintains a 
separate set of books and records with respect to his activities in 
Spain, and is engaged in a trade or business as defined in paragraph (c) 
of this section. Therefore, under paragraph (b)(2)(ii) of this section, 
the activities of A in Spain are considered to be a QBU.
    Example 9. Foreign corporation FX is incorporated in Mexico and is 
wholly owned by a domestic corporation. The domestic corporation elects 
to treat FX as a domestic corporation under section 1504(d). FX operates 
entirely in Mexico and maintains a separate set of books and records 
with respect to its activities in Mexico. FX is a QBU under paragraph 
(b)(2)(i) of this section. The activities of FX in Mexico also 
constitute a QBU under paragraph (b)(2)(ii) of this section.
    Example 10. F, a foreign corporation, computes a gain of $100 from 
the disposition of a United States real property interest (as defined in 
section 897(c)). The gain is taken into account as if F were engaged in 
a trade or business in the United States and as if such gain were 
effectively connected with such trade or business. F is a QBU under 
paragraph (b)(2)(i) of this section because of its corporate status. F's 
disposition activity constitutes a separate QBU under paragraph (b)(3) 
of this section.

[T.D. 8279, 55 FR 284, Jan. 4, 1990, as amended by T.D. 9794, 81 FR 
88851, Dec. 8, 2016]



Sec. 1.989(b)-1  Definition of weighted average exchange rate.

    For purposes of section 989(b)(3) and (4), the term ``weighted 
average exchange rate'' means the simple average of the daily exchange 
rates (determined by reference to a qualified source of exchange rates 
described in Sec. 1.988-1(d)(1)), excluding weekends,

[[Page 792]]

holidays and any other nonbusiness days for the taxable year.

[T.D. 8263, 54 FR 38664, Sept. 20, 1989. Redesignated by T.D. 8367, 56 
FR 48437, Sept. 25, 1991; 57 FR 6060, Feb. 18, 1992; T.D. 9452, 74 FR 
27890, June 11, 2009]

                Domestic International Sales Corporations



Sec. 1.991-1  Taxation of a domestic international sales corporation.

    (a) In general. A corporation which is a DISC for a taxable year is 
not subject to any tax imposed by subtitle A of the Code (sections 1 
through 1564) for such taxable year, except for the tax imposed by 
chapter 5 thereof (sections 1491 through 1494) on certain transfers to 
avoid tax. Thus, for example, a corporation which is a DISC for a 
taxable year is not subject for such year to the corporate income tax 
(section 11), the minimum tax on tax preferences (sections 56 through 
58), or the accumulated earnings tax (sections 531 through 537). A DISC 
is liable for the payment of all taxes payable by corporations under 
other subtitles of the Code, such as, for example, income taxes withheld 
at the source and other employment taxes under subtitle C and the 
interest equalization tax and other miscellaneous excise taxes imposed 
by subtitle D. In addition, a DISC is subject to the provisions of 
chapter 3 of subtitle A (including section 1461), relating to 
withholding of tax on nonresident aliens and foreign corporations and 
tax-free covenant bonds. See Sec. 1.992-1 for the definition of the 
term ``DISC.''
    (b) Determination of taxable income--(1) In general. Although a DISC 
is not subject to tax under subtitle A of the Code (other than chapter 5 
thereof), a DISC's taxable income shall be determined for each taxable 
year in order to determine, for example, the amount deemed distributed 
for that taxable year to its shareholders pursuant to Sec. 1.995-2. 
Except as otherwise provided in the Code and the regulations thereunder, 
the taxable income of a DISC shall be determined in the same manner as 
if the DISC were a domestic corporation which had not elected to be 
treated as a DISC. Thus, for example, a DISC chooses its method of 
depreciation, inventory method, and annual accounting period in the same 
manner as if it were a corporation which had not elected to be treated 
as a DISC. Any elections affecting the determination of taxable income 
shall be made by the DISC. Thus, as a further example, a DISC which 
makes an installment sale described in section 453 is able to avail 
itself of the benefits of section 453: Provided, The DISC complies with 
the election requirements of such section. See Sec. 1.995-2(e) and 
Sec. 1.996-8 and the regulations thereunder for rules relating to the 
application for a taxable year of a DISC of a deduction under section 
172 for a net operating loss carryback or carryover or of a capital loss 
carryback or carryover under section 1212.
    (2) Choice of method of accounting. A DISC may, generally, choose 
any method of accounting permissible under section 446(c) and the 
regulations thereunder. However, if a DISC is a member of a controlled 
group (as defined in Sec. 1.993-1(k)), the DISC may not choose a method 
of accounting which, when applied to transactions between the DISC and 
other members of the controlled group, will result in a material 
distortion of the income of the DISC or any other member of the 
controlled group. Such a material distortion of income would occur, for 
example, if a DISC chooses to use the cash method of accounting where 
the DISC acts as commission agent in a substantial volume of sales of 
property by a related corporation which uses the accrual method of 
accounting and which customarily pays commissions to the DISC more than 
2 months after such sales. As a further example, a material distortion 
of income would occur if a DISC chooses to use the accrual method of 
accounting where the DISC leases a substantial amount of property from a 
related corporation which uses the cash method of accounting, if the 
DISC customarily accrues any portion of the rent on such property more 
than 2 months before the rent is paid. Changes in the method of 
accounting of a DISC are subject to the requirements of section 446(e) 
and the regulations thereunder.
    (3) Choice of annual accounting period--(i) In general. A DISC may 
choose its annual accounting period without

[[Page 793]]

regard to the annual accounting period of any of its stockholders. In 
general, changes in the annual accounting period of a DISC are subject 
to the requirements of section 442 and the regulations thereunder.
    (ii) Transition rule for change in taxable year in order to become a 
DISC. A corporation may, without the consent of the Commissioner, change 
its annual accounting period and adopt a new taxable year beginning on 
the first day of any month in 1972: Provided, That--
    (a) Such change has the effect of accelerating the time as of which 
such corporation can become a DISC,
    (b) The Commissioner is notified of such change by means of a 
statement filed (with the regional service center with which such 
corporation files its election to be treated as a DISC) not later than 
the end of the period during which such corporation may file an election 
to be treated as a DISC for such new taxable year, and
    (c) The short period required to effect such change is not a taxable 
year in which such corporation has a net operating loss as defined in 
section 172.


Thus, for example, if a corporation which uses the calendar year for its 
taxable year does not complete arrangements to become a DISC until May 
15, 1972, such corporation can, pursuant to this subdivision, change its 
annual accounting period and adopt a taxable year beginning on the first 
day of any month in 1972 after May. A change to a new annual accounting 
period made pursuant to this subdivision is effective only if the 
corporation which makes such change qualifies as a DISC for such new 
period. A corporation may change its annual accounting period and adopt 
a new taxable year pursuant to this subdivision without regard to the 
provisions of Sec. 1.1502-76 (relating to the taxable year of members 
of a group). A copy of the statement described in (b) of this 
subdivision shall be attached to the return of a corporation for the new 
taxable year to which such corporation changes pursuant to this 
subdivision. A corporation which changes its annual accounting period 
pursuant to this subparagraph will not be permitted under section 442 to 
change its annual accounting period at any time before 1982, except with 
the consent of the Commissioner as provided in Sec. 1.442-1(b)(1) or 
pursuant to subparagraph (4) of this paragraph.
    (4) Transition rule for change of taxable year of certain DISC's. In 
the case of a DISC all of the shares of which are held by a single 
shareholder or by members of a group who file a consolidated return, 
such DISC may (without the consent of the Commissioner) change its 
annual accounting period and adopt a taxable year beginning in 1972 
which is the same as the taxable year of such shareholder or the members 
of such group. A change to a new annual accounting period may be made by 
a DISC pursuant to this subparagraph even if such DISC has changed its 
annual accounting period pursuant to subparagraph (3)(ii) of this 
paragraph.
    (5) Transition rule for beginning of first taxable year of certain 
corporations. If a corporation organized before January 1, 1972, neither 
acquires assets (other than cash or other property acquired as 
consideration for the issuance of stock) nor begins doing business prior 
to January 1, 1972, the first taxable year of such corporation is deemed 
to begin at the time such corporation acquires any asset (other than 
cash or other property acquired as consideration for the issuance of 
stock) or begins doing business, whichever is earlier: Provided, That 
such corporation is a DISC for such first taxable year. For purposes of 
Sec. 1.6012-2(a), such corporation is treated as not coming into 
existence until the beginning of such first taxable year.
    (c) Effective date. The provisions of this section and the 
regulations under sections 992 through 997 apply with respect to taxable 
years ending after December 31, 1971, except that a corporation may not 
be a DISC for any taxable year beginning before January 1, 1972.
    (d) Related statutes. For rules relating to the transfer, during a 
taxable year beginning before January 1, 1976, to a DISC of assets of an 
export trade corporation (as defined in section 971), where a parent 
owns all the outstanding stock of both such DISC and such export trade 
corporation, see section 505(b) of the Revenue Act of 1971 (85 Stat. 
551). For rules regarding limitations on the qualification of a 
corporation as an export trade corporation

[[Page 794]]

for any taxable year beginning after October 31, 1971, see section 
971(a)(3).

[T.D. 7323, 39 FR 34402, Sept. 25, 1974, as amended by T.D. 7854, 47 FR 
51738, Nov. 17, 1982]



Sec. 1.992-1  Requirements of a DISC.

    (a) ``DISC'' defined. The term ``DISC'' refers to a domestic 
international sales corporation. The term ``DISC'' means a corporation 
which, for a taxable year--
    (1) Is duly incorporated and existing under the laws of any State or 
the District of Columbia,
    (2) Satisfies the gross receipts test described in paragraph (b) of 
this section,
    (3) Satisfies the assets test described in paragraph (c) of this 
section,
    (4) Satisfies the capitalization requirement described in paragraph 
(d) of this section,
    (5) Satisfies the requirement that an election to be treated as a 
DISC be in effect for such year, as described in paragraph (e) of this 
section,
    (6) [Reserved]
    (7) Maintains separate books and records, and
    (8) Is not an ineligible corporation described in paragraph (f) of 
this section.


A corporation which satisfies the requirements described in 
subparagraphs (1) through (8) of this paragraph for a taxable year is 
treated as a separate corporation for Federal tax purposes and qualifies 
as a DISC, even though such corporation would not be treated (if it were 
not a DISC) as a corporate entity for Federal income tax purposes. An 
association cannot qualify as a DISC even if such association is taxable 
as a corporation pursuant to section 7701(a)(3). In addition, a 
corporation created or organized in, or under the law of, a possession 
of the United States cannot qualify as a DISC. The rules contained in 
this paragraph constitute a relaxation of the general rules of corporate 
substance otherwise applicable under the Code. The separate 
incorporation of a DISC is required under section 992(a)(1) to make it 
possible to keep a better record of the income which is subject to the 
special treatment provided by sections 991 through 996, but this does 
not necessitate in all other respects the separate relationships which 
otherwise would be required between a parent corporation and its 
subsidiary. However, this relaxation of the general rules of corporate 
substance does not apply with respect to other corporations in other 
contexts. In the case of a transaction between a DISC and a person 
related to such DISC for purposes of section 482, see Sec. 1.993-1(l) 
for rules for determining whether income is income of a DISC to which 
the intercompany pricing rules authorized by section 994 apply.
    (b) Gross receipts test. In order for a corporation described in 
paragraph (a)(1) of this section to be a DISC for a taxable year, 95 
percent or more of its gross receipts (as defined in Sec. 1.993-6) for 
such year must consist of qualified export receipts (as defined in Sec. 
1.993-1). Gross receipts for a taxable year are determined in accordance 
with the method of accounting adopted by the corporation pursuant to 
Sec. 1.991-1(b)(2). However, for rules regarding gross receipts in the 
case of a commission sale by such corporation, see Sec. 1.993-6.
    (c) Assets test--(1) In general. In order for a corporation 
described in paragraph (a)(1) of this section to be a DISC for a taxable 
year, the adjusted basis (determined under section 1011) of its 
qualified export assets at the close of such year must equal or exceed 
95 percent of the sum of the adjusted bases (determined under section 
1011) of all assets of such corporation at the close of such year.
    (2) Assets acquired to meet assets test. For purposes of determining 
whether the requirements of subparagraph (1) of this paragraph are 
satisfied by a corporation at the end of a taxable year, an asset which 
is a qualified export asset is treated as not being an asset of such 
corporation at such time if such asset is held for a total of 60 days or 
less and is acquired directly or indirectly through borrowing, unless 
the acquisition of such asset is established to the satisfaction of the 
Commissioner or his delegate to have been for bona fide purposes. Such 
acquisition is deemed to have been for bona fide purposes if, for 
example, it is made in the usual course of the corporation's trade or 
business.

[[Page 795]]

    (d) Capitalization requirement--(1) In general. To qualify as a DISC 
for a taxable year, a corporation must have, on each day of that taxable 
year, only one class of stock. The par value (or, in the case of stock 
without par value, the stated value) of the corporation's outstanding 
stock must be on each day of the taxable year at least $2,500. In the 
case of a corporation which elects to be treated as a DISC for its first 
taxable year, the requirements of this paragraph (d)(1) are satisfied if 
the corporation has no more than one class of stock at any time during 
the year and if the par value (or, in the case of stock without par 
value, the stated value) of the corporation's outstanding stock is at 
least $2,500 on the last day of the period within which the election 
must be made and on each succeeding day of the year. For purposes of 
this paragraph (d)(1), the stated value of shares is the aggregate 
amount of the consideration paid for such shares which is not allotted 
to paid in surplus, or other surplus. The law of the State of 
incorporation of the DISC determines what consideration may be used to 
capitalize the DISC. A corporation will not be a qualified DISC unless 
at least $2,500 of valid consideration was used for this purpose. If a 
corporation has a realized or unrealized loss during a taxable year 
which results in the impairment of all or part of the capital required 
under this paragraph (d)(1), that impairment does not result in 
disqualification under this paragraph (d)(1), provided that the 
corporation does not take any legal or formal action under State law to 
reduce capital for that year below the amount required under this 
paragraph (d)(1).
    (2) Treatment of debt payable to shareholders--(i) In general. 
Purported debt of a DISC payable to any person, whether or not such 
person is a shareholder or a member of a controlled group (as defined in 
Sec. 1.993-1(k)) of which such DISC is a member, is treated as debt for 
all purposes of the Code, provided that such purported debt--
    (a) Would qualify as debt for purposes of the Code if the DISC were 
a corporation which did not qualify as a DISC,
    (b) Qualifies under subdivision (ii) of this subparagraph, or
    (c) Are trade accounts payable described in subdivision (iii) of 
this subparagraph.


Such debt is not treated as stock, and interest payable by the DISC on 
such debt is treated as interest by both the DISC and the holder of such 
debt. Payment of the principal of such debt by a DISC does not 
constitute the payment of a dividend by such DISC. The provisions of 
this subparagraph apply for a taxable year of a DISC, even though debt 
described in this subparagraph would be treated as stock of the 
corporation if such corporation did not qualify as a DISC for such year.
    (ii) Safe harbor rule. Purported debt of a DISC will in no event be 
treated as other than debt for purposes of subdivision (i) of this 
subparagraph if--
    (a) It is a written obligation to pay a sum certain on or before a 
fixed maturity date,
    (b) Interest is payable on such purported debt at an arm's length 
interest rate (as determined under Sec. 1.482-2(a)(2)), expressed as a 
fixed dollar amount or a fixed percentage of principal,
    (c) Such purported debt is not convertible into stock or into other 
purported debt unless such other purported debt qualifies under this 
subparagraph as debt of the DISC,
    (d) Such purported debt does not confer voting rights upon its 
holder, except in the event of default thereon, and
    (e) Interest and principal are paid in accordance with the terms of 
such purported debt or with any modification of such terms consistent 
with (a) through (d) of this subdivision.


The determination of whether purported debt of a DISC constitutes debt 
described in this subdivision is made without regard to the proportion 
of debt of the DISC held by any of its shareholders, to the ratio of the 
outstanding debt of the DISC to its equity, or to the amount of 
outstanding debt of such DISC. The provisions of (e) of this subdivision 
do not prevent the modification of the terms of debt of a DISC where, 
for example, a DISC becomes unable to make timely payments of principal 
required under such terms, provided that such modification

[[Page 796]]

is consistent with (a) through (d) of this subdivision.
    (iii) Trade accounts payable. Trade accounts payable of a DISC which 
arise in the normal course of its trade or business (such as in 
consideration for inventory or supplies) constitute debt of the DISC 
(whether or not such accounts payable are debt described in subdivision 
(i) (a) or (b) of this subparagraph), provided that such accounts are 
payable within 15 months after they arise. If such accounts are payable 
more than 15 months after they arise, they are debt of such DISC only if 
they are debt described in subdivision (i) (a) or (b) of this 
subparagraph.
    (iv) Relation of subparagraph to other corporations. The provisions 
of this subparagraph generally constitute a relaxation of the ordinary 
rules used in determining whether purported debt of a corporation is 
debt or equity. This relaxation is in recognition of the principle that 
a corporation may qualify as a DISC even though it has relatively little 
capital. This relaxation does not apply with respect to purported debt 
of other corporations in other contexts. The provisions of subdivisions 
(i), (ii), and (iii) of this subparagraph apply only for taxable years 
for which a corporation qualifies (or is treated) as a DISC.
    (3) Classes of stock. [Reserved]
    (e) Election in effect. In order for a corporation to be a DISC for 
a taxable year, an election to be treated as a DISC must be made by such 
corporation pursuant to Sec. 1.992-2 and must be in effect for such 
taxable year. A corporation does not become or remain a DISC solely by 
making such an election. A corporation is a DISC for a taxable year only 
if such an election is in effect for that year and the corporation also 
satisfies the requirements of paragraphs (a) through (d) of this 
section. See Sec. 1.992-2 for rules regarding the time and manner of 
making such an election.
    (f) Ineligible corporations. The following corporations shall not be 
eligible to be treated as a DISC--
    (1) A corporation exempt from tax by reason of section 501,
    (2) A personal holding company (as defined in section 542),
    (3) A financial institution to which section 581 or 593 applies,
    (4) An insurance company subject to the tax imposed by subchapter L,
    (5) A regulated investment company (as defined in section 851(a)),
    (6) A China Trade Act corporation receiving the special deduction 
provided in section 941(a), or
    (7) An electing small business corporation (as defined in section 
1371(b)).
    (g) Status as DISC after having filed return as a DISC. Under 
section 992(a)(2), notwithstanding the failure of a corporation to meet 
the requirements of paragraph (a) of this section for a taxable year, 
such corporation will be treated as a DISC for purposes of the Code for 
such taxable year (and, thus, will not be able to claim that it is not 
eligible to be a DISC) if--
    (1) Such corporation files a return as a DISC for such taxable year,
    (2) Such corporation does not notify the district director, more 
than 30 days before the expiration of the period of limitation 
(including extensions thereof) on assessment for underpayment of tax for 
such taxable year (as determined under section 6501 and the regulations 
thereunder), that it is not a DISC for such taxable year, and
    (3) The Internal Revenue Service has not issued, within such period 
of limitation (including extensions thereof) on assessment for 
underpayment of tax for such taxable year, a notice of deficiency based 
on a determination that such corporation is not a DISC for such taxable 
year.


A corporation is treated as a DISC, for all purposes, pursuant to the 
provisions of this paragraph for any taxable year for which it meets the 
requirements of this paragraph, even if such corporation is an 
ineligible corporation described in paragraph (f) of this section for 
such taxable year. Thus, for example, a corporation which is treated as 
a DISC for a taxable year pursuant to this paragraph is treated as a 
DISC for that taxable year for purposes of Sec. 1.992-2(e)(3) (relating 
to the termination of a DISC election if a corporation is not a DISC for 
each of any 5 consecutive taxable years). If a corporation is treated as 
a DISC for a taxable year pursuant to this paragraph,

[[Page 797]]

persons who held stock of such corporation at any time during such 
taxable year are treated, with respect to such stock, as holders of 
stock in a DISC for the period or periods during which they held such 
stock within such taxable year.
    (h) Definition of ``former DISC''. Under section 992(a)(3), the term 
``former DISC'' refers to a corporation which is not a DISC for a 
taxable year but which was (or was treated as) a DISC for a prior 
taxable year. However, a corporation is not a former DISC for a taxable 
year unless such corporation has, at the beginning of such taxable year, 
undistributed previously taxed income (as defined in Sec. 1.996-3(c) or 
accumulated DISC income (as defined in Sec. 1.996-3(b)). A corporation 
which is a former DISC for a taxable year is a former DISC for all 
purposes of the Code.

(Secs. 385 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 613 
and 68A Stat. 917; 26 U.S.C. 385 and 7805))

[T.D. 7323, 39 FR 34403, Sept. 25, 1974, as amended by T.D. 7420, 41 FR 
20654, May 20, 1976; 41 FR 22267, June 2, 1976; T.D. 7747, 45 FR 86459, 
Dec. 31, 1980; T.D. 7920, 48 FR 50712, Nov. 3, 1983; T.D. 8371, 56 FR 
55234, Oct. 25, 1991]



Sec. 1.992-2  Election to be treated as a DISC.

    (a) Manner and time of election--(1) Manner--(i) In general. A 
corporation can elect to be treated as a DISC for a taxable year 
beginning after December 31, 1971. Except as provided in paragraph 
(a)(1)(ii) of this section, the election is made by the corporation 
filing Form 4876 with the service center with which it would file its 
income tax return if it were subject for such taxable year to all the 
taxes imposed by subtitle A of the Internal Revenue Code of 1954. The 
form shall be signed by any person authorized to sign a corporation 
return under section 6062, and shall contain the information required by 
such form. Except as provided in paragraphs (b)(3) and (c) of this 
section, such election to be treated as a DISC shall be valid only if 
the consent of every person who is a shareholder of the corporation as 
of the beginning of the first taxable year for which such election is 
effective is on or attached to such Form 4876 when filed with the 
service center.
    (ii) Transitional rule for corporations electing during 1972. If the 
first taxable year for which an election by a corporation to be treated 
as a DISC is a taxable year beginning after December 31, 1971, and on or 
before December 31, 1972, such election may be made either in the manner 
prescribed in subdivision (i) of this subparagraph or by filing, at the 
place prescribed in subdivision (i) of this subparagraph, a statement 
captioned ``Election to be Treated as a DISC.'' Such statement of 
election shall be valid only if the consent of each shareholder is filed 
with the service center in the form, and at the time, prescribed in 
paragraph (b) of this section. Such statement shall be signed by any 
person authorized to sign a corporation return under section 6062 and 
shall include the name, address, and employer identification number (if 
known) of the corporation, the beginning date of the first taxable year 
for which the election is effective, the number of shares of stock of 
the corporation issued and outstanding as of the earlier of the 
beginning of the first taxable year for which the election is effective 
or the time the statement is filed, the number of shares held by each 
shareholder as of the earlier of such dates, and the date and place of 
incorporation. As a condition of the election being effective, a 
corporation which elects to become a DISC by filing a statement in 
accordance with this subdivision must furnish (to the service center 
with which the statement was filed) such additional information as is 
required by Form 4876 by March 31, 1973.
    (2) Time of making election--(i) In general. In the case of a 
corporation making an election to be treated as a DISC for its first 
taxable year, such election shall be made within 90 days after the 
beginning of such taxable year. In the case of a corporation which makes 
an election to be treated as a DISC for any taxable year beginning after 
March 31, 1972 (other than the first taxable year of such corporation), 
the election shall be made during the 90-day period immediately 
preceding the first day of such taxable year.

[[Page 798]]

    (ii) Transitional rules for certain corporations electing during 
1972. In the case of a corporation which makes an election to be treated 
as a DISC for a taxable year beginning after December 31, 1971, and on 
or before March 31, 1972 (other than its first taxable year), the 
election shall be made within 90 days after the beginning of such 
taxable year.
    (b) Consent by shareholders--(1) In general--(i) Time and manner of 
consent. Under paragraph (a)(1)(i) of this section, subject to certain 
exceptions, the election to be treated as a DISC is not valid unless 
each person who is a shareholder as of the beginning of the first 
taxable year for which the election is effective signs either the 
statement of consent on Form 4876 or a separate statement of consent 
attached to such form. A shareholder's consent is binding on such 
shareholder and all transferees of his shares and may not be withdrawn 
after a valid election is made by the corporation. In the case of a 
corporation which files an election to become a DISC for a taxable year 
beginning after December 31, 1972, if a person who is a shareholder as 
of the beginning of the first taxable year for which the election is 
effective does not consent by signing the statement of consent set forth 
on Form 4876, such election shall be valid (except in the case of an 
extension of the time for filing granted under the provisions of 
subparagraph (3) of this paragraph or paragraph (c) of this section) 
only if the consent of such shareholder is attached to the Form 4876 
upon which such election is made.
    (ii) Form of consent. A consent other than the statement of consent 
set forth on Form 4876 shall be in the form of a statement which is 
signed by the shareholder and which sets forth (a) the name and address 
of the corporation and of the shareholder and (b) the number of shares 
held by each such shareholder as of the time the consent is made and (if 
the consent is made after the beginning of the corporation's taxable 
year for which the election is effective) as of the beginning of such 
year. If the consent is made by a recipient of transferred shares 
pursuant to paragraph (c) of this section, the statement of consent 
shall also set forth the name and address of the person who held such 
shares as of the beginning of such taxable year and the number of such 
shares. Consent shall be made in the following form: ``I (insert name of 
shareholder), a shareholder of (insert name of corporation seeking to 
make the election) consent to the election of (insert name of 
corporation seeking to make the election) to be treated as a DISC under 
section 992(b) of the Internal Revenue Code. The consent so made by me 
is irrevocable and is binding upon all transferees of my shares in 
(insert name of corporation seeking to make the election).'' The 
consents of all shareholders may be incorporated in one statement.
    (iii) Who may consent. Where stock of the corporation is owned by a 
husband and wife as community property (or the income from such stock is 
community property), or is owned by tenants in common, joint tenants, or 
tenants by the entirety, each person having a community interest in such 
stock or the income therefrom and each tenant in common, joint tenant, 
and tenant by the entirety must consent to the election. The consent of 
a minor shall be made by his legal guardian or by his natural guardian 
if no legal guardian has been appointed. The consent of an estate shall 
be made by the executor or administrator thereof. The consent of a trust 
shall be made by the trustee thereof. The consent of an estate or trust 
having more than one executor, administrator, or trustee, may be made by 
any executor, administrator, or trustee, authorized to make a return of 
such estate or trust pursuant to section 6012(b)(5). The consent of a 
corporation or partnership shall be made by an officer or partner 
authorized pursuant to section 6062 or 6063, as the case may be, to sign 
the return of such corporation or partnership. In the case of a foreign 
person, the consent may be signed by any individual (whether or not a 
U.S. person) who would be authorized under sections 6061 through 6063 to 
sign the return of such foreign person if he were a U.S. person.
    (2) Transitional rule for corporations electing during 1972. In the 
case of a corporation which files an election to be treated as a DISC 
for a taxable year beginning after December 31, 1971, and on

[[Page 799]]

or before December 31, 1972, such election shall be valid only if the 
consent of each person who is a shareholder as of the beginning of the 
first taxable year for which such election is effective is filed with 
the service center with which the election was filed within 90 days 
after the first day of such taxable year or within the time granted for 
an extension of time for filing such consent. The form of such consent 
shall be the same as that prescribed in subparagraph (1) of this 
paragraph. Such consent shall be attached to the statement of election 
or shall be filed separately (with such service center) with a copy of 
the statement of election. An extension of time for filing a consent may 
be granted in the manner, and subject to the conditions, described in 
subparagraph (3) of this paragraph.
    (3) Extension of time to consent. An election which is timely filed 
and would be valid except for the failure to attach the consent of any 
shareholder to the Form 4876 upon which the election was made or to 
comply with the 90-day requirement in subparagraph (2) of this paragraph 
or paragraph (c)(1) of this section, as the case may be, will not be 
invalid for such reason if it is shown to the satisfaction of the 
service center that there was reasonable cause for the failure to file 
such consent, and if such shareholder files a proper consent to the 
election within such extended period of time as may be granted by the 
Internal Revenue Service. In the case of a late filing of a consent, a 
copy of the Form 4876 or statement of election shall be attached to such 
consent and shall be filed with the same service center as the election. 
The form of such consent shall be the same as that set forth in 
paragraph (b)(1)(ii) of this section. In no event can any consent be 
made pursuant to this paragraph on or after the last day of the first 
taxable year for which a corporation elects to be treated as a DISC.
    (c) Consent by holder of transferred shares--(1) In general. If a 
shareholder of a corporation transfers--
    (i) Prior to the first day of the first taxable year for which such 
corporation elects to be treated as a DISC, some or all of the shares 
held by him without having consented to such election, or
    (ii) On or before the 90th day after the first day of the first 
taxable year for which such corporation elects to be treated as a DISC, 
some or all of the shares held by him as of the first day of such year 
(or if later, held by him as of the time such shares are issued) without 
having consented to such election, then consent may be made by any 
recipient of such shares on or before the 90th day after the first day 
of such first taxable year. If such recipient fails to file his consent 
on or before such 90th day, an extension of time for filing such consent 
may be granted in the manner, and subject to the conditions, described 
in paragraph (b)(3) of this section. In addition, if the transfer occurs 
more than 90 days after the first day of such taxable year, an extension 
of time for filing such consent may be granted to such recipient only if 
it is determined under paragraph (b)(3) of this section that an 
extension of time would have been granted the transferor for the filing 
of such consent if the transfer had not occurred. A consent which is not 
attached to the original Form 4876 or statement of election (as the case 
may be) shall be filed with the same service center as the original Form 
4876 or statement of election and shall have attached a copy of such 
original form or statement of election. The form of such consent shall 
be the same as that set forth in paragraph (b)(1)(ii) of this section. 
For the purposes of this paragraph, a transfer of shares includes any 
sale, exchange, or other disposition, including a transfer by gift or at 
death.
    (2) Requirement for the filing of an amended Form 4876 or statement 
of election. In any case in which a consent to a corporation's election 
to be treated as a DISC is made pursuant to subparagraph (1) of this 
paragraph, such corporation must file an amended Form 4876 or statement 
of election (as the case may be) reflecting all changes in ownership of 
shares. Such form must be filed with the same service center with which 
the original Form 4876 or statement of election was filed by such 
corporation.
    (d) Effect of election--(1) Effect on corporation. A valid election 
to be treated as a DISC remains in effect (without

[[Page 800]]

regard to whether the electing corporation qualifies as a DISC for a 
particular year) until terminated by any of the methods provided in 
paragraph (e) of this section. While such election is in effect, the 
electing corporation is subject to sections 991 through 997 and other 
provisions of the Code applicable to DISC's for any taxable year for 
which it qualifies as a DISC (or is treated as qualifying as a DISC 
pursuant to Sec. 1.992-1(g)). Such corporation is also subject to such 
provisions for any taxable year for which it is treated as a former DISC 
as a result of qualifying or being treated as a DISC for any taxable 
year for which such election was in effect.
    (2) Effect on shareholders. A valid election by a corporation to be 
treated as a DISC subjects the shareholders of such corporation to the 
provisions of section 995 (relating to the taxation of the shareholders 
of a DISC or former DISC) and to all other provisions of the Code 
relating to the shareholders of a DISC or former DISC. Such provisions 
of the Code apply to any person who is a shareholder of a DISC or former 
DISC whether or not such person was a shareholder at the time the 
corporation elected to become a DISC.
    (e) Termination of election--(1) In general. An election to be 
treated as a DISC is terminated only as provided in subparagraph (2) or 
(3) of this paragraph.
    (2) Revocation of election--(i) Manner of revocation. An election by 
a corporation to be treated as a DISC may be revoked by the corporation 
for any taxable year of the corporation after the first taxable year for 
which the election is effective. Such revocation shall be made by the 
corporation filing a statement that the corporation revokes its election 
under section 992(b) to be treated as a DISC. Such statement shall 
indicate the corporation's name, address, employer identification 
number, and the first taxable year of the corporation for which the 
revocation is to be effective. The statement shall be signed by any 
person authorized to sign a corporation return under section 6062. Such 
revocation shall be filed with the service center with which the 
corporation filed its election, except that, if it filed an annual 
information return under section 6011(e)(2), the revocation shall be 
filed with the service center with which it filed its last such return.
    (ii) Years for which revocation is effective. If a corporation files 
a statement revoking its election to be treated as a DISC during the 
first 90 days of a taxable year (other than the first taxable year for 
which such election is effective), such revocation will be effective for 
such taxable year and all taxable years thereafter. If the corporation 
files a statement revoking its election to be treated as a DISC after 
the first 90 days of a taxable year, the revocation will be effective 
for all taxable years following such taxable year.
    (3) Continued failure to be a DISC. If a corporation which has 
elected to be treated as a DISC does not qualify as a DISC (and is not 
treated as a DISC pursuant to Sec. 1.992-1(g)) for each of any 5 
consecutive taxable years, such election terminates and will not be 
effective for any taxable year after such fifth taxable year. Such 
termination will be effective automatically, without notice to such 
corporation or to the Internal Revenue Service. If, during any 5-year 
period for which an election is effective, the corporation should 
qualify as a DISC (or be treated as a DISC pursuant to Sec. 1.992-1(g)) 
for a taxable year, a new 5-year period shall automatically start at the 
beginning of the following taxable year.
    (4) Election after termination. If a corporation has made a valid 
election to be treated as a DISC and such election terminates in either 
manner described in subparagraph (2) or (3) of this paragraph, such 
corporation is eligible to reelect to be treated as a DISC at any time 
by following the procedures described in paragraphs (a) through (c) of 
this section. If a corporation terminates its election and subsequently 
reelects to be treated as a DISC, the corporation and its shareholders 
continue to be subject to sections 995 and 996 with respect to the 
period during which its first election was in effect. Thus, for example, 
distributions upon disqualification includible in the gross incomes of 
shareholders of a corporation pursuant to section 995(b)(2) continue to 
be so includible for taxable years for

[[Page 801]]

which a second election of such corporation is in effect without regard 
to the second election.

[T.D. 7323, 39 FR 34405, Sept. 25, 1974, as amended by T.D. 7420, 41 FR 
20655, May 20, 1976]



Sec. 1.992-3  Deficiency distributions to meet qualification 
requirements.

    (a) In general. A corporation which meets the requirements described 
in Sec. 1.992-1 for treatment as a DISC for a taxable year, other than 
the 95 percent of gross receipts test described in Sec. 1.992-1(b) or 
the 95-percent assets test described in Sec. 1.992-1(c), or both tests, 
may nevertheless qualify as a DISC for such year by making deficiency 
distributions (attributable to its gross receipts other than qualified 
export receipts and its assets other than qualified export assets) if 
all of the following requirements are satisfied:
    (1) The corporation distributes the amount determined under 
paragraph (b) of this section as a deficiency distribution. The amount 
of a deficiency distribution is determined without regard to the amount 
by which the corporation fails to meet either test.
    (2) The reasonable cause requirements prescribed in paragraph (c)(1) 
of this section are satisfied with respect to both the corporation's 
failure to meet either test and its failure to make a deficiency 
distribution prior to the time the distribution is made.
    (3) The corporation makes such deficiency distribution pro rata to 
all its shareholders.
    (4) The corporation designates the distribution, at the time of the 
distribution, as a deficiency distribution, pursuant to section 992(c), 
to meet the qualification requirements to be a DISC. Such designation 
shall be in the form of a communication sent at the time of such 
distribution to each shareholder and to the service center with which 
the corporation has filed or will file its return for the taxable year 
to which the distribution relates. A corporation may not retroactively 
designate a prior distribution as a deficiency distribution to meet 
qualification requirements. Subject to the limitation described in 
paragraph (c)(3) of this section, a corporation may make a deficiency 
distribution with respect to a taxable year at any time after the close 
of such taxable year or, in the case of a deficiency distribution made 
on or before September 29, 1975, at any time during or after such 
taxable year.


See sections 246(d), 904(f), 995, and 996 for rules regarding the 
treatment of a deficiency distribution to meet qualification 
requirements by the shareholders and the corporation.
    (b) Amount of deficiency distribution--(1) In general. In order to 
meet the requirements of paragraph (a) of this section, the amount of a 
deficiency distribution must be, if the corporation fails to meet--
    (i) The 95 percent of gross receipts test, the amount determined in 
subparagraph (2) of this paragraph,
    (ii) The 95-percent assets test, the amount determined in 
subparagraph (3) of this paragraph, and
    (iii) Both such tests, except as provided in subparagraph (4) of 
this paragraph, the sum of the amounts determined in subparagraphs (2) 
and (3) of this paragraph.
    (2) Computation of deficiency distribution to meet 95 percent of 
gross receipts test--(i) In general. If a corporation fails to meet the 
95 percent of gross receipts test described in Sec. 1.992-1(b) for its 
taxable year, the amount of the deficiency distribution required by this 
subparagraph is an amount equal to the sum of its taxable income (if 
any) from each transaction giving rise to gross receipts (as defined in 
Sec. 1.993-6) which are not qualified export receipts (as defined in 
Sec. 1.993-1). A corporation's taxable income from a transaction shall 
be the amount of such gross receipts from such transaction reduced only 
by (a) its cost of goods sold attributable to such gross receipts, and 
by (b) its expenses, losses, and other deductions properly apportioned 
or allocated thereto in a manner consistent with the rules set forth in 
Sec. 1.861-8. For purposes of this subdivision, however, any expenses, 
losses, or other deductions which cannot definitely be allocated to some 
item or class of gross income in such manner shall not reduce such gross 
receipts. If the corporation is a commission agent for a principal in a 
transaction, the corporation's taxable income is the amount of the 
commission from such transaction reduced

[[Page 802]]

only by the amounts described in (b) of this subdivision.
    (ii) Example. The provisions of this subparagraph may be illustrated 
by the following example:

    Example. (a) X and Y are calendar year taxpayers. X, a domestic 
manufacturing company, owns all the stock of Y, which seeks to qualify 
as a DISC for 1973. During 1973, X manufactures a machine which is 
eligible to be export property as defined in Sec. 1.993-3. Y is made a 
commission agent with respect to exporting such machine. Thereafter, 
during 1973 Y is considered to receive gross receipts of $100,000, as 
determined under section 993(f), attributable to X's sale of the machine 
in a manner which causes the gross receipts to be excluded receipts 
pursuant to section 993(a)(2) and, therefore, not qualified export 
receipts. Y's total gross receipts for 1973 are $1 million of which 
$900,000 (i.e., 90 percent) are qualified export receipts. Therefore, Y 
does not satisfy the 95 percent of gross receipts test for 1973 because 
less than 95 percent of its gross receipts are qualified export 
receipts. Y has $9,000 of expenses properly apportioned or allocated to 
its gross income from such sale and $1,000 of other expenses which 
cannot definitely be allocated to some item or class of gross income, 
determined in a manner consistent with the rules set forth in Sec. 
1.861-8. In order to satisfy the 95 percent of gross receipts test for 
1973, if the commission due from X to Y were $15,000, Y must make a 
deficiency distribution of $6,000 computed as follows:

Y's commission (gross income) from the transaction.........      $15,000
Less: Y's expenses apportioned or allocated to its gross           9,000
 income from the transaction...............................
                                                            ------------
Required deficiency distribution by reason of $100,000 of          6,000
 gross receipts which are not qualified export receipts....
 

    (b) If the commission due from X to Y were $9,400, resulting in a 
net loss of $600 to Y ($9,400 to $10,000), Y must make a deficiency 
distribution of $400 computed as follows:

Y's commissions (gross income) from the transaction........       $9,400
Less: Y's expenses apportioned or allocated to its gross           9,000
 income from the transaction...............................
                                                            ------------
Required deficiency distribution by reason of $100,000 of            400
 gross receipts which are not qualified export receipts....
 

    (c) If the commission due from X to Y were $8,500, Y would not be 
required to make a deficiency distribution since, under this 
subparagraph, there would be no taxable income attributable to gross 
receipts from the sale.

    (3) Computation of deficiency distribution to meet 95 percent assets 
test--(i) In general. If a corporation fails to meet the 95 percent 
assets test described in Sec. 1.992-1(c) for its taxable year, the 
amount of the deficiency distribution required by this subparagraph is 
an amount equal to the fair market value as of the last day of such 
taxable year of the assets which are not qualified export assets held by 
such corporation on such last day.
    (ii) Asset held for more than 1 year. In the case of a corporation 
which holds continuously an asset which is not a qualified export asset 
at the close of more than 1 taxable year, it must distribute an amount 
equal to its fair market value (or, if greater, the amount determined 
under subparagraph (4) of this paragraph) only once if, at the close of 
the first such taxable year, such corporation reasonably believed that 
such asset was a qualified export asset. This subdivision shall not 
apply for any taxable year beginning after the date the corporation 
knows (or a reasonable man would have known) that an asset is not a 
qualified export asset and in order to qualify for each such year, the 
corporation must distribute the fair market value of such asset for each 
such year.
    (4) Computation in the case of a failure to meet both tests as a 
result of a single transaction. If a corporation fails to meet both the 
95 percent of gross receipts test and the 95 percent assets test for a 
taxable year, and if the corporation holds at the end of such year 
assets (other than cash or qualified export assets) which were received 
as proceeds of a sale or exchange during such year which resulted in 
gross receipts other than qualified export receipts, then the amount of 
the deficiency distribution required by this paragraph with respect to 
such sale or exchange and assets held is the larger of the amount 
required by subparagraph (2) of this paragraph with respect to the sale 
or exchange or the amount required by subparagraph (3) of this paragraph 
with respect to such assets held. Thus, for example, if a corporation 
sells property which is not a qualified export asset for $100, receives 
$85 in cash and a note for $15, and derives $25 of taxable income from 
the sale as determined under subparagraph (2) of this paragraph, it must 
distribute $25. If the provisions of this subparagraph are applied with 
respect

[[Page 803]]

to assets of a DISC (other than qualified export assets), such 
provisions do not apply to any property received as proceeds from a sale 
or exchange of such assets.
    (c) Reasonable cause for failure--(1) In general. If for a taxable 
year, a corporation has failed to meet the 95 percent of gross receipts 
test, the 95 percent assets test, or both tests, such corporation may 
satisfy any such test for such year by means of a deficiency 
distribution in the amount determined under paragraph (b) of this 
section only if the reasonable cause requirements of this subparagraph 
are satisfied. Such reasonable cause requirements are satisfied if--
    (i) There is reasonable cause (as determined in accordance with 
subparagraph (2) of this paragraph) for such corporation's failure to 
satisfy such test and to make such distribution prior to the date on 
which it was made, the time limit in subparagraph (3) of this paragraph 
for making the distribution is satisfied, and interest (if required) is 
paid in the amount and in the manner prescribed by subparagraph (4) of 
this paragraph, or
    (ii) The time and ``70-percent'' requirements of the reasonable 
cause test of paragraph (d) of this section are satisfied.
    (2) Determination of reasonable cause. In general, whether a 
corporation's failure to meet the 95 percent of gross receipts test, the 
95 percent assets test, or both tests for a taxable year and its failure 
to make a pro rata distribution prior to the date on which it was made 
will be considered for reasonable cause where the action or inaction 
which resulted in such failure occurred in good faith, such as failure 
to meet the 95 percent assets test resulting from blocked currency or 
expropriation, or failure to meet either test because of reasonable 
uncertainty as to what constitutes a qualified export receipt or a 
qualified export asset. For further examples, if a corporation's 
reasonable determination of the percentage of its total gross receipts 
that are qualified export receipts is subsequently redetermined to be 
less than 95 percent as a result of a price adjustment by the Internal 
Revenue Service under section 482, or if the corporation has a casualty 
loss for which it receives an unanticipated insurance recovery which 
causes its qualified export receipts to be less than 95 percent of its 
total gross receipts, then the failure to satisfy the 95 percent of 
gross receipts test is considered to be due to reasonable cause.
    (3) Time limit for deficiency distribution. Except as otherwise 
provided in this subparagraph, the time limit prescribed by this 
subparagraph for making a deficiency distribution is satisfied if the 
amount of the distribution required by paragraph (b) of this section is 
made within 90 days from the date of the first written notification to 
the corporation by the Internal Revenue Service that it had not 
satisfied the 95 percent of gross receipts test or the 95 percent assets 
test or both tests, for a taxable year. Upon a showing by the 
corporation that an extension of the 90-day time limit is reasonable and 
necessary, the Commissioner may grant such extension of such time limit. 
In any case in which a corporation contests the decision of the Internal 
Revenue Service that such corporation has not met the 95 percent of 
gross receipts test, the 95 percent assets test, or both tests, an 
extension of the 90-day time limit will be allowed until 30 days after 
the final determination of such contest. The date of the final 
determination of such contest shall, for purposes of section 992(c), be 
established in the manner specified in subdivisions (i) through (iv) of 
this subparagraph:
    (i) The date of final determination by a decision of the United 
States Tax Court is the date upon which such decision becomes final, as 
prescribed in section 7481.
    (ii) The date of final determination in a case which is contested in 
a court (and upon which there is a judgment) other than the Tax Court is 
the date upon which the judgment becomes final and will be determined on 
the basis of the facts and circumstances of each particular case. For 
example, ordinarily a judgment of a United States district court becomes 
final upon the expiration of the time allowed for taking an appeal, if 
no such appeal is duly taken within such time; and a judgment of the 
United States Court of

[[Page 804]]

Claims becomes final upon the expiration of the time allowed for filing 
a petition for certiorari if no such petition is duly filed within such 
time.
    (iii) The date of a final determination by a closing agreement, made 
under section 7121, is the date such agreement is approved by the 
Commissioner.
    (iv) A final determination under section 992(c) may be made by an 
agreement signed by the district director or director of the service 
center with which the corporation files its annual return or by such 
other official to which authority to sign has been delegated, and by or 
on behalf of the taxpayer. The agreement shall set forth the total 
amount of the deficiency distribution to be paid to the shareholders of 
the DISC for the taxable year or years. An agreement under this 
subdivision shall be sent to the taxpayer at his last known address by 
either registered or certified mail. For further guidance regarding the 
definition of last known address, see Sec. 301.6212-2 of this chapter. 
If registered mail is used for such purpose, the date of registration is 
considered the date of final determination; if certified mail is used 
for such purpose, the date of postmark on the sender's receipt for such 
mail is considered the date of final determination. If the corporation 
makes a deficiency distribution before such registration or postmark 
date but on or after the date the district director or director of the 
service center or other official has signed the agreement, the date of 
signature by the district director or director of the service center or 
other official is considered the date of final determination. If the 
corporation makes a deficiency distribution before the district director 
or director of the service center or other official signs the agreement, 
the date of final determination is considered to be the date of the 
making of the deficiency distribution. During any extension of time the 
interest charge provided in subparagraph (4) of this paragraph will 
continue to accrue at the rate provided for in such subparagraph.
    (4) Payment of interest for delayed distribution--(i) In general. If 
a corporation makes a deficiency distribution after the 15th day of the 
ninth month after the close of the taxable year with respect to which 
such distribution is made, such distribution will not be deemed to 
satisfy the 95 percent of gross receipts test or the 95 percent assets 
test for such year unless such corporation pays to the Internal Revenue 
Service a charge determined by multiplying (a) an amount equal to 4\1/2\ 
percent of such distribution by (b) the number of its taxable years 
which begin (1) after the taxable year with respect to which the 
distribution is made and (2) before such distribution is made. Such 
charge must be paid, within the 30-day period beginning with the day on 
which such distribution is made, to the service center with which the 
corporation files its annual information return for its taxable year in 
which the distribution is made. For purposes of the Internal Revenue 
Code, such charge is considered interest.
    (ii) Example. The provisions of subdivision (i) of this subparagraph 
may be illustrated by the following example:

    Example. X corporation, which uses the calendar year as its taxable 
year, meets the 95 percent assets test but fails to meet the 95 percent 
of gross receipts test for 1972 and does not by September 15, 1973, make 
the deficiency distribution required by reason of its failure to meet 
such test. Assume that reasonable cause exists for the corporation's 
failure to meet the 95 percent of gross receipts test and failure to 
make the required deficiency distribution. If X makes the required 
deficiency distribution, in the amount of $10,000, on April 1, 1976, X 
must pay on or before April 30, 1976, to the service center with which 
it files its annual information return a charge of $1,800, computed as 
follows:

Deficiency distribution made by X..........................      $10,000
Multiplied by 4\1/2\ percent...............................         .045
                                                            ------------
Intermediate product.......................................          450
Multiplied by: Number of X's taxable years beginning after             4
 1972 and before April 1, 1976.............................
                                                            ------------
Charge to be paid service center because of late deficiency        1,800
 distribution (which is considered interest)...............
 

    (d) Certain distributions deemed for reasonable cause. If a 
corporation makes a distribution in the amount required by paragraph (b) 
of this section with respect to a taxable year on or before the 15th day 
of the ninth month after the close of such year, it will be deemed to 
have acted with reasonable cause with respect to its failure to satisfy 
the 95 percent of gross receipts test, the 95

[[Page 805]]

percent assets test, or both tests, for such year and its failure to 
make such distribution prior to the date on which the distribution was 
made if--
    (1) At least 70 percent of the gross receipts of such corporation 
for such taxable year consist of qualified export receipts, and
    (2) The sum of the adjusted bases of the qualified export assets 
held by such corporation on the last day of each month of the taxable 
year equals or exceeds 70 percent of the sum of the adjusted bases of 
all assets held by the corporation on each such day.

[T.D. 7323, 39 FR 34407, Sept. 25, 1974; 39 FR 36009, Oct. 7, 1974, as 
amended by T.D. 7420, 41 FR 20655, May 20, 1976; T.D. 7854, 47 FR 51739, 
Nov. 17, 1982; T.D. 8939, 66 FR 2819, Jan. 12, 2001]



Sec. 1.992-4  Coordination with personal holding company provisions
in case of certain produced film rents.

    (a) In general. Section 992(d)(2) provides that a personal holding 
company is not eligible to be treated as a DISC. Section 543(a)(5)(B) 
provides that, for purposes of section 543, the term ``produced film 
rents'' means payments received with respect to an interest in a film 
for the use of, or the right to use, such film, but only to the extent 
that such interest was acquired before substantial completion of 
production of such film. Under section 992(e), if such produced film 
rents are included in the ordinary gross income (as defined in section 
543(b)(1)) of a qualified subsidiary for a taxable year of such 
subsidiary, and such interest was acquired by such subsidiary from its 
parent, such interest is deemed (for purposes of the application of 
sections 541, 543(b)(1), and 992(d)(2), and Sec. 1.992-1(f) for such 
taxable year) to have been acquired by such subsidiary at the time such 
interest was acquired by such parent. Thus, for example, if a parent 
acquires an interest in a film before it is substantially completed, 
then substantially completes such film prior to transferring an interest 
in such motion picture to a qualified subsidiary, the qualified 
subsidiary is considered as having acquired such interest prior to 
substantial completion of such motion picture for purposes of 
determining whether payments from the rental of such motion picture will 
be classified as produced film rents of such subsidiary. The provisions 
of section 992(e) and this section are not applicable in determining 
whether payments received with respect to an interest in a film are 
included in the ordinary gross income of a parent or a qualified 
subsidiary. Thus, even though a qualified subsidiary is treated pursuant 
to this section as having acquired an interest in a film at the time 
such interest was acquired by such subsidiary's parent, payments 
received by such parent with respect to such interest prior to the 
transfer of such interest to such subsidiary are includible in the 
ordinary gross income of such parent and not includible in the ordinary 
gross income of such subsidiary.
    (b) Definitions--(1) Qualified subsidiary. For purposes of this 
section, a corporation is a qualified subsidiary for a taxable year if--
    (i) Such corporation was established for the purpose of becoming a 
DISC,
    (ii) Such corporation would qualify (or be treated) as a DISC for 
such taxable year if it is not a personal holding company, and
    (iii) On every day of such taxable year on which shares of such 
corporation are outstanding, at least 80 percent of such shares are held 
directly by a second corporation.
    (2) Parent. For purposes of this section, the term ``parent'' means 
a second corporation referred to in subparagraph (1)(iii) of this 
paragraph.

[T.D. 7323, 39 FR 34409, Sept. 25, 1974]



Sec. 1.993-1  Definition of qualified export receipts.

    (a) In general. For a corporation to qualify as a DISC, at least 95 
percent of its gross receipts for a taxable year must consist of 
qualified export receipts. Under section 993(a), the term ``qualified 
export receipts'' means any of the eight amounts described in paragraphs 
(b) through (i) of this section, except to the extent that any of the 
eight amounts is an excluded receipt within the meaning of paragraph (j) 
of this section. For purposes of this section and Sec. Sec. 1.993-2 
through 1.993-6--
    (1) DISC. All references to a DISC mean a DISC, except when the 
context

[[Page 806]]

indicates that such term means a corporation in the process of meeting 
the conditions necessary for that corporation to become a DISC, or a 
corporation being tested as to whether it qualifies as a DISC.
    (2) Sale, lease, and license. The term ``sale'' includes an exchange 
or other disposition and the term ``lease'' includes a rental or a 
sublease. The term ``license'' includes a sublicense. All rules under 
this section and Sec. Sec. 1.993-2 through 1.993-6 applicable to leases 
of export property apply in the same manner to licenses of export 
property. See Sec. 1.993-3(f)(3) for a description of intangible 
property which cannot be export property.
    (3) Gross receipts. The term ``gross receipts'' is defined by 
section 993(f) and Sec. 1.993-6.
    (4) Qualified export assets. The term ``qualified export assets'' is 
defined by section 993(b) and Sec. 1.993-2.
    (5) Export property. The term ``export property'' is defined by 
section 993(c) and Sec. 1.993-3.
    (6) Related person. The term ``related person'' means a person who 
is related to another person if either immediately before or after a 
transaction--
    (i) The relationship between such persons would result in a 
disallowance of losses under section 267 (relating to disallowance of 
losses, etc., between related taxpayers), or section 707(b) (relating to 
losses disallowed, etc., between partners and controlled partnerships), 
and the regulations thereunder, or
    (ii) Such persons are members of the same controlled group of 
corporations, as defined in section 1563(a) (relating to definition of 
controlled group of corporations), except that (a) ``more than 50 
percent'' shall be substituted for ``at least 80 percent'' each place it 
appears in section 1563(a) and the regulations thereunder, and (b) the 
provisions of section 1563(b) shall not apply in determining whether 
such persons are members of the same controlled group.
    (7) Related supplier. The term ``related supplier'' is defined by 
Sec. 1.994-1(a)(3)(ii).
    (8) Controlled group. The term ``controlled group'' is defined by 
paragraph (k) of this section.
    (b) Sales of export property. Qualified export receipts of a DISC 
include gross receipts from the sale of export property by such DISC, or 
by any principal for whom such DISC acts as a commission agent (whether 
or not such principal is a related supplier), pursuant to the terms of a 
contract entered into with a purchaser by such DISC or by such principal 
at any time or by any other person and assigned to such DISC or such 
principal at any time prior to the shipment of such property to the 
purchaser. Any agreement, oral or written, which constitutes a contract 
at law, satisfies the contractual requirement of this paragraph. Gross 
receipts from the sale of export property, whenever received, do not 
constitute qualified export receipts unless the seller (or the 
corporation acting as commission agent for the seller) is a DISC at the 
time of the shipment of such property to the purchaser. For example, if 
a corporation which sells export property under the installment method 
is not a DISC for the taxable year in which the property is shipped to 
the purchaser, gross receipts from such sale do not constitute qualified 
export receipts for any taxable year of the corporation.
    (c) Leases of export property--(1) In general. Qualified export 
receipts of a DISC include gross receipts from the lease of export 
property provided that--
    (i) Such property is held by such DISC (or by a principal for whom 
such DISC acts as commission agent with respect to the lease) either as 
an owner or lessee at the beginning of the term of such lease, and
    (ii) Such DISC qualified (or was treated) as a DISC for its taxable 
year in which the term of such lease began.
    (2) Prepayment of lease receipts. If part or all of the gross 
receipts from a lease of property are prepaid, then--
    (i) All such prepaid gross receipts are qualified export receipts of 
a DISC if it is reasonably expected at the time of such prepayment that 
throughout the term of such lease they would be qualified export 
receipts if received not as a prepayment; or
    (ii) If it is reasonably expected at the time of such prepayment 
that throughout the term of such lease they would not be qualified 
export receipts if received not as a prepayment, then only

[[Page 807]]

those prepaid receipts, for the taxable years of the DISC for which they 
would be qualified export receipts, are qualified export receipts.


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

[[Page 808]]

subparagraph (2) of this paragraph). In the case of a sale, reasonable 
expectations at the time of the sale are based on the gross receipts 
from all related services which may reasonably be expected to be 
performed at any time before the end of the 10-year period following the 
date of such-sale. In the case of a lease, reasonable expectations at 
the time of the lease are based on the gross receipts from all related 
services which may reasonably be expected to be performed at any time 
before the end of the term of such lease (determined without regard to 
renewal options).
    (ii) Allocation of gross receipts from services. In determining 
whether the services related to a sale or lease of export property are 
subsidiary to such sale or lease, the gross receipts to be treated as 
derived from the furnishing of services may not be less than the amount 
of gross receipts reasonably allocated to such services as determined 
under the facts and circumstances of each case without regard to 
whether--
    (a) Such services are furnished under a separate contract or under 
the same contract pursuant to which such sale or lease occurs or
    (b) The cost of such services is specified in the contract of sale 
or lease.
    (iii) Transactions involving more than one item of export property. 
If more than one item of export property is sold or leased in a single 
transaction pursuant to one contract, the total gross receipts from such 
transaction and the total gross receipts from all services related to 
such transaction are each taken into account in determining whether such 
services are subsidiary to such transaction. However, the provisions of 
this subdivision apply only if such items could be included in the same 
product line, as determined under Sec. 1.994-1(c)(7).
    (iv) Renewed service contracts. If under the terms of a contract for 
related services, such contract is renewable within 10 years after a 
sale of export property, or during the term of a lease of export 
property, related services to be performed under the renewed contract 
are subsidiary to such sale or lease if it is reasonably expected at the 
time of such renewal that the gross receipts from all related services 
which have been and which are to be furnished by the DISC (as described 
in subparagraph (2) of this paragraph) will not exceed 50 percent of the 
sum of (a) the gross receipts from such sale or lease and (b) the gross 
receipts from related services furnished by the DISC (as so described). 
Reasonable expectations are determined as provided in subdivision (i) of 
this subparagraph.
    (v) Parts used in services. In a services contract described in 
subparagraph (3) of this paragraph provides for the furnishing of parts 
in connection with the furnishing of related services, gross receipts 
from the furnishing of such parts are not taken into account in 
determining whether under this subparagraph the services are subsidiary. 
See paragraph (b) or (c) of this section to determine whether the gross 
receipts from the furnishing of parts consitute qualified export 
receipts. See Sec. 1.993-3(c)(2)(iv) and (e)(3) for rules regarding the 
treatment of such parts with respect to the manufacture of export 
property and the foreign content of such property, respectively.
    (5) Relation to leases. If the gross receipts for services which are 
related and subsidiary to a lease of property have been prepaid at any 
time for all such services which are to be performed before the end of 
the term of such lease, then as of the time of the prepayment the rules 
in paragraph (c)(2) of this section (relating to prepayment of lease 
receipts) will determine whether prepaid services under this subdivision 
are qualified export receipts. Thus, for example if it is reasonably 
expected that leased property will be export property for the first year 
of the term of the lease but will not be export property for the second 
year of the term, prepaid gross receipts for related and subsidiary 
services to be furnished in the first year may be qualified export 
receipts. However, any prepaid gross receipts for such services to be 
furnished in the second year cannot be qualified export receipts.
    (6) Relation with export property determination. The determination 
as to whether gross receipts from the sale or lease of export property 
constitute qualified export receipts does not depend upon whether 
services connected with such sale or lease are related and

[[Page 809]]

subsidiary to such sale or lease. Thus, for example, assume that a DISC 
receives gross receipts of $1,000 from the sale of export property and 
gross, receipts of $1,100 from installation and maintenance services 
which are to be furnished by such DISC within 10 years after the sale 
and which are related to such sale. The $1,100 which the DISC receives 
for such services would not be qualified export receipts since the gross 
receipts from the services exceed 50 percent of the sum of the gross 
receipts from the sale and the gross receipts from the related services 
furnished by such DISC. The $1,000 which the DISC receives from the sale 
of export property would, however, be a qualified export receipt if the 
sale met the requirements of paragraph (b) of this section.
    (e) Gains from sales of certain qualified export assets. Qualified 
export receipts of a DISC include gross receipts from the sale by such 
DISC of any assets (wherever located) which, as of the date of such 
sale, are qualified export assets as defined in Sec. 1.993-2 even 
though such assets are not export property (as defined in Sec. 1.993-
3). Gross receipts are derived from the sale of such assets only where 
such sale results in recognized gain (see Sec. 1.993-6(a)). For 
purposes of this paragraph, losses from the sale of such qualified 
export assets shall not be taken into account for purposes of 
determining the DISC's qualified export receipts.
    (f) Dividends. Qualified export receipts of a DISC for a taxable 
year include all dividends includible in the gross income of such DISC 
for such taxable year with respect to the stock of related foreign 
export corporations (as defined in Sec. 1.993-5) and all amounts 
includible in the gross income of such DISC with respect to such 
corporations pursuant to section 951 (relating to amounts included in 
the gross income of U.S. shareholders of controlled foreign 
corporations).
    (g) Interest on obligations which are qualified export assets. 
Qualified export receipts of a DISC include interest on any obligation 
which is a qualified export asset of such DISC, including any amount 
includible in gross income as interest (such as, for example, an amount 
treated as original issue discount pursuant to section 1232) or as 
imputed interest under section 483. Gain from the sale of obligations 
described in this paragraph is treated (to the extent such gain is not 
treated as interest on such obligations) as qualified export receipts 
pursuant to paragraph (e) of this section.
    (h) Engineering and architectural services--(1) In general. 
Qualified export receipts of a DISC include gross receipts from 
engineering services (as described in subparagraph (5) of this 
paragraph) or architectural services (as described in subparagraph (5) 
of this paragraph) or architectural services (as described in 
subparagraph (6) of this paragraph) furnished by such DISC (as described 
in subparagraph (7) of this paragraph) for a construction project (as 
defined in subparagraph (8) of this paragraph) located, or proposed for 
location, outside the United States. Such services may be performed 
within or without the United States.
    (2) Services included. Engineering and architectural services 
include feasibility studies for a proposed construction project whether 
or not such project is ultimately initiated.
    (3) Excluded services. Engineering and architectural services do not 
include--
    (i) Services connected with the exploration for minerals or
    (ii) Technical assistance or knowhow.


For purposes of this paragraph, the term ``technical assistance or 
knowhow'' includes activities or programs designed to enable business, 
commerce, industrial establishments, and governmental organizations to 
acquire or use scientific, architectural, or engineering information.
    (4) Other services. Receipts from the performance of construction 
activities other than engineering and architectural services constitute 
qualified export receipts to the extent that such activities are related 
and subsidiary services (within the meaning of paragraph (d) of this 
section) with respect to a sale or lease of export property.
    (5) Engineering services. For purposes of this paragraph, 
engineering services in connection with any construction project (within 
the meaning of subparagraph (8) of this paragraph) include

[[Page 810]]

any professional services requiring engineering education, training, and 
experience and the application of special knowledge of the mathematical, 
physical, or engineering sciences to such professional services as 
consultation, investigation, evaluation, planning, design, or 
responsible supervision of construction for the purpose of assuring 
compliance with plans, specifications, and design.
    (6) Architectural services. For purposes of this paragraph, 
architectural services include the offering or furnishing of any 
professional services such as consultation, planning, aesthetic, and 
structural design, drawings and specifications, or responsible 
supervision of construction (for the purpose of assuring compliance with 
plans, specifications, and design) or erection, in connection with any 
construction project (within the meaning of subparagraph (8) of this 
paragraph).
    (7) Definition of ``furnished by such DISC''. For purposes of this 
paragraph, architectural and engineering services are considered 
furnished by a DISC if such services are provided--
    (i) By the DISC,
    (ii) By another person (whether or not a United States person) 
pursuant to a contract entered into by such person with the DISC at any 
time prior to the furnishing of such services, provided that the DISC 
acts as principal with respect to the furnishing of such services, or
    (iii) By another person (whether or not a United States person) 
pursuant to a contract for the furnishing of such services entered into 
at any time prior to the furnishing of such services provided that the 
DISC acts as commission agent with respect to such services.
    (8) Definition of ``construction project''. For purposes of this 
paragraph, the term ``construction project'' includes the erection, 
expansion, or repair (but not including minor remodeling or minor 
repairs) of new or existing buildings or other physical facilities 
including, for example, roads, dams, canals, bridges, tunnels, railroad, 
tracks, and pipelines. The term also includes site grading and 
improvement and installation of equipment necessary for the 
construction. Gross receipts from the sale or lease of construction 
equipment are not qualified export receipts unless such equipment is 
export property (as defined in Sec. 1.993-3).
    (i) Managerial services--(1) In general. Qualified export receipts 
of a first DISC for its taxable year include gross receipts from the 
furnishing of managerial services provided for another DISC, which is 
not a related person, to aid such unrelated DISC in deriving qualified 
export receipts, provided that at least 50 percent of the gross receipts 
of the first DISC for such year consists of qualified export receipts 
derived from the sale or lease of export property and the furnishing of 
related and subsidiary services, as described in paragraph (b), (c), and 
(d) of this section, respectively.


For purposes of this paragraph, managerial services are considered 
furnished by a DISC if such services are provided--
    (i) By the first DISC,
    (ii) By another person (whether or not a United States person) 
pursuant to a contract entered into by such person with the first DISC 
at any time prior to the furnishing of such services, provided that the 
first DISC acts as principal with respect to the furnishing of such 
services, or
    (iii) By another person (whether or not a United States person) 
pursuant to a contract for the furnishing of such services entered into 
at any time prior to the furnishing of such services provided that the 
DISC acts as commission agent with respect to such services.
    (2) Definition of ``managerial services.'' The term ``managerial 
services'' as used in this paragraph means activities relating to the 
operation of another unrelated DISC which derives qualified export 
receipts from the sale or lease of export property and from the 
furnishing of services related and subsidiary to such sales or leases. 
Such term includes staffing and operational services necessary to 
operate such other DISC, but does not include legal, accounting, 
scientific, or technical services. Examples of managerial services are: 
(i) Export market studies, (ii) making shipping arrangements, and (iii) 
contracting potential foreign purchasers.

[[Page 811]]

    (3) Status of recipient of managerial services--(i) In general. 
Qualified export receipts of a first DISC include receipts from the 
furnishing of managerial services during any taxable year of a recipient 
if such recipient qualifies as a DISC (within the meaning of Sec. 
1.992-1(a) for such taxable year.
    (ii) Recipient deemed to qualify as a DISC. For purposes of 
subdivision (i) of this subparagraph, a recipient is deemed to qualify 
as a DISC for its taxable year if the first DISC obtains from such 
recipient a copy of such recipient's election to be treated as a DISC as 
described in Sec. 1.992-2(a) together with such recipient's sworn 
statement that such election has been filed with the Internal Revenue 
Service Center. The recipient may mark out the names of its shareholders 
on a copy of its election to be treated as a DISC before submitting it 
to the first DISC. The copy of the election and the sworn statement of 
such recipient must be received by the first DISC within 6 months after 
the beginning of the first taxable year of the recipient during which 
such first DISC furnishes managerial services for such recipient. The 
copy of the election and the sworn statement of the recipient need not 
be obtained by the first DISC for subsequent taxable years of the 
recipient.
    (iii) Recipient not treated as a DISC. For purposes of subdivision 
(i) of this subparagraph, a recipient of managerial services is not 
treated as a DISC with respect to such services performed during a 
taxable year for which such recipient does not qualify as a DISC if the 
DISC performing such services does not believe or if a reasonable person 
would not believe (taking into account the furnishing DISC's managerial 
relationship with such recipient DISC) at the beginning of such taxable 
year that the recipient will qualify as a DISC for such taxable year.
    (j) Excluded receipts--(1) In general. Notwithstanding the 
provisions of paragraphs (b) through (i) of this section, qualified 
export receipts of a DISC do not include any of the five amounts 
described in subparagraphs (2) through (6) of this paragraph.
    (2) Sales and leases of property for ultimate use in the United 
States. Property which is sold or leased for ultimate use in the United 
States does not constitute export property. See Sec. 1.993-3(d)(4) 
(relating to determination of where the ultimate use of the property 
occurs). Thus, qualified export receipts of a DISC described in 
paragraph (b) or (c) of this section do not include gross receipts of 
the DISC from the sale or lease of such property.
    (3) Sales of export property accomplished by subsidy. Qualified 
export receipts of a DISC do not include gross receipts described in 
paragraph (b) of this section if the sale of export property (whether or 
not such property consists of agricultural products) is pursuant to any 
of the following:
    (i) The development loan program, or grants under the technical 
cooperation and development grants program of the Agency for 
International Development, or grants under the military assistance 
program administered by the Department of Defense, pursuant to the 
Foreign Assistance Act of 1961, as amended (22 U.S.C. 2151), unless the 
DISC shows to the satisfaction of the district director that, under the 
conditions existing at the time of the sale, the purchaser had a 
reasonable opportunity to purchase, on competitive terms and from a 
seller who was not a U.S. person, goods which were substantially 
identical to such property and which were not manufactured, produced, 
grown, or extracted (as described in Sec. 1.993-3(c)) in the United 
States,
    (ii) The Pub. L. 480 program authorized under title I of the 
Agricultural Trade Development and Assistance Act of 1954, as amended (7 
U.S.C. 1691, 1701-1710),
    (iii) For taxable years ending before January 1, 1974, the Barter 
program of the Commodity Credit Corporation authorized by section 4(h) 
of the Commodity Credit Corporation Charter Act, as amended (15 U.S.C. 
714b(h)), and section 303 of the Agricultural Trade Development and 
Assistance Act of 1954, as amended (7 U.S.C. 1692) but only if the 
taxpayer treats such sales as sales giving rise to excluded receipts,
    (iv) The Export Payment program of the Commodity Credit Corporation 
authorized by sections 5(d) and (f) of the Commodity Credit Corporation 
Charter

[[Page 812]]

Act, as amended (15 U.S.C. 714c (d) and (f)),
    (v) The section 32 export payment programs authorized by section 32 
of the Act of August 24, 1935, as amended (7 U.S.C. 612c), and
    (vi) For taxable years beginning after November 3, 1972, the Export 
Sales program of the Commodity Credit Corporation authorized by sections 
5 (d) and (f) of the Commodity Credit Corporation Charter Act, as 
amended (15 U.S.C. 714c (d) and (f)), other than the GSM-4 program 
provided under 7 CFR part 1488, and section 407 of the Agricultural Act 
of 1949, as amended (7 U.S.C. 1427), for the purpose of disposing of 
surplus agricultural commodities and exporting or causing to be exported 
agricultural commodities, except that for taxable years beginning on or 
before November 3, 1972, the taxpayer may treat such sales as sales 
giving rise to excluded receipts.
    (4) Sales or lease of export property and furnishing of engineering 
or architectural services for use by the United States--(i) In general. 
Qualified export receipts of a DISC do not include gross receipts 
described in paragraph (b), (c), or (h) of this section if a sale or 
lease of export property, or the furnishing of engineering or 
architectural services, is for use by the United States or an 
instrumentality thereof in any case in which any law or regulation 
requires in any manner the purchase or lease of property manufactured, 
produced, grown, or extracted in the United States or requires the use 
of engineering or architectural services performed by a U.S. person. For 
example, a sale by a DISC of export property to the Department of 
Defense for use outside the United States would not produce qualified 
export receipts for such DISC if the Department of Defense purchased 
such property from appropriated funds subject to any provisions of the 
Armed Services Procurement Regulations (32 CFR subchapter A, part 6, 
subpart A) or any appropriations act for the Department of Defense for 
the applicable year which restricts the availability of such 
appropriated funds to the procurement of items which are grown, 
reprocessed, reused, or produced in the United States.
    (ii) Direct or indirect sales or leases. Any sale or lease of export 
property is for use by the United States or an instrumentality thereof 
is such property is sold or leased by a DISC (or by a principal for whom 
such DISC acts as commission agent) to--
    (a) A person who is a related person with respect to such DISC or 
such principal and who sells or leases such property for use by the 
United States or an instrumentality thereof or
    (b) A person who is not a related person with respect to such DISC 
or such principal if, at the time of such sale or lease, there is an 
agreement or understanding that such property will be sold or leased for 
use by the United States or an instrumentality thereof (or if a 
reasonable person would have known at the time of such sale or lease 
that such property would be sold or leased for use by the United States 
or an instrumentality thereof) within 3 years after such sale or lease.
    (iii) Excluded programs. The provisions of subdivisions (i) and (ii) 
of this subparagraph do not apply in the case of a purchase by the 
United States or an instrumentality thereof if such purchase is pursuant 
to--
    (a) The Foreign Military Sales Act, as amended (22 U.S.C. 2751 et 
seq.), or a program under which the U.S. Government purchases property 
for resale, on commercial terms, to a foreign government or agency or 
instrumentality thereof, or
    (b) A program (whether bilateral or multilateral) under which sales 
to the U.S. Government are open to international competitive bidding.
    (5) Services. Qualified export receipts of a DISC do not include 
gross receipts described in paragraph (d) of this section (concerning 
related and subsidiary services) if the services from which such gross 
receipts are derived are related and subsidiary to the sale or lease of 
property which results in excluded receipts pursuant to this paragraph.
    (6) Receipts within controlled group--(i) In general. Gross receipts 
of a corporation do not constitute qualified export receipts for any 
taxable year of such corporation if--
    (a) At the time of the sale, lease, or other transaction resulting 
in such

[[Page 813]]

gross receipts, such corporation and the person from whom such receipts 
are directly or indirectly derived (whether or not such corporation and 
such person are the same person) are members of the same controlled 
group (as defined in paragraph (k) of this section) and
    (b) Such corporation and such person each qualifies (or is treated 
under section 992(a)(2)) as a DISC for its taxable year in which its 
receipts arise.


Thus, for example, assume that R, S, X, and Y are members of the same 
controlled group and that X and Y are DISC's. If R sells property to S 
and pays X a commission relating to that sale and if S sells the same 
property to an unrelated foreign party and pays Y a commission relating 
to that sale, the receipts received by X from the sale of such property 
by R to S will be considered to be derived from Y, a DISC which is a 
member of the same controlled group as X, and thus will not result in 
qualified export receipts to X. The receipts received by Y from the sale 
to an unrelated foreign party may, however, result in qualified export 
receipts to Y. For another example, if R and S both assign the 
commissions to X, receipts derived from the sale from R to S will be 
considered to be derived from X acting as commission agent for S and 
will not result in qualified export receipts to X. Receipts derived by X 
from the sale of property by S to an unrelated foreign party, may, 
however, constitute qualified export receipts.
    (ii) Leased property. See Sec. 1.993-3(f)(2) regarding property not 
constituting export property in certain cases where such property is 
leased to any corporation which is a member of the same controlled group 
as the lessor.
    (k) Definition of ``controlled group''. For purposes of sections 991 
through 996 and the regulations thereunder, the term ``controlled 
group'' has the same meaning as is assigned to the term ``controlled 
group of corporations'' by section 1563(a), except that (1) the phrase 
``more than 50 percent'' is substituted for the phrase ``at least 80 
percent'' each place the latter phrase appears in section 1563(a), and 
(2) section 1563(b) shall not apply. Thus, for example, a foreign 
corporation subject to tax under section 881 may be a member of a 
controlled group. Furthermore, two or more corporations (including a 
foreign corporation) are members of a controlled group at any time such 
corporations meet the requirements of section 1563(a) (as modified by 
this paragraph).
    (l) DISC's entitlement to income--(1) Application of section 994. A 
corporation which meets the requirements of Sec. 1.992-1(a) to be 
treated as a DISC for a taxable year is entitled to income, and the 
intercompany pricing rules of section 994(a)(1) or (2) apply, in the 
case of any transactions described in Sec. 1.994-1(b) between such DISC 
and its related supplier (as defined in Sec. 1.994-1(a)(3)). For 
purposes of this subparagraph, such DISC need not have employees or 
perform any specific function.
    (2) Other transactions. In the case of a transaction to which the 
provisions of subparagraph (1) of this paragraph do not apply but from 
which a DISC derives gross receipts, the income to which the DISC is 
entitled as a result of the transaction is determined pursuant to the 
terms of the contract for such transaction and, if applicable, section 
482 and the regulations thereunder.
    (3) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. P Corporation forms S Corporation as a wholly-owned 
subsidiary. S qualifies as a DISC for its taxable year. S has no 
employees on its payroll. S is granted a franchise with respect to 
specified exports of P. P will sell such exports to S for resale by S. 
Such exports are of a type which produce qualified export receipts as 
defined in paragraph (b) of this section. P's sales force will solicit 
orders in the name of S using S's order forms. S places orders with P 
only when S itself has received orders. No inventory is maintained by S. 
P makes shipments directly to customers of S. Employees of P will act 
for S and billings and collections will be handled by P in the name of 
S. Under these facts, the income derived by S for such taxable year from 
the purchase and resale of the specified export is treated for Federal 
income tax purposes as the income of S, and the amount of income 
allocable to S will be determined under section 994 of the Code.
    Example 2. P Corporation forms S Corporation as a wholly-owned 
subsidiary. S qualifies as a DISC for its taxable year. S has no 
employees on its payroll. S is granted a sales franchise with respect to 
specified exports of P and will receive commissions with respect

[[Page 814]]

to such exports. Such exports are of a type which will produce gross 
receipts for S which are qualified export receipts as defined in 
paragraph (b) of this section. P's sales force will solicit orders in 
the name of P. Billings and collections are handled directly by P. Under 
these facts, the commissions paid to S for such taxable year with 
respect to the specified exports shall be treated for Federal income tax 
purposes as the income of S, and the amount of income allocable to S is 
determined under section 994 of the Code.

[T.D. 7514, 42 FR 55454, Oct. 17, 1977; 42 FR 60910, Nov. 30, 1977, as 
amended by T.D. 7854, 47 FR 51739, Nov. 17, 1982]



Sec. 1.993-2  Definition of qualified export assets.

    (a) In general. For a corporation to qualify as a DISC, at the close 
of its taxable year it must have qualified export assets with adjusted 
bases equal to at least 95 percent of the sum of the adjusted bases of 
all its assets. An asset which is a qualified export asset under more 
than one paragraph of this section shall be taken into account only once 
in determining the sum of the adjusted bases of all qualified export 
assets. Under section 993(b), the qualified export assets held by a 
corporation are--
    (1) Export property as defined in Sec. 1.993-3 (see paragraph (b) 
of this section),
    (2) Business assets described in paragraph (c) of this section,
    (3) Trade receivables described in paragraph (d) of this section,
    (4) Temporary investments to the extent described in paragraph (e) 
of this section,
    (5) Producer's loans as defined in Sec. 1.993-4 (see paragraph (f) 
of this section),
    (6) Stock or securities (described in paragraph (g) of this section) 
of related foreign export corporations as defined in Sec. 1.993-5,
    (7) Export-Import Bank and other obligations described in paragraph 
(h) of this section,
    (8) Financing obligations described in paragraph (i) of this 
section, and
    (9) Funds awaiting investment described in paragraph (j) of this 
section.
    (b) Export property. In general, export property is certain property 
held for sale or lease which meets the requirements of Sec. 1.993-3.
    (c) Business assets. For purposes of this section, business assets 
are assets used by a DISC (other than as a lessor) primarily in 
connection with--
    (1) The sale, lease, storage, handling, transportation, packaging, 
assembly, or servicing of export property, or
    (2) The performance of engineering or architectural services 
(described in Sec. 1.993-1(h)) or managerial services (described in 
Sec. 1.993-1(i)) in furtherance of the production of qualified export 
receipts.


Assets used primarily in the manufacture, production, growth, or 
extraction (within the meaning of Sec. 1.993-3(c)) of property are not 
business assets.
    (d) Trade receivables--(1) In general. For purposes of this section, 
trade receivables are accounts receivable and evidences of indebtedness 
which arise by reason of transactions of such corporation or of another 
corporation which is a DISC and which is a member of a controlled group 
which includes such corporation described in subparagraph (A), (B), (C), 
(D), (G), or (H), of section 993(a)(1) and which are due the DISC (or, 
if it acts as an agent, due its principal) and held by the DISC.
    (2) Trade receivables representing commissions. If a DISC acts as 
commission agent for a principal in a transaction described in Sec. 
1.993-1 (b), (c), (d), (e), (h), or (i) which results in qualified 
export receipts for the DISC, and if an account receivable or evidence 
of indebtedness held by the DISC and representing the commission payable 
to the DISC as a result of the transaction arises (and, in the case of 
an evidence of indebtedness, designated on its face as representing such 
commission), such account receivable or evidence of indebtedness shall 
be treated as a trade receiveable. If, however, the principal is a 
related supplier (as defined in Sec. 1.994-1(a)(3)) with respect to the 
DISC, such account receivable or evidence of indebtedness will not be 
treated as a trade receivable unless it is payable and paid in a time 
and manner which satisfy the requirements of Sec. 1.994-1(e)(3) or (5) 
(relating to initial payment of transfer price or commission and 
procedure for adjustments to transfer price or commission, 
respectively), as the case may be. However, see subparagraph (3) of

[[Page 815]]

this paragraph for rules regarding certain accounts receivable 
representing commissions payable to a DISC by its related supplier.
    (3) Indebtedness arising under Sec. 1.994-1(e). An indebtedness 
arising under Sec. 1.994-1(e)(3)(iii) (relating to initial payment of 
transfer price or commission) in favor of a DISC is not a qualified 
export asset. An indebtedness arising under Sec. 1.994-1(e)(5)(i) 
(relating to procedure for adjustments to transfer price or commission) 
in favor of a DISC is a trade receivable if it is paid in the time and 
manner described in Sec. 1.994-1(e)(5)(i) and (ii) and if it otherwise 
satisfies the requirements of subparagraph (2) of this paragraph. If 
such an indebtedness is not paid in the time and manner described in 
Sec. 1.994-1(e)(5)(i) and (ii), it is not a qualified export asset.
    (e) Temporary investments--(1) In general. For purposes of this 
section, temporary investments are money, bank deposits (not including 
time deposits of more than 1 year), and other similar temporary 
investments to the extent maintained by a DISC as reasonably necessary 
to meet its requirements for working capital. For purposes of this 
paragraph, a temporary investment is an obligation, including an 
evidence of indebtedness as defined in paragraph (d)(1) of this section, 
which is a demand obligation or has a period remaining to maturity of 
not more than 1 year at the date it is acquired by the DISC. A temporary 
investment does not include trade receivables.
    (2) Determination of amount of working capital maintained. For 
purposes of this paragraph--
    (i) The working capital of a DISC is the excess of its current 
assets over current liabilities.
    (ii) Current assets are cash and other assets (other than trade 
receivables) which may reasonably be expected to be converted into cash 
or sold or consumed during the current normal operating cycle of the 
DISC's trade or business.
    (iii) Current liabilities are obligations (or portions of 
obligations) due within the current normal operating cycle of the trade 
or business of the DISC whose satisfaction when due is reasonably 
expected to require the use of current assets.
    (iv) Generally accepted financial accounting treatments will be 
accepted, and
    (v) Current assets (other than temporary investments) are taken into 
account before temporary investments, and trade receivables are never 
taken into account, in determining whether such temporary investments 
are maintained by the DISC as reasonably necessary to meet his current 
liabilities and its requirements for working capital.
    (3) Determination of amount of working capital reasonably required. 
For purposes of this paragraph, a determination of the amount of money, 
bank deposits, and other similar temporary investments reasonably 
necessary to meet the requirements of the DISC for working capital will 
depend upon the nature and volume of the activities of the DISC existing 
at the end of the DISC's taxable year for which such determination is 
made, such as, for example--
    (i) In the case of a DISC which purchases and sells inventory, the 
amount of working capital reasonably required is limited to an amount 
reasonably necessary to meet the ordinary operating expenses during the 
current normal operating cycle of the trade or business of the DISC, an 
amount reasonably needed to meet specific and definite plans for 
expansion and any amounts necessary for reasonably anticipated 
extraordinary business expenses.
    (ii) In the case of a DISC which actively conducts a trade or 
business (including the employment of a sales force) and receives 
commissions in respect of goods to which such DISC does not have title, 
the amount of working capital required will depend upon the nature and 
volume of the activities of the DISC which produce such income as they 
exist on the applicable determination date. In determining the amount of 
working capital which is reasonably required for the production of such 
income, the anticipated future needs of the business will be taken into 
account to the extent that such needs relate to the year of the DISC 
following the applicable determination date. Anticipated future needs 
relating to a later period will not be taken into account unless it is 
clearly established

[[Page 816]]

that such needs are reasonably related to the production of such income 
as of the applicable determination date.
    (iii) In the case of a DISC which does not actively conduct a trade 
or business, and which receives commissions solely by reason of section 
994(a)(1), (a)(2), or (b) with respect to goods to which such DISC does 
not have title, no working capital would be required beyond a de minimis 
amount unless it appears from the facts and circumstances that 
additional working capital will be required.
    (iv) In the case of a DISC deriving income from the leasing of 
property, the amount of working capital required will be determined on 
the basis of the facts and circumstances in such case.
    (4) Relationship of working capital to other qualified export 
assets. If a temporary investment is a qualified export asset under any 
provision of this section (other than this paragraph), this paragraph 
shall not affect its status as a qualified export asset. However, any 
such temporary investment is taken into account before other temporary 
investments in determining whether such other temporary investments are 
maintained by a DISC as reasonably necessary to meet its requirements 
for working capital. Current assets (other than temporary investments) 
are taken into account before temporary investments, and trade 
receivables are never taken into account, in determining whether such 
temporary investments are maintained by the DISC as reasonably necessary 
requirements for working capital. An obligation issued or incurred by a 
member of a controlled group (as defined in Sec. 1.993-1(k)) of which 
the DISC is a member is not a qualified export asset under this 
paragraph. For rules regarding working capital as of the end of each 
month of a taxable year for purposes of the 70-percent reasonableness 
standard with respect to certain deficiency distributions, see paragraph 
(j)(3) of this section.
    (f) Producer's loans. For purposes of this section, a producer's 
loan is an evidence of indebtedness arising in connection with 
producer's loans which are made by a DISC and which meet the 
requirements of Sec. 1.993-4. If a producer's loan is a qualified 
export asset, interest accrued with respect to the producer's loan will 
also be treated as a qualified export asset provided that payment is 
made in the form of money, property (valued at its fair market value on 
its date of transfer and including accounts receivable for sales by or 
through a DISC), a written obligation which qualifies as a debt under 
the safe harbor rule of Sec. 1.992-1(d)(2)(ii), or an accounting entry 
offsetting the account receivable against an existing debt owed by the 
person in whose favor the account receivable was established to the 
person with whom it engaged in the transaction and that payment is made 
no later than 60 days following the close of the taxable year of accrual 
of the interest. This paragraph (f) is effective for taxable years 
beginning after January 10, 1985 except that the taxpayer may at its 
option apply the provisions of this paragraph to taxable years ending 
after December 31, 1971.
    (g) Stock or securities of related foreign corporations. For 
purposes of this section, the term ``stock or securities'', with respect 
to a related foreign export corporation (as defined in Sec. 1.993-5), 
has the same meaning as such term has as used in section 351 (relating 
to transfers to controlled corporations), except that the term 
``securities'' does not include obligations which are repaid, in whole 
or in part, at any time during the taxable year of the DISC following 
the taxable year of the DISC during which such obligations were acquired 
by the DISC or were issued, unless the DISC demonstrates to the 
satisfaction of the district director that the repayment was for bona 
fide business purposes and not for the purpose of avoidance of Federal 
income taxes.
    (h) Export-Import Bank obligations. For purposes of this section, 
the term ``Export-Import Bank obligations'' means obligations issued, 
guaranteed, insured, or reinsured (in whole or in part) by the Export-
Import Bank of the United States or by the Foreign Credit Insurance 
Association, but only if such obligations are acquired by the DISC--
    (1) From the Export-Import Bank of the United States,
    (2) From the Foreign Credit Insurance Association, or
    (3) From the person selling or purchasing the goods or services by 
reason

[[Page 817]]

of which such obligations arose, or from any corporation which is a 
member of the same controlled group (as defined in Sec. 1.993-1(k)) as 
such person.


For purposes of this paragraph, obligations issued by a person described 
in subparagraphs (1), (2), and (3) of this paragraph are treated as 
acquired from such person by the DISC if acquired from any person not 
more than 90 days after the date of original issue (as defined in Sec. 
1.1232-3(b)(3)). Examples of specific types of Export-Import Bank 
obligations include debentures issued by such bank and certificates of 
loan participation.
    (i) Financing obligations. For purposes of this section, financing 
obligations are obligations (held by a DISC) of a domestic corporation 
organized solely for the purpose of financing sales of export property 
pursuant to an agreement with the Export-Import Bank of the United 
States under which such corporation makes export loans guaranteed by 
such Bank.
    (j) Funds awaiting investment--(1) In general. For purposes of this 
section, subject to the limitation descibed in subparagraph (2) of this 
paragraph, if, at the close of a DISC's taxable year, the sum of the 
DISC's money, bank deposits, and other similar temporary investments is 
determined under paragraph (e) of this section to exceed an amount 
reasonably necessary to meet the DISC's requirements for working 
capital, the amount of the DISC's bank deposits in the United States to 
the extent of the amount of this excess are funds awaiting investment at 
the close of such taxable year.
    (2) Limitation. Bank deposits described in subparagraph (1) of this 
paragraph are funds awaiting investment only if, by the last day of each 
of the sixth, seventh, and eighth months after the close of such taxable 
year, the sum of the adjusted bases of the qualified export assets of 
the DISC (other than such bank deposits) equals or exceeds 95 percent of 
the sum of the adjusted bases of all assets of the DISC (including such 
bank deposits) it held on the last day of such taxable year. For 
purposes of this subparagraph, the adjusted bases of assets of a DISC 
are determined as of the end of each of the months referred to in this 
subparagraph. Funds awaiting investment as described in this paragraph 
need not be traceable to any of the qualified export assets held by the 
DISC at the end of any of the months referred to in this subparagraph.
    (3) Coordination with certain deficiency distribution provisions. 
Under section 992(c)(3) and Sec. 1.992-3(d) a deficiency distribution 
made on or before the 15th day of the ninth month after the end of a 
corporation's taxable year is deemed to be for reasonable cause if 
certain requirements are met, including the requirement (described in 
section 992(c)(3)(B) and Sec. 1.992-3(d)(2)) that the sum of the 
adjusted bases of the qualified export assets held by the corporation on 
the last day of each month of such year equals or exceeds 70 percent of 
the sum of the adjusted bases of all assets held by the corporation on 
each such last day. If, on any such last day, the sum or a DISC's money, 
bank deposits, and other similar temporary investments is determined 
under paragraph (e) of this section to exceed an amount reasonably 
necessary to meet the DISC's requirements for working capital, the 
amount of the DISC's bank deposits to the extent of the amount of this 
excess are funds awaiting investment on such last day, if either--
    (i) The requirements of subparagraph (2) of this paragraph are 
satisfied with respect to the taxable year of the DISC which includes 
such month or
    (ii) At the close of such taxable year the sum of the DISC's money, 
bank deposits, and other similar temporary investments is determined 
under paragraph (e) of this section not to exceed an amount reasonably 
necessary to meet the DISC's requirements for working capital.

(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7514, 42 FR 55459, Oct. 17, 1977; 42 FR 60910, Nov. 30, 1977, as 
amended by T.D. 7854, 47 FR 51740, Nov. 17, 1982; T.D. 7984, 49 FR 
40018, Oct. 12, 1984]

[[Page 818]]



Sec. 1.993-3  Definition of export property.

    (a) General rule. Under section 993(c), except as otherwise provided 
with respect to excluded property in paragraph (f) of this section and 
with respect to certain short supply property in paragraph (i) of this 
section, export property is property in the hands of any person (whether 
or not a DISC)--
    (1) Manufactured, produced, grown, or extracted in the United States 
by any person or persons other than a DISC (see paragraph (c) of this 
section),
    (2) Held primarily for sale or lease in the ordinary course of a 
trade or business to any person for direct use, consumption, or 
disposition outside the United States (see paragraph (d) of this 
section),
    (3) Not more than 50 percent of the fair market value of which is 
attributable to articles imported into the United States (see paragraph 
(e) of this section), and
    (4) Which is not sold or leased by a DISC, or with a DISC as 
commission agent, to another DISC which is a member of the same 
controlled group (as defined in Sec. 1.993-1(k)) as the DISC.
    (b) Services. For purposes of this section, services (including the 
written communication of services in any form) are not export property. 
Whether an item is property or services shall be determined on the basis 
of the facts and circumstances attending the development and disposition 
of the item. Thus, for example, the preparation of a map of a particular 
construction site would constitute services and not export property, but 
standard maps prepared for sale to customers generally would not 
constitute services and would be export property if the requirements of 
this section were otherwise met.
    (c) Manufacture, production, growth, or extraction of property--(1) 
By a person other than a DISC. Export property may be manufactured, 
produced, grown, or extracted in the United States by any person, 
provided that such person does not qualify (and is not treated) as a 
DISC. Property held by a DISC which was manufactured, produced, grown, 
or extracted by it at a time when it did not qualify (and was not 
treated) as a DISC is not export property of the DISC. Property which 
sustains further manufacture or production outside the United States 
prior to sale or lease by a person but after manufacture or production 
in the United States will not be considered as manufactured, produced, 
grown, or extracted in the United States by such person.
    (2) Manufactured or produced--(i) In general. For purposes of this 
section, property which is sold or leased by a person is considered to 
be manufactured or produced by such person if such property is 
manufactured or produced (within the meaning of either subdivision (ii), 
(iii), or (iv) of this subparagraph) by such person or by another person 
pursuant to a contract with such person. Except as provided in 
subdivision (iv) of this subparagraph, manufacture or production of 
property does not include assembly or packaging operations with respect 
to property.
    (ii) Substantial transformation. Property is manufactured or 
produced by a person if such property is substantially transformed by 
such person. Examples of substantial transformation of property would 
include the conversion of woodpulp to paper, steel rods to screws and 
bolts, and the canning of fish.
    (iii) Operations generally considered to constitute manufacturing. 
Property is manufactured or produced by a person if the operations 
performed by such person in connection with such property are 
substantial in nature and are generally considered to constitute the 
manufacture or production of property.
    (iv) Value added to property. Property is manufactured or produced 
by a person if with respect to such property conversion costs (direct 
labor and factory burden including packaging or assembly) of such person 
account for 20 percent of more of--
    (a) The cost of goods sold or inventory amount of such person for 
such property is such property is sold or held for sale, or
    (b) The adjusted basis of such person for such property, as 
determined in accordance with the provisions of section 1011, if such 
property is held for lease or leased.


The value of parts provided pursuant to a services contract, as 
described in Sec. 1.993-1 (d)(4)(v), is not taken into account in 
applying this subdivision.

[[Page 819]]

    (d) Primary purpose of which property is held--(1) In general--(i) 
General rule. Under paragraph (a)(2) of this section, export property 
(a) must be held primarily for the purpose of sale or lease in the 
ordinary course of trade or business to a DISC, or to any other person, 
and (b) such sale or lease must be for direct use, consumption, or 
disposition outside the United States. Thus, property cannot qualify as 
export property unless it is sold or leased for direct use, consumption 
or disposition outside the United States. Property is sold or leased for 
direct use, consumption, or disposition outside the United States if 
such sale or lease satisfies the destination test described in 
subparagraph (2) of this paragraph, the proof of compliance requirements 
described in subparagraph (3) of this paragraph, and the use outside the 
United States test described in subparagraph (4) of this paragraph.
    (ii) Factors not taken into account. In determining whether property 
which is sold or leased to a DISC is sold or leased for direct use 
consumption, or disposition outside the United States, the fact that the 
acquiring DISC holds the property in inventory or for lease prior to the 
time it sells or leases it for direct use, consumption, or disposition 
outside the United States will not affect the characterization of the 
property as export property. Export property need not be physically 
segregated from other property.
    (2) Destination test. (i) For purposes of subparagraph (1) of this 
paragraph the destination test in this subparagraph is satisfied with 
respect to property sold or leased by a seller or lessor only if it is 
delivered by such seller or lessor (or an agent of such seller or 
lessor) regardless of the F.O.B. point or the place at which title 
passes or risk of loss shifts from the seller or lessor--
    (a) Within the United States to a carrier or freight forwarder for 
ultimate delivery outside the United States to a purchaser or lessee (or 
to a subsequent purchaser or sublessee),
    (b) Within the United States to a purchaser or lessee, if such 
property is ultimately delivered, directly used, or directly consumed 
outside the United States (including delivery to a carrier or freight 
forwarder for delivery outside the United States) by the purchaser or 
lessee (or a subsequent purchaser or sublessee) within 1 year after such 
sale or lease,
    (c) Within or outside the United States to a purchaser or lessee 
which, at the time of the sale or lease, is a DISC and is not a member 
of the same controlled group (as defined in Sec. 1.993-1(k)) as the 
seller or lessor,
    (d) From the United States to the purchaser or lessee (or a 
subsequent purchaser or sublessee) at a point outside the United States 
by means of a ship, aircraft, or other delivery vehicle, owned, leased, 
or chartered by the seller or lessor,
    (e) Outside the United States to a purchaser or lessee from a 
warehouse, a storage facility, or assembly site located outside the 
United States, if such property was previously shipped by such seller or 
lessor from the United States, or
    (f) Outside the United States to a purchaser or lessee if such 
property was previously shipped by such seller or lessor from the United 
States and if such property is located outside the United States 
pursuant to a prior lease by the seller or lessor, and either (1) such 
prior lease terminated at the expiration of its term (or by the action 
of the prior lessee acting alone), (2) the sale occurred or the term of 
the subsequent lease began after the time at which the term of the prior 
lease would have expired, or (3) the lessee under the subsequent lease 
is not a related person (as defined in Sec. 1.993-1(a)(6)) with respect 
to the lessor and the prior lease was terminated by the action of the 
lessor (acting alone or together with the lessee).
    (ii) For purposes of this subparagraph (other than (c) and (f)(3) of 
subdivision (i) thereof), any relationship between the seller or lessor 
and any purchaser, subsequent purchaser, lessee, or sublessee is 
immaterial.
    (iii) In no event is the destination test of this subparagraph 
satisfied with respect to property which is subject to any use (other 
than a resale or sublease), manufacture, assembly, or other processing 
(other than packaging) by any person between the time of the sale or 
lease by such seller or lessor and the delivery or ultimate delivery

[[Page 820]]

outside the United States described in this subparagraph.
    (iv) If property is located outside the United States at the time it 
is purchased by a person or leased by a person as lessee, such property 
may be export property in the hands of such purchaser or lessee only if 
it is imported into the United States prior to its further sale or lease 
(including a sublease) outside the United States. Paragraphs (a)(3) and 
(e) of this section (relating to 50 percent foreign content test) are 
applicable in determining whether such property is export property. 
Thus, for example, if such property is not subjected to manufacturing or 
production (as defined in paragraph (c) of this section) within the 
United States after such importation, it does not qualify as export 
property.
    (3) Proof of compliance with destination test--(i) Delivery outside 
the United States. For purposes of subparagraph (2) of this paragraph 
(other than subdivision (i)(c) thereof), a seller or lessor shall 
establish ultimate delivery, use, or consumption of property outside the 
United States by providing--
    (a) A facsimile or carbon copy of the export bill of lading issued 
by the carrier who delivers the property,
    (b) A certificate of an agent or representative of the carrier 
disclosing delivery of the property outside the United States,
    (c) A facsimile or carbon copy of the certificate of lading for the 
property executed by a customs officer of the country to which the 
property is delivered,
    (d) If such country has no customs administration, a written 
statement by the person to whom delivery outside the United States was 
made,
    (e) A facsimile or carbon copy of the shipper's export declaration, 
a monthly shipper's summary declaration filed with the Bureau of 
Customs, or a magnetic tape filed in lieu of the Shipper's Export 
Declaration, covering the property,
    (f) Any other proof (including evidence as to the nature of the 
property or the nature of the transaction) which establishes to the 
satisfaction of the Commissioner that the property was ultimately 
delivered, or directly sold, or directly consumed outside the United 
States within 1 year after the sale or lease.
    (ii) The requirements of subdivision (i) (a), (b), (c), or (e) of 
this subparagraph will be considered satisfied even though the name of 
the ultimate consignee and the price paid for the goods is marked out 
provided that, in the case of a Shipper's Export Declaration or other 
document listed in such subdivision (e) or a document such as an export 
bill of lading such document still indicates the country in which 
delivery to the ultimate consignee is to be made and, in the case of a 
certificate of an agent or representative of the carrier, that such 
document indicates that the property was delivered outside the United 
States.
    (iii) A seller or lessor shall also establish the meeting of the 
requirement of subparagraph (2)(i) of this paragraph (other than 
subdivision (c) thereof), that the property was delivered outside the 
United States without further use, manufacture, assembly, or other 
processing within the United States.
    (iv) Sale or lease to an unrelated DISC. For purposes of 
subparagraph (2)(i)(c) of this paragraph, a purchaser or lessee of 
property is deemed to qualify as a DISC for its taxable year if the 
seller or lessor obtains from such purchaser or lessee a copy of such 
purchaser's or lessee's election to be treated as a DISC as described in 
Sec. 1.992-2(a) together with such purchaser's or lessee's sworn 
statement that such election has been filed with the Internal Revenue 
Service Center. The copy of the election and the sworn statement of such 
purchaser or lessee must be received by the seller or lessor within 6 
months after the sale or lease. A purchaser or lessee is not treated as 
a DISC with respect to a sale or lease during a taxable year for which 
such purchaser or lessee does not qualify as a DISC if the seller or 
lessor does not believe or if a reasonable person would not believe at 
the time such sale or lease is made that the purchaser or lessee will 
qualify as a DISC for such taxable year.
    (v) Failure of proof. If a seller or lessor fails to provide proof 
of compliance with the destination test as required by this 
subparagraph, the property sold or leased is not export property.

[[Page 821]]

    (4) Sales and leases of property for ultimate use in the United 
States--(i) In general. For purposes of subparagraph (1) of this 
paragraph, the use test in this subparagraph is satisfied with respect 
to property which--
    (a) Under subdivisions (ii) through (iv) of this subparagraph is not 
sold for ultimate use in the United States or
    (b) Under subdivision (v) of this subparagraph is leased for 
ultimate use outside the United States.
    (ii) Sales of property for ultimate use in the United States. For 
purposes of subdivision (i) of this subparagraph, a purchaser of 
property (including components, as defined in subdivision (vii) of this 
subparagraph) is deemed to use such property ultimately in the United 
States if any of the following conditions exists:
    (a) Such purchaser is a related person (as defined in Sec. 1.993-
1(a)(6)) with respect to the seller and such purchaser ultimately uses 
such property, or a second product into which such property is 
incorporated as a component, in the United States.
    (b) At the time of the sale, there is an agreement or understanding 
that such property, or a second product into which such property is 
incorporated as a component, will be ultimately used by the purchaser in 
the United States.
    (c) At the time of the sale, a reasonable person would have believed 
that such property or such second product would be ultimately used by 
such purchaser in the United States unless, in the case of a sale of 
components, the fair market value of such components at the time of 
delivery to the purchaser constitutes less than 20 percent of the fair 
market value of the second product into which such components are 
incorporated (determined at the time of completion of the production, 
manufacture or assembly of such second product).


For purposes of (b) of this subdivision, there is an agreement or 
understanding that property will ultimately be used in the United States 
if, for example, a component is sold abroad under an express agreement 
with the foreign purchaser that the component is to be incorporated into 
a product to be sold back to the United States. As a further example 
there would also be such an agreement or understanding if the foreign 
purchaser indicated at the time of the sale or previously that the 
component is to be incorporated into a product which is designed 
principally for the United States market. However, such an agreement or 
understanding does not result from the mere fact that a second product, 
into which components exported from the United States have been 
incorporated and which is sold on the world market, is sold in 
substantial quantities in the United States.
    (iii) Use in the United States. For purposes of subdivision (ii) of 
this subparagraph, property (including components incorporated into a 
second product) is or would be ultimately used in the United States by 
such purchaser if, at any time within 3 years after the purchase of such 
property or components, either such property or components (or the 
second product into which such components are incorporated) is resold by 
such purchaser for use by a subsequent purchaser within the United 
States or such purchaser or subsequent purchaser fails, for any period 
of 365 consecutive days, to use such property or second product 
predominantly outside the United States as defined in subdivision (vi) 
of this subparagraph).
    (iv) Sales to retailers. For purposes of subdivision (ii)(c) of this 
subparagraph, property sold to any person whose principal business 
consists of selling from inventory to retail customers at retail outlets 
ouside the United States will be considered as property for ultimate use 
outside the United States.
    (v) Leases of property for ultimate use outside the United States. 
For purposes of subdivision (i) of this subparagraph a lessee of 
property is deemed to use such property ultimately outside the United 
States during a taxable year of the lessor if such property is used 
predominantly outside the United States (as defined in subdivision (vi) 
of this subparagraph) by the lessee during the portion of the lessor's 
taxable year which is included within the term of the lease. A 
determination as to whether the ultimate use of leased property 
satisfies the requirements of this subdivision is made for each taxable 
year of the lessor. Thus, leased property may be used predominantly 
outside the

[[Page 822]]

United States for a taxable year of the lessor (and thus, constitute 
export property if the remaining requirements of this section are met) 
even if the property is not used predominantly outside the United States 
in earlier taxable years or later taxable years of the lessor.
    (vi) Predominant use outside the United States. For purposes of this 
subparagraph, property is used predominantly outside the United States 
for any period if, during such period, such property is located outside 
the United States more than 50 percent of the time. An aircraft, 
railroad rolling stock, vessel, motor vehicle, container, or other 
property used for transportation purposes in deemed to be used 
predominantly outside the United States for any period if, during such 
period, either such property is located outside the United States more 
than 50 percent of the time or more than 50 percent of the miles 
traversed in the use of such property are traversed in outside the 
United States. However, any such property is deemed to be within the 
United States at all times during which it is engaged in transport 
between any two points within the United States, except where such 
transport constitutes uninterrupted international air transportation 
within the meaning of section 4262(c)(3) and the regulations thereunder 
(relating to tax on air transportation of persons). For purposes of 
applying section 4262(c)(3) to this subdivision, the term ``United 
States'' has the same meaning as in Sec. 1.993-7.
    (vii) Component. For purposes of this subparagraph, a component is 
property which is (or is reasonably expected to be) incorporated into a 
second product by the purchaser of such component by means of 
production, manufacture, or assembly.
    (e) Foreign content of property--(1) The 50 percent test. Under 
paragraph (a)(3) of this section, no more than 50 percent of the fair 
market value of export property may be attributable to the fair market 
value of articles which were imported into the United States. For 
purposes of this paragraph, articles imported into the United States are 
referred to as ``foreign content''. The fair market value of the foreign 
content of export property is computed in accordance with subparagraph 
(4) of this paragraph. The fair market value of export property which is 
sold to a person who is not a related person with respect to the seller 
is the sale price for such property (not including interest finance or 
carrying charges, or similar charges)
    (2) Application of 50 percent test. The 50 percent test described in 
subparagraph (1) of this paragraph is applied on an item-by-item basis 
If, however, a person sells or leases a substantial volume of 
substantially identical export property in a taxable year and if all of 
such property contains substantially identical foreign content is 
substantially the same proportion, such person may determine the portion 
of foreign content contained in such property on an aggregate basis.
    (3) Parts and services. If, at the time property is sold or leased 
the seller or lessor agrees to furnish parts pursuant to a services 
contract (as provided in Sec. 1.993-1(d)(4)(v)) and the price for the 
parts is not separately stated, the 50 percent test described in 
subparagraph (1) of this paragraph is applied on an aggregate basis to 
the property and parts. If the price for the parts is described in 
subparagraph (1) of this paragraph is applied separately to the property 
and to the parts.
    (4) Computation of foreign content--(i) Valuation. For purposes of 
applying the 50 percent test described in subparagraph (1) of this 
paragraph, it is necessary to determine the fair market value of all 
articles which constitute foreign content of the property being tested 
to determine if it is export property. The fair market value of such 
imported articles is determined as of the time such articles are 
imported into the United States. With respect to articles imported into 
the United States before July 1, 1980, the fair market value of such 
articles is their appraised value as determined under section 402 or 
402a of the Tariff Act of 1930 (19 U.S.C. 1401a or 1402) in connection 
with their importation. With respect to articles imported into the 
United States on or after July 1, 1980, the fair market value of such 
articles is their appraised value as determined under section 402 of the 
Tariff Act of 1930 (19 U.S.C.

[[Page 823]]

1401a) in connection with their importation. The appraised value of such 
articles is the full dutiable value of such articles, determined, 
however, without regard to any special provision in the United States 
tariff laws which would result in a lower dutiable value. Thus, an 
article which is imported into the United States is treated as entirely 
imported even if all or a portion of such article was originally 
manufactured, produced, grown, or extracted in the United States.
    (ii) Evidence of fair market value. For purposes of subdivision (i) 
of this subparagraph, the fair market value of imported articles 
constituting foreign content may be evidenced by the customs invoice 
issued on the importation of such articles into the United States. If 
the holder of such articles is not the importer (or a related person 
with respect to the importer), the fair market value of such articles 
may be evidenced by a certificate based upon information contained in 
the customs invoice and furnished to the holder by the person from whom 
such articles (or property incorporating such articles) were purchased. 
If a customs invoice or certificate described in the preceding sentence 
is not available to a person purchasing property, such person shall 
establish that no more than 50 percent of the fair market value of such 
property is attributable to the fair market value of articles which were 
imported into the United States.
    (iii) Interchangeable component articles. (a) Where identical or 
similar component articles can be incorporated interchangeably into 
property and a person acquires some such component articles that are 
imported into the United States and other such component articles that 
are not imported into the United States, the determination whether 
imported component articles were incorporated in such property as is 
exported from the United States shall be made on a substitution basis as 
in the case of the rules relating to drawback accounts under the customs 
laws. See section 313(b) of the Tariff Act of 1930, as amended (19 
U.S.C. 1313(b)).
    (b) The provisions of (a) of this subdivision may be illustrated by 
the following example:

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

    (f) Excluded property--(1) In general. Notwithstanding any other 
provision of this section, the following property is not export 
property--
    (i) Property described in subparagraph (2) of this paragraph 
(relating to property leased to a member of a controlled group),
    (ii) Property described in subparagraph (3) of this paragraph 
(relating to certain types of intangible property),
    (iii) Products described in paragraph (g) of this section (relating 
to depletable products), and
    (iv) Products described in paragraph (h) of this section (relating 
to certain export controlled products).
    (2) Property leased to member of controlled group--(i) In general. 
Property leased to a person (whether or not a DISC) which is a member of 
the same controlled group (as defined in Sec. 1.993-1(k)) as the lessor 
constitutes export property for any period of time only if during the 
period--
    (a) Such property is held for sublease, or is subleased, by such 
person to a third person for the ultimate use of such third person;
    (b) Such third person is not a member of the same controlled group; 
and

[[Page 824]]

    (c) Such property is used predominantly outside the United States by 
such third person.
    (ii) Predominant use. The provisions of paragraph (d)(4)(vi) of this 
section apply in determining under subdivision (i)(c) of this 
subparagraph whether such property is used predominently outside the 
United States by such third person.
    (iii) Leasing rule. For purposes of this subparagraph, leased 
property is deemed to be ultimately used by a member of the same 
controlled group as the lessor if such property is leased to a person 
which is not a member of such controlled group but which subleases such 
property to a person which is a member of such controlled group. Thus, 
for example, if X, a DISC for the taxable year, leases a movie film to 
Y, a foreign corporation which is not a member of the same controlled 
group as X, and Y then subleases the film to persons which are members 
of such group for showing to the general public, the film is not export 
property. On the other hand, if X, a DISC for the taxable year, leases a 
movie film to Z, a foreign corporation which is a member of the same 
controlled group as X, and Z then subleases the film to Y, another 
foreign corporation, which is not a member of the same controlled group 
for showing to the general public, the film is not disqualified under 
this subparagraph from being export property.
    (iv) Certain copyrights. With respect to a copyright which is not 
excluded by subparagraph (3) of this paragraph from being export 
property, the ultimate use of such property is the sale or exhibition of 
such property to the general public. Thus, if A, a DISC for the taxable 
year, leases recording tapes to B, a foreign corporation which is a 
member of the same controlled group as A, and if B makes records from 
the recording tape and sells the records to C, another foreign 
corporation, which is not a member of the same controlled group, for 
sale by C to the general public, the recording tape is not disqualified 
under this subparagraph from being export property, notwithstanding the 
leasing of the recording tape by A to a member of the same controlled 
group, since the ultimate use of the tape is the sale of the records 
(i.e., property produced from the recording tape).
    (3) Intangible property. Export property does not include any 
patent, invention, model, design, formula, or process, whether or not 
patented, or any copyright (other than films, tapes, records, or similar 
reproductions, for commercial or home use), goodwill, trademark, 
tradebrand, franchise, or other like property. Although a copyright such 
as a copyright on a book does not constitute export property, a 
copyrighted article (such as a book) if not accompanied by a right to 
reproduce it is export property if the requirements of this section are 
otherwise satisfied. However, a license of a master recording tape for 
reproduction outside the United States is not disqualified under this 
subparagraph from being export property.
    (g) Depletable products--(1) In general. Under section 993(c)(2)(C), 
a product or commodity which is a depletable product (as defined in 
subparagraph (2) of this paragraph) or contains a depletable product is 
not export property if--
    (i) It is a primary product from oil, gas, coal, or uranium (as 
described in subparagraph (3) of this paragraph), or
    (ii) It does not qualify as a 50-percent manufactured or processed 
product (as described in subparagraph (4) of this paragraph).
    (2) Definition of ``depletable product''. For purposes of this 
paragraph, the term ``depletable product'' means any product or 
commodity of a character with respect to which a deduction for depletion 
is allowable under section 613 or 613A. Thus, the term depletable 
product includes any mineral extracted from a mine, an oil or gas well, 
or any other natural deposit, whether or not the DISC or related 
supplier is allowed a deduction, or is eligible to take a deduction, for 
depletion with respect to the mineral in computing its taxable income. 
Thus, for example, iron ore purchased by a DISC from a broker is a 
depletable product in the hands of the DISC for purposes of this 
paragraph even though the DISC is not eligible to take a deduction for 
depletion under section 613 or 613A.
    (3) Primary product from oil, gas, coal, or uranium. A primary 
product from oil, gas, coal, or uranium is not export

[[Page 825]]

property. For purposes of this paragraph--
    (i) Primary product from oil. The term ``primary product from oil'' 
means crude oil and all products derived from the destructive 
distillation of crude oil, including--
    (a) Volatile products,
    (b) Light oils such as motor fuel and kerosene,
    (c) Distillates such as naphtha,
    (d) Lubricating oils,
    (e) Greases and waxes, and
    (f) Residues such as fuel oil.


For purposes of this paragraph, a product or commodity derived from 
shale oil which would be a primary product from oil if derived from 
crude oil is considered a primary product from oil.
    (ii) Primary product from gas. The term ``primary product from gas'' 
means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the lease or upon further processing, 
including--
    (a) Natural gas,
    (b) Condensates,
    (c) Liquefied petroleum gases such as ethane, propane, and butane, 
and
    (d) Liquid products such as natural gasoline.
    (iii) Primary product from coal. The term ``primary product from 
coal'' means coal and all products recovered from the carbonization of 
coal including--
    (a) Coke,
    (b) Coke-oven gas,
    (c) Gas liquor,
    (d) Crude light oil, and
    (e) Coal tar.
    (iv) Primary product from uranium. The term ``primary product from 
uranium'' means uranium ore and uranium concentrates (known in the 
industry as ``yellow cake''), and nuclear fuel materials derived from 
the refining of uranium ore and uranium concentrates, or produced in a 
nuclear reaction, including--
    (a) Uranium hexafluoride,
    (b) Enriched uranium hexafluoride,
    (c) Uranium metal,
    (d) Uranium compounds, such as uranium carbide,
    (e) Uranium dioxide, and
    (f) Plutonium fuels.
    (v) Primary products and changing technology. The primary products 
from oil, gas, coal, or uranium described in subdivisions (i) through 
(iv) of this subparagraph and the processes described in those 
subdivisions are not intended to represent either the only primary 
products from oil, gas, coal, or uranium, or the only processes from 
which primary products may be derived under existing and future 
technologies, such as the gasification and liquefaction of coal.
    (vi) Petrochemicals. For purposes of this paragraph, petrochemicals 
are not considered primary products from oil, gas, or coal.
    (4) 50-percent manufactured or processed product--(i) In general. A 
product or commodity (other than a primary product from oil, gas, coal, 
or uranium) which is or contains a depletable product is not excluded 
from the term ``export property'' by reason of section 993(c)(2)(C) if 
it is a 50-percent manufactured or processed product. Such a product or 
commodity is a ``50-percent manufactured or processed product'' if, 
after the cutoff point of the depletable product, it is manufactured or 
processed (as defined in subdivision (ii) of this subparagraph) and 
either the cost test described in subdivision (iv) of this subparagraph 
or the fair market value test described in subdivision (v) of this 
subparagraph is satisfied. To determine cutoff point, see subdivisions 
(vi) and (vii) of this subparagraph.
    (ii) Manufactured or processed. A product is manufactured or 
processed if it is manufactured or produced within the meaning of 
paragraph (c)(2) of this section, except that for purposes of this 
subdivision the term manufacturing or processing does not include any 
excluded process (as defined in subdivision (iii) of this subparagraph) 
and the term conversion costs (as used in subdivision (iv) of such 
paragraph (c)(2)) does not include any costs attributable to any 
excluded process.
    (iii) Excluded processes. For purposes of this paragraph, excluded 
processes are extracting (i.e., all processes which are applied before 
the cutoff point of the mineral to which such processes are applied), 
and handling, packing, packaging, grading, storing, and transporting.

[[Page 826]]

    (iv) Cost test. A product or commodity will qualify as a 50-percent 
manufactured or processed product if--
    (a) Its manufacturing and processing costs (that is, the portion of 
the cost of goods sold or inventory amount of the product or commodity 
attributable to the aggregate cost of manufacturing or processing each 
mineral contained therein) equal or exceed--
    (b) An amount equal to either of the following:
    (1) 50 percent of its cost of goods sold or inventory amount 
(decreased, at the DISC's option, by the portion of such cost or amount 
the DISC establishes is allocable to the difference between each prior 
owner's selling price for each depletable product contained in such 
product or commodity and such prior owner's cost of goods sold with 
respect thereto).
    (2) The aggregate of the cost at the cutoff point (see subdivisions 
(vi) and (vii) of this subparagraph) properly attributable to each 
mineral contained in such product or commodity. However, if this 
subdivision (2) is applied, then the amount in (a) of this subparagraph 
(iv) shall be decreased and the amount in this subdivision (2) shall be 
increased, by so much of the cost of goods sold or inventory amount of 
the product or commodity as is properly allocable to any process other 
than transportation applied after the cutoff point of such mineral which 
would be a mining process (within the meaning of Sec. 1.613-4) were it 
applied before such point.
    (v) Fair market value test. A product or commodity will qualify as a 
50-percent manufactured or processed product if--
    (a) The excess of its fair market value on the date it is sold, 
exchanged, or otherwise disposed of (or, if not sold, exchanged, or 
otherwise disposed of, the last day of the DISC's taxable year) over the 
portion thereof properly allocable to excluded processes other than 
extracting is equal to or greater than
    (b) Twice the aggregate of the fair market value at the cutoff point 
for each mineral contained in such product or commodity.


For purposes of this subdivision (v), the fair market value of a product 
or commodity on the date it is sold, exchanged, or otherwise disposed of 
is the price at which it is disposed of, subject to any adjustment that 
may be required under the arm's length standard of section 482 and the 
regulations thereunder. If such product or commodity is not sold, 
exchanged, or otherwise disposed of, then, for purposes of section 
992(a)(1)(B) (relating to the 95-percent test with respect to qualified 
export assets), the fair market value of a product or commodity on the 
last day of the DISC's taxable year is the arm's length price at which 
such product or commodity would have been sold on such date, determined 
by applying the principles of section 482 and the regulations 
thereunder.
    (vi) Cutoff point of a mineral. For purposes of this subparagraph:
    (a) The cutoff point is the point at which gross income from the 
property (within the meaning of section 613(a)) was in fact determined.
    (b) The cost at the cutoff point is deemed to be the amount of the 
gross income from the property of the taxpayer eligible for a depletion 
deduction with respect to the mineral.
    (c) The fair market value at the cutoff point is deemed to be the 
amount of the gross income from the property of the taxpayer eligible 
for a depletion deduction with respect to the mineral, except that, if 
(1) the fair market value of a product or commodity on the date 
specified in subdivision (v)(a) of this subparagraph exceeds the 
aggregate of the fair market value at the cutoff point for each mineral 
contained therein and (2) 10 percent or more of such excess is 
attributable to a net increase in the fair market values of such 
minerals by reason of factors other than manufacturing or processing or 
the application of excluded processes (such as, for example, increases 
in the fair market values of some minerals by reason of inflation or 
speculation exceed decreases in such values of other minerals by reason 
of deflation or speculation), then the aggregate of the fair market 
value at the cutoff point for each such mineral shall be increased to 
reflect the net excess so attributable.
    (d) The provisions of this subdivision (vi) are illustrated by the 
following example.


[[Page 827]]


    Example. An integrated manufacturer, X, on February 1, 1976, had 
gross income from the property (within the meaning of section 613(a)) of 
$50 with respect to a specified volume of a mineral. Thus, the cost at 
the cutoff point of the mineral was $50. X converted the mineral into a 
product which it sold on July 15, 1976, for $75. Of the $25 excess of 
the selling price over the gross income from the property, $23 was 
attributable to manufacturing, processing, and the application or 
excluded processes, and $2 was attributable to an increase in the fair 
market value of the mineral due to inflation between February 1 and July 
15, 1976. Since only 8 percent of such excess ($2/$25) was attributable 
to factors other than manufacturing, processing, and the application of 
excluded processes, the fair market value at the cutoff point of the 
mineral is $50. However, had $3 of the $25 excess, or 12 percent, been 
attributable to an increase in the fair market value of the mineral due 
to inflation, then the fair market value at the cutoff point of the 
mineral would be $53.

    (vii) [Reserved]
    (viii) Special rule for certain used products and scrap products. If 
a product or commodity is a used 50-percent manufactured or processed 
product, or is recovered as scrap from a 50-percent manufactured or 
processed product, such product or commodity will be treated as a 50-
percent manufactured or processed product.
    (ix) Special rule for byproducts and waste products. For purposes of 
applying the cost test or fair market value test of subdivision (iv) or 
(v) of this subparagraph if a depletable product is recovered from a 
manufacturing process as a byproduct or waste product, then the cost and 
fair market value at the cutoff point are each deemed to be the lesser 
of--
    (a) The fair market value of the waste product or byproduct 
containing the depletable product, determined as of the date the 
byproduct or waste product is recovered, or
    (b) The amount the cost at the cut-off point would be for a 
depletable product of like kind and grade which is extracted, determined 
as of the date the byproduct or waste product is recovered.


For purposes of (b) of this subdivision the cutoff point for the 
depletable product of like kind and grade is deemed to be the point at 
which gross income from the property would be determined if such 
depletable product were sold by the taxpayer eligible to take a 
deduction for depletion after the completion of all mining processes 
applied to the depletable product and before the application of any 
nonmining process.
    (x) Proof of satisfaction of 50-percent manufactured or processed 
test. (a) No substantiation is required to establish that either the 
cost test or the fair market value test of subdivisions (iv) or (v) of 
this subparagraph is satisfied or that a product or commodity qualifies 
under (viii) of this subdivision as either a used 50-percent 
manufactured or processed product or as scrap from a 50-percent 
manufactured or processed product as long as it is reasonably obvious, 
on the basis of all relevant facts and circumstances, that either the 
cost test or fair market value test is satisfied, or that the product or 
commodity qualifies as either as used 50-percent manufactured or 
processed product or as scrap from a 50-percent manufactured or 
processed product. Thus, for example, in the case of a DISC exporting a 
high precision lens at least 50 percent of the fair market value of 
which is obviously attributable to grinding, no substantiation of gross 
income from the property properly allocable to the depletable products 
contained in the lens, cost, or fair market values will be required.
    (b) In cases in which satisfaction of either the cost test or the 
fair market value test is not reasonably obvious, a DISC will be 
required to substantiate the gross income from the property properly 
allocable to each depletable product in a product or commodity and 
either all costs or fair market values relied upon the DISC.
    (c) For purposes of substantiating (1) gross income from the 
property properly allocable to a depletable product, (2) costs, and (3) 
fair market values, the DISC and related supplier shall each identify 
items in (or that were in) inventory in the same manner each used to 
identify items in inventory for purposes of computing Federal income 
tax.
    (xi) Application of 50-percent test. The 50-percent test described 
in this subparagraph is applied on an item-by-item basis. If, however, a 
DISC sells a

[[Page 828]]

substantial volume of substantially identical products or commodities 
and if all or a group of such products or commodities contain 
substantially identical depletable products in substantially the same 
proportions and have cost or fair market value relationships (as the 
case may be) that are in substantially the same proportions, such DISC 
may apply the 50-percent test on an aggregate basis with respect to all 
such products or commodities, or group, as the case may be.
    (5) Effective dates. Except as provided in subparagraph (6) of this 
paragraph, section 993(c)(2)(C) applies--
    (i) With respect to any product or commodity not owned by a DISC, to 
sales, exchanges, or other dispositions made after March 18, 1975, with 
respect to which the DISC derives gross receipts.
    (ii) With respect to any product or commodity acquired by a DISC 
after March 18, 1975.
    (iii) With respect to any product or commodity owned by a DISC on 
March 18, 1975, to sales, exchanges, or other dispositions made after 
March 18, 1976, and to owning such product or commodity after such date.


For purposes of this paragraph and subparagraph (6) of this paragraph, 
the date of a sale, exchange, or other disposition of a product or 
commodity is the date as of which title to such product or commodity 
passes. The accounting method of a person is not determinative of the 
date of a sale, exchange, or other disposition.
    (6) Fixed contracts. Section 1101(f) of the Tax Reform Act of 1976 
provides an exception to the effective date rules in this paragraph and 
in paragraph (h) of this section. Section 1101(f)(2) of the Act provides 
that section 993(c)(2)(C) and (D) shall not apply to sales, exchanges, 
and other dispositions made after March 18, 1975, but before March 19, 
1980, if they are made pursuant to a fixed contract. Section 1101(f)(2) 
also defines fixed contract. Under that definition, if the seller can 
vary the price of the product for unspecified cost increases (which 
could include tax cost increases), or if the quantity of products or 
commodities to be sold can be increased or decreased under the contract 
by the seller without penalty, the contract is not to be considered a 
fixed contract with respect to the amount over which the seller has 
discretion. For example, if a contract calls for a minimum delivery of x 
amount of a product but allows the seller to refuse to deliver goods 
beyond that minimum amount (or allows a renegotiation of the sales price 
of goods beyond that amount), then with respect to the amount above the 
minimum the contract is not a fixed quantity contract.
    (h) Export controlled products--(1) In general. An export controlled 
product is not export property. A product or commodity may be an export 
controlled product at one time but not an export controlled product at 
another time. For purposes of this paragraph, a product or commodity is 
an ``export controlled product'' at a particular time if at that time 
the export of such product or commodity is prohibited or curtailed under 
section 4(b) of the Export Administration Act of 1969 or section 7(a) of 
the Export Administration Act of 1979, to effectuate the policy relating 
to the protection of the domestic economy set forth in such Acts 
(paragraph (2)(A) of section 3 of the Export Administration Act of 1969 
and paragraph (2)(C) of section 3 of the Export Administration Act of 
1979). Such policy is to use export controls to the extent necessary 
``to protect the domestic economy from the excessive drain of scarce 
materials and to reduce the serious inflationary impact of foreign 
demand.''
    (2) Products considered export controlled products--(i) In general. 
For purposes of this paragraph, an export controlled product is a 
product or commodity which is subject to short supply export controls 
under 15 CFR part 377. A product or commodity is considered an export 
controlled product for the duration of each control period which applies 
to such product or commodity. A control period of a product or commodity 
begins on and includes the initial control date (as defined in 
subdivision (ii) of this subparagraph) and ends on and includes the 
final control date (as defined in subdivision (iii) of this 
subparagraph).
    (ii) Initial control date. The initial control date of a product or 
commodity which was subject to short supply export controls on March 19, 
1975, is

[[Page 829]]

March 19, 1975. The initial control date of a product or commodity which 
is subject to short supply export controls after March 19, 1975, is the 
effective date stated in the regulations to 15 CFR part 377 which 
subjects such product or commodity to short supply export controls. If 
there is no effective date stated in such regulations, the initial 
control date of such product or commodity is the date on which such 
regulations are filed for publications in the Federal Register.
    (iii) Final control date. The final control date of a product or 
commodity is the effective date stated in the regulations to 15 CFR part 
377 which removes such product or commodity from short supply export 
controls. If there is no effective date stated in such regulations, the 
final control date of such product or commodity is the date on which 
such regulations are filed for publication in the Federal Register.
    (iv) Expiration of Export Administration Act. An initial control 
date and a final control date cannot occur after the expiration date of 
the Export Administration Act under the authority of which the short 
supply export controls were issued.
    (3) Effective dates--(i) Products controlled on March 19, 1975. 
Except as provided in paragraph (g)(6) of this section, if a product or 
commodity was subject to short supply export controls on March 19, 1975, 
this paragraph applies--
    (a) With respect to any such product or commodity not owned by a 
DISC, to sales, exchanges, other dispositions, or leases made after 
March 18, 1975, with respect to which the DISC derives gross receipts.
    (b) With respect to any such product or commodity acquired by a DISC 
after March 18, 1975, and
    (c) With respect to any such product or commodity owned by a DISC on 
March 18, 1975, to sales, exchanges, other dispositions, and leases made 
after March 18, 1976, and to owning such product or commodity after such 
date.
    (ii) Products first controlled after March 19, 1975. If a product or 
commodity becomes subject to short supply export controls after March 
19, 1975, this paragraph applies to sales, exchanges, other 
dispositions, or leases of such product or commodity made on or after 
the initial control date of such product or commodity, and to owning 
such product or commodity on or after such date.
    (iii) Date of sale, exchange, lease, or other disposition. For 
purposes of this subparagraph, the date of sale, exchange, or other 
disposition of a product or commodity is the date as of which title to 
such product or commodity passes. The date of a lease is the date as of 
which the lessee takes possession of a product or commodity. The 
accounting method of a person is not determinative of the date of sale, 
exchange, other disposition, or lease.
    (iv) Property in short supply. If the President determines that the 
supply of any property which is otherwise export property as defined in 
this section is insufficient to meet the requirements of the domestic 
economy, he may by Executive order designate such property as in short 
supply. Any property so designated will be treated as property which is 
not export property during the period beginning with the date specified 
in such Executive order and ending with the date specified in an 
Executive order setting forth the President's determination that such 
property is no longer in short supply.

[T.D. 7514, 42 FR 55461, Oct. 17, 1977, as amended by T.D. 7513, 42 FR 
57309, Nov. 2, 1977; T.D. 7854, 47 FR 51740, Nov. 17, 1982]



Sec. 1.993-4  Definition of producer's loans.

    (a) General rule--(1) Definition. Under section 993(d), a loan made 
by a DISC to a person, referred to in this section as the ``borrower,'' 
is a producer's loan if--
    (i) The loan is made out of accumulated DISC income within the 
meaning of subparagraph (3) of this paragraph.
    (ii) The loan is evidenced by an obligation described in 
subparagraph (4) of this paragraph.
    (iii) The requirement as to the trade or business of the borrower 
described in subparagraph (5) of this paragraph is satisfied.
    (iv) At the time the loan is made, the obligation referred to in 
subdivision (ii) of this subparagraph bears a legend stating ``This 
Obligation Is Designated

[[Page 830]]

A Producer's Loan Within The Meaning of section 993(d) of the Internal 
Revenue Code'' or words of substantially the same meaning.
    (v) The limitation as to the export-related assets of the borrower 
described in paragraph (b) of this section is satisfied.
    (vi) The requirement as to the increased investment of the borrower 
in export-related assets described in paragraph (c) of this section is 
satisfied, and
    (vii) The requirement of paragraph (d) of this section as to proof 
of compliance with paragraphs (b) and (c) of this section is satisfied.
    (2) Application of this section--(i) In general. A loan which is a 
producer's loan is a qualified export asset of the DISC (see Sec. 
1.993-2(a)(5) and (F)). The interest on a producer's loan is a qualified 
export receipt of the DISC (see Sec. 1.993-1(g)). A producer's loan is 
not a dividend to a borrower which is also a shareholder of the DISC 
making the loan. For rules with respect to deemed distributions by 
reason of the amount of foreign investment attributable to producer's 
loans, see section 995(b)(1)(G) and (d) and the regulations thereunder.
    (ii) No tracing of loan proceeds. For purposes of applying this 
section, in order to qualify as a producer's loan, the proceeds of the 
loan need not be traced to an investment in any specific asset.
    (iii) Unrelated borrower. For purposes of applying this section, it 
is not necessary for a borrower to be a related person with respect to 
the DISC from which it receives a producer's loan, or a member of the 
same controlled group as the DISC.
    (iv) Unpaid balance of producer's loans. For purposes of applying 
this section, the unpaid balance of producer's loans does not include 
the unpaid balance of any producer's loan to the extent the loan has 
been deducted or charged off by the DISC as totally or partially 
worthless under section 165 or 166.
    (v) Refinancing, renewal, and extension. For purposes of applying 
this section, the refinancing, renewal, or extension of a producer's 
loan shall be treated as the making of a new loan which may qualify as a 
producer's loan only if the requirements of subparagraph (1) of this 
paragraph are met.
    (vi) Events subsequent to time loan is made. The determination as to 
whether a loan qualifies as a producer's loan is made on the basis of 
the relevant facts taken into account for purposes of determining 
whether the loan was a producer's loan when made. Thus, for example, if 
the accumulated DISC income of the lender is later reduced below the 
unpaid balance of all producer's loans previously made by the DISC, such 
subsequent decrease in the amount of accumulated DISC income will not 
result in later disqualification of such loan (or part thereof) as a 
producer's loan. Similarly, if a loan (or part of a loan) does not 
qualify as a producer's loan because of an insufficient amount of 
accumulated DISC income at the time the loan is made, a subsequent 
increase in the amount of accumulated DISC income will not result in 
later qualification of such loan (or part thereof) as a producer's loan. 
As a further example, for purposes of applying the borrower's export 
related assets limitation described in paragraph (b) of this section, a 
loan which qualifies as a producer's loan when made will not later be 
disqualified if property, the gross receipts from the sale or lease of 
which were includible in the numerator of the fraction described in 
paragraph (b)(3)(i) of this section at the time of sale or lease by the 
borrower, is later characterized as excluded property (as defined in 
Sec. 1.993-3(f)).
    (vii) Application of tests under paragraphs (b) and (c) on 
controlled group bases. If the borrower is a member of a controlled 
group (as defined in Sec. 1.993-1(k)) at the time a loan is made, all 
amounts that must be determined for purposes of applying the limitation 
and increased investment requirement with respect to the export-related 
assets of the borrower (described in paragraphs (b) and (c), 
respectively, of this section) may be determined at the election of the 
borrower by aggregating such amounts for all members of the controlled 
group, determined for the taxable year of each member of the controlled 
group during which the loan is made, excluding only such members of the 
group as are DISC's or foreign

[[Page 831]]

corporations for such year. However, such amounts may be included only 
to the extent that such amounts have not already been taken into account 
in applying the limitation and increased investment requirement with 
respect to any other borrower. Amounts to be aggregated for all such 
members if such election is made include, for example, gross receipts 
(described in paragraphs (b)(3)(i) and (ii) of this section) and export-
related assets (described in paragraph (b)(2) of this section). The 
borrower may make such election by causing its written statement of 
election to be attached to the lending DISC's return under section 
6011(e)(2) for the first taxable year of the lending DISC within which 
or with which the borrower's taxable year for which the election is to 
apply ends. An election once made is binding on all members of the 
controlled group which includes the borrower with respect to all taxable 
years of the borrower beginning with its first taxable year for which 
the election is made. A borrower who makes such election may revoke it 
only if it secures the consent of the Commissioner to such revocation 
upon application made through the lending DISC.
    (3) Loan out of accumulated DISC income--(i) In general. A loan is a 
producer's loan only to the extent that it is made out of accumulated 
DISC income. A loan is made out of accumulated DISC income only if the 
amount of the loan, when added to the unpaid balance at the time such 
loan is made of all other producer's loans made by a DISC, does not 
exceed the amount of accumulated DISC income of the DISC at the 
beginning of the month in which the loan is made. The amount of 
accumulated DISC income at the beginning of any month is determined as 
if the DISC's taxable year closed at the end of the immediately 
preceding month.
    (ii) Presumption. A loan made during a taxable year shall be deemed 
under subdivision (i) of this subparagraph to have been made out of 
accumulated DISC income if the balance of producer's loans at the 
beginning of the year and those made during the year do not exceed 
accumulated DISC income at the end of the year.
    (iii) Deemed distributions. For purposes of this subparagraph, 
accumulated DISC income as of the end of any taxable year (or month) 
shall be determined without regard to deemed distributions under section 
995(b)(1)(G) for the amount of foreign investment attributable to 
producer's loans for such year (or for the taxable year for which such 
month is a part) but actual distributions shall be taken into account.
    (4) Evidence and terms of obligation. A loan is a producer's loan 
only if the loan is evidenced by a note or other evidence of 
indebtedness which is made by the borrower and which has a stated 
maturity date not more than 5 years from the date the loan is made. 
Accordingly, a loan which does not have a stated maturity date or which 
has a stated maturity date more than 5 years from the date such loan is 
made can never meet the 5-year requirement of this subparagraph. Thus, 
for example, even if there is a period of less than 5 years remaining to 
the stated maturity date of a loan, the loan can never be a producer's 
loan if it had a stated maturity date more than 5 years from the date it 
was made. For a further example, if a loan having a period remaining to 
maturity of 2 years is extended for a further period of 3 years (making 
a total of 5 years to maturity from the date of the extension), the 
extension of the loan would under subparagraph (2)(v) of this paragraph 
constitute the making of a new producer's loan and the original 
producer's loan would terminate. If, however, a loan having a period 
remaining to maturity of 2 years is extended for a further period of 4 
years (making a total of 6 years to maturity from the date of the 
extension), the original producer's loan will terminate and the new loan 
will not be a producer's loan. If a producer's loan is not paid in full 
at its maturity date and is not formally refinanced, renewed, or 
extended, such loan shall be deemed to be a new loan which does not have 
a stated maturity date and, thus, will not be a producer's loan. For 
purposes of this subparagraph, an evidence of indebtedness is a written 
instrument of indebtedness. Section 482 and the regulations thereunder 
are applicable to determine, in the case of a loan by the DISC to a 
borrower which

[[Page 832]]

is owned or controlled directly or indirectly by the same interests as 
the DISC within the meaning of section 482, whether the interest charged 
on such loan is at an arm's length rate.
    (5) Borrower's trade or business. A loan is a producer's loan only 
if the loan is made to a person engaged in the United States in the 
manufacture, production, growth, or extraction (within the meaning of 
Sec. 1.993-3(c)) of export property determined without regard to Sec. 
1.993-3(f)(1)(iii) and (iv). The borrower may also be engaged in other 
trades or businesses and the loan need not be traceable to specific 
investments in export property.
    (b) Borrower's export related assets limitation--(1) General rule. A 
loan to a borrower is a producer's loan only to the extent that the 
amount of the loan, when added to the unpaid balance of all other 
producer's loans made by all DISC's to the borrower which are 
outstanding at the time the loan is made, does not exceed an amount 
equal to the amount of the borrower's export-related assets (determined 
under subparagraph (2) of this paragraph) multiplied by the fraction set 
forth in subparagraph (3) of this paragraph.
    (2) Amount of export-related assets--(i) In general. For purposes of 
subparagraph (1) of this paragraph, the amount of the borrower's export-
related assets is the sum of the amounts described in subdivisions (ii), 
(iii), and (iv) of this subparagraph.
    (ii) Borrower's plant and equipment. The amount described in this 
subdivision is the sum of the borrower's adjusted bases (determined as 
of the beginning of the borrower's taxable year in which a loan is made 
to it) for plant, machinery, equipment, and supporting production 
facilities, which are located in the United States. Supporting 
production facilities are all property used primarily in connection with 
the manufacture, production, growth, or extraction (within the meaning 
of Sec. 1.993-3(c)) or storage, handling, transportation, or assembly 
of property by the borrower.
    (iii) Borrower's property held primarily for sale or lease. The 
amount described in this subdivision is the amount of the borrower's 
property (at the beginning of the taxable year of the borrower in which 
a loan is made to it) held primarily for sale or lease to customers in 
the ordinary course of its trade or business. The amount of such 
property held for sale is determined under the methods of identifying 
and valuing inventory normally used by the borrower. The amount of such 
property held for lease or leased is the borrower's adjusted bases, 
determined under section 1011, for such property.
    (iv) Borrower's research and experimental expenditures. The amount 
described in this subdivision is the aggregate amount, whether or not 
charged to capital account, of research and experimental expenditures 
(within the meaning of section 174) incurred in the United States by the 
borrower during each of its taxable years which begin after December 31, 
1971, and precede the taxable year in which the loan is made to the 
borrower. Such research and experimental expenditures need bear no 
relationship to export property (as defined in Sec. 1.993-3) of the 
borrower. The aggregate amount of all such expenditures for each of such 
preceding taxable years is taken into account for purposes of this 
subparagraph, regardless of whether all or any portion of the aggregate 
amount has been taken into account with respect to producer's loans made 
to the borrower by any DISC in preceding taxable years. The aggregate 
amount of all such expenditures shall include such expenditures of a 
corporation, the assets of which were acquired by the borrower in a 
distribution or a transfer described in section 381(a)(1) or (2) 
(relating to carryovers in certain corporate acquisitions).
    (3) Fraction referred to in subparagraph (1) of this paragraph--(i) 
Numerator of fraction. The numerator of the fraction set forth in this 
subparagraph is the sum of the borrower's gross receipts for each of its 
3 taxable years immediately preceding the taxable year in which the loan 
is made (but not including any taxable year beginning before January 1, 
1972) from the sale or lease of export property (determined without 
regard to Sec. 1.993-3(f)(1)(iii) and (iv)) which is manufactured, 
produced, grown, or extracted (within the meaning of Sec. 1.993-3(c)) 
by the borrower whether or not

[[Page 833]]

sold or leased directly or through a related domestic person 
(notwithstanding Sec. 1.993-3(a)(4) and (f)(2)). For purposes of the 
preceding sentence, with respect to a sale or lease to a related DISC in 
which the transfer price is determined under section 994(a)(1) or (2), 
the rules under Sec. 1.994-1(c)(5) (relating to incomplete 
transactions) shall be applied, and with respect to all other sales and 
leases the rules under Sec. 1.994-1(c)(5) other than subdivision (i)(d) 
thereof shall be applied.
    (ii) Denominator of fraction. The denominator of the fraction set 
forth in this subparagraph is the sum of the amount included in the 
numerator and all other gross receipts of the borrower, for each of its 
taxable years for which gross receipts are included in the numerator of 
the fraction, from all sales or leases of all property held by the 
borrower primarily for sale or lease to customers in the ordinary course 
of its trade or business. For purposes of subdivision (i) of this 
subparagraph and this subdivision, if such property is sold or leased to 
a domestic related person which resells or subleases such property, the 
borrower's gross receipts shall be the gross receipts derived by the 
domestic related person from the resale or sublease of the export 
property.
    (iii) Taxable years. If the borrower has not engaged in the sale or 
lease of property (as described in this subparagraph) for the 3 
immediately preceding taxable years, or if 3 taxable years beginning 
after December 31, 1971, have not elapsed, the fraction will be computed 
on the basis of such gross receipts for its taxable years immediately 
preceding the loan and beginning after December 31, 1971, during which 
the borrower has so engaged. No producer's loans can be made to a 
borrower until after the end of the first taxable year of the borrower 
beginning after December 31, 1971.
    (c) Requirement for increased investment in export-related assets--
(1) In general. A loan to a borrower is a producer's loan only to the 
extent that the amount of the loan, when added to the unpaid balance of 
all other producer's loans made by all DISC's to the borrower during the 
borrower's taxable year during which such loan is made, does not exceed 
the amount of the borrower's increase for the year in investment in 
export-related assets. Such increase for any taxable year is the sum 
of--
    (i) The increase (if any) in the borrowers adjusted basis of certain 
types of assets as determined under subparagraph (2) of this paragraph 
and
    (ii) The amount (if any) during the year of its research and 
experimental expenditures as determined under paragraph (b)(2)(iv) of 
this section.
    (2) Increase in adjusted basis. The amount under this subparagraph 
is the amount (not less than zero) by which--
    (i) The borrower's adjusted basis (determined as of the end of its 
taxable year in which the producer's loan is made) in all of its 
property which is described in paragraph (b)(2)(ii) (plant and 
equipment), and (iii) (property held primarily for sale or lease) of 
this section, including any such property acquired by it during such 
taxable year, exceeds
    (ii) Its adjusted bases in all such property (determined as of the 
beginning of such year).
    (3) Ordering rule. If during the borrower's taxable year the amount 
of increase in investment in export-related assets determined under this 
subparagraph is exceeded by amounts loaned to the borrower during such 
year that would otherwise qualify as producer's loans, such loans shall 
be applied in the order made against the amount of such increase in 
order to determine which loans qualify as producer's loans.
    (d) Proof of borrower's compliance with paragraphs (b) and (c) of 
this section. For purposes of paragraphs (b) and (c) of this section, a 
DISC shall be prepared to establish initially the compliance of the 
borrower with the requirements of such paragraphs by providing the 
written statement of the borrower, certified by a certified public 
accountant, stating that the borrower has complied with the limitation 
and increased investment requirement in section 993(d)(2) and (3) of the 
Internal Revenue Code of 1954. In lieu of certification by a certified 
public accountant, the DISC may attach to its return a statement signed 
by the borrower under penalties of perjury on a form provided by the 
Internal Revenue Service certifying

[[Page 834]]

that the borrower has complied with the limitation and increased 
investment requirement in section 993(d)(2) and (3) of the Internal 
Revenue Code of 1954. For taxable years ending after October 17, 1977, 
the DISC must attach either the certification by the certified public 
accountant or the certification by the borrower to its return. 
Additional full substantiation of the borrower's compliance with the 
requirements of such paragraphs may be required by the district 
director. If full substantiation of such compliance is not provided by 
the DISC (or the borrower) when required, the loan shall be deemed not 
to be a producer's loan.
    (e) Special limitation in the case of domestic film maker--(1) 
General rule. The limitation of paragraph (b) of this section as to the 
export-related assets of the borrower will be considered satisfied if 
the DISC--
    (i) Is engaged in the trade or business of selling or leasing films 
which are export property, or is acting as a commission agent for a 
person who is so engaged,
    (ii) Makes a loan to a borrower which is a domestic film maker (as 
defined in subparagraph (5) of this paragraph) for the purpose of making 
a film, and
    (iii) The amount of such loan, when added to the unpaid balance of 
all other producer's loans made by all DISC's to the borrower which are 
outstanding at the time the loan is made, does not exceed an amount 
determined by multiplying--
    (a) The sum of (1) the amount of the export-related assets of the 
borrower (determined under paragraph (b)(2)(i) of this section as of the 
beginning of the borrower's taxable year in which the loan is made), 
plus (2) the amount of a reasonable estimate of the amount of such 
export related assets obtained or to be obtained by the borrower during 
such year and subsequent years with respect to films as to which filming 
begins within such year by
    (b) The percentage which, based on the experience of other film 
makers of similar films for the 5 calendar years preceding the calendar 
year in which the loan is made, the annual gross receipts (as described 
in Sec. 1.993-6(a)(1), whether or not such films constitute property 
described therein) of such other film makers from the sale or lease of 
such films outside the United States is of the annual gross receipts of 
such other film makers from all sales or leases of such films.
    (2) Purpose of loan. A loan by a DISC will be deemed to be for the 
making of a film if there exists a written agreement between the DISC 
and the borrower, executed at or before the time the loan is made, 
stating that the loan is made or to be made to enable the borrower to 
make such film.
    (3) Reasonable estimate of amounts. For purposes of subparagraph 
(1)(iii)(a)(2) of this paragraph, a reasonable estimate shall be based 
on the conditions known by the DISC and borrower to exist at the time a 
loan is made (or which the DISC and borrower have reason to know to 
exist at such time).
    (4) Experience of film makers. For purposes of subparagraph 
(1)(iii)(b) of this paragraph, the experience of other film makers of 
similar films for the 5 calendar years preceding the calendar year in 
which the loan is made shall be derived from such records and statistics 
as are acknowledged in the trade as reasonably reliable.
    (5) Domestic film maker. For purposes of this section, a borrower is 
a domestic film maker with respect to a film if--
    (i) The borrower is a U.S. person within the meaning of section 
7701(a)(30), except that (a) with respect to a partnership all of the 
partners must be U.S. persons and (b) with respect to a corporation all 
of its officers and at least a majority of its directors must be U.S. 
persons,
    (ii) The borrower is engaged in the trade or business of making the 
film with respect to which the loan is made,
    (iii) Each studio, if any, used or to be used for filming or for 
recording sound incorporated into such film is located in the United 
States (as defined in section 7701(a)(9)),
    (iv) At least 80 percent of the aggregate playing time of the film 
is or will be photographed within the United States (as defined in 
section 7701(a)(9)), and
    (v) At least 80 percent of the total amount (not including any 
amount which is contingent upon receipts or profits of such film and 
which is fully

[[Page 835]]

taxable by the United States) paid or to be paid for services performed 
in the making of the film is either paid or to be paid to persons who 
are U.S. persons at the time such services are performed or consists of 
amounts which are fully taxable by the United States.
    (6) Amounts as fully taxable. For purposes of subparagraph (5)(v) of 
this paragraph, an amount is considered fully taxable by the United 
States if the entire amount is included in gross income under section 61 
or is subject to withholding under any provision of U.S. law or treaty 
to which the U.S. is a party and is not exempt from taxation under any 
provision of such law or treaty. Where a nonresident alien individual is 
engaged for the making of a film or where a foreign corporation is 
engaged to furnish the services of one of its officers or employees for 
the making of a film, the amount paid such individual or corporation 
will be considered as fully taxable by the United States only if it 
meets the test of this subparagraph.

[T.D. 7514, 42 FR 55464, Oct. 17, 1977, as amended by T.D. 7513, 42 FR 
57311, Nov. 2, 1977; T.D. 7514, 42 FR 60910, Nov. 30, 1977; T.D. 7854, 
47 FR 51741, Nov. 17, 1982]



Sec. 1.993-5  Definition of related foreign export corporation.

    (a) General rule--(1) Definition. Under section 993(e), a foreign 
corporation is a related foreign export corporation with respect to a 
DISC if--
    (i) It is a foreign international sales corporation described in 
paragraph (b) of this section,
    (ii) It is a real property holding company described in paragraph 
(c) of this section, or
    (iii) It is an associated foreign corporation described in paragraph 
(d) of this section.
    (2) Application of this section. It is necessary to determine 
whether a foreign corporation is a related foreign export corporation 
with respect to a DISC for the following two purposes:
    (i) Qualified export assets. Under Sec. 1.993-2(g), the stock or 
securities of a related foreign export corporation held by the DISC are 
qualified export assets.
    (ii) Qualified export receipts. Under Sec. 1.993-1 (e), (f), and 
(g), certain receipts of the DISC with respect to stock or securities of 
a related foreign export corporation held by the DISC are qualified 
export receipts.
    (b) Foreign international sales corporation--(1) In general. A 
foreign corporation is a foreign international sales corporation with 
respect to a taxable year of a DISC if--
    (i) On each day during such taxable year of the DISC on which the 
foreign corporation has stock issued and outstanding, the DISC owns 
directly stock of the foreign corporation possessing more than 50 
percent of the total combined voting power of all classes of stock of 
the foreign corporation entitled to vote as determined under the 
principles of Sec. 1.957-1(b) (relating to definition of controlled 
foreign corporation),
    (ii) 95 percent or more of such foreign corporation's gross receipts 
(as defined in Sec. 1.993-6) for its taxable year ending with or within 
such taxable year of the DISC consists of qualified export receipts 
described in Sec. 1.993-1 (b) through (e) or interest described in 
Sec. 1.993-1(g) derived from any obligations described in Sec. 1.993-2 
(d) or (e), and
    (iii) The sum of the adjusted bases of the assets of the foreign 
corporation which are qualified export assets described in Sec. 1.993-2 
(b) through (e) and which are held by the foreign corporation at the 
close of its taxable year which ends with or within such taxable year of 
the DISC equals or exceeds 95 percent of the sum of the adjusted bases 
of all assets held by the foreign corporation at the close of such 
taxable year.
    (2) Certain determinations. The determinations as to whether gross 
receipts are qualified export receipts described in subparagraph (1)(ii) 
of this paragraph and as to whether assets are qualified export assets 
described in subparagraph (1)(iii) of this paragraph are made by 
applying the requirements of Sec. Sec. 1.993-1 and 1.993-2 to the 
foreign corporation as if it were a domestic corporation being tested to 
determine whether it is a DISC. For purposes of making either of such 
determinations, the principles of accounting applicable for purposes of 
computing earnings and profits under Sec. 1.964-1 (relating to a 
controlled foreign corporation's earnings and profits) shall apply.

[[Page 836]]

    (c) Real property holding company--(1) In general. A foreign 
corporation is a real property holding company with respect to a taxable 
year of a DISC if--
    (i) On each day during such taxable year of the DISC on which the 
foreign corporation has stock issued and outstanding, the DISC owns 
directly stock of the foreign corporation possessing more than 50 
percent of the total combined voting power of all classes of stock of 
the foreign corporation entitled to vote as determined under the 
principles of Sec. 1.957-1(b) and
    (ii) The sole function of the foreign corporation is to hold title 
to real property situated outside the United States for the exclusive 
use of the DISC, title to which may not be held by the DISC (and, if the 
DISC subleases such property to a related supplier, as described in 
subparagraph (3) of this paragraph, by such related supplier) under the 
law of the country in which such property is situated.
    (2) Activities of the foreign corporation. For purposes of 
subparagraph (1)(ii) of this paragraph, a foreign corporation which 
holds title to real property situated outside the United States may also 
perform activities with respect to such property (such as management, 
maintenance, and payment of taxes) which are ancillary to its function 
of holding title to such property.
    (3) Exclusive use by the DISC. Real property held by the foreign 
corporation must be used exclusively by the DISC whether under a lease 
or any other arrangement. Real property is not so used by the DISC if 
the DISC subleases such property to any other person. If, however, 
during a taxable year of the DISC--
    (i) 90 percent or more of the qualified export receipts of the DISC 
for such year are derived from transactions with respect to which it is 
a commission agent for a related supplier (as defined in Sec. 1.994-
1(a)(3)(ii)), and
    (ii) The DISC subleases such property to such related supplier


then such property will be considered as used exclusively by the DISC 
during such year if such related supplier does not sublease such 
property.
    (d) Associated foreign corporation--(1) In general. A foreign 
corporation is an associated foreign corporation with respect to a 
taxable year of the DISC if--
    (i) On each day during such taxable year of the DISC on which the 
foreign corporation has stock issued and outstanding, the DISC, or one 
or more members of the same controlled group of corporations (as defined 
in subparagraph (2) of this paragraph) as the DISC, owns (within the 
meaning of section 1563 (d) and (e)) stock of the foreign corporation 
possessing less than 10 percent of the total combined voting power of 
all classes of stock of the foreign corporation entitled to vote, as 
determined under the principles of Sec. 1.957-1(b), or owns no stock of 
such corporation, and
    (ii) The ownership of stock, or of securities (as defined in Sec. 
1.993-2(g)), of the foreign corporation by the DISC or by one or more 
members of such controlled group of corporations reasonably furthers a 
transaction or transactions giving rise to qualified export receipts for 
the DISC.
    (2) Controlled group of corporations. For purposes of this 
paragraph, the term ``controlled group of corporations'' has the same 
meaning assigned to the term in section 1563(a) and not section 
993(a)(3) and Sec. 1.993-1(k). Thus, for purposes of this paragraph, 
the test of control is 80 percent control and, since the rules of 
section 1563(b) apply, only domestic members are considered to be 
members of the controlled group.
    (3) Furtherance of qualified export receipts. Ownership of stock or 
securities of a foreign corporation will be considered as reasonably 
furthering a transaction or transactions giving rise to qualified export 
receipts for a DISC if--
    (i) The ownership is necessary to obtain or maintain the foreign 
corporation as a customer of the DISC or of a related supplier, as 
defined in Sec. 1.994-1(a)(3)(ii) of the DISC or to aid the sales 
distribution system of the DISC or of such related supplier, and
    (ii) The amount of the investment in the foreign corporation bears a 
reasonable relationship to the amount of the DISC's annual net profit 
from transactions in its trade or business which it may reasonably 
expect to derive on account of such ownership.


In determining whether the amount of the investment is reasonable, there

[[Page 837]]

shall be taken into account any stock or securities of the foreign 
corporation owned by any other foreign corporation which, if it were a 
domestic corporation, would be a member of the same controlled group of 
corporations as the DISC.

[T.D. 7514, 42 FR 55467, Oct. 17, 1977; 42 FR 60910, Nov. 30, 1977]



Sec. 1.993-6  Definition of gross receipts.

    (a) General rule. Under section 993(f), for purposes of sections 991 
through 996, the gross receipts of a person for a taxable year are--
    (1) The total amounts received or accrued by the person from the 
sale or lease of property held primarily for sale or lease in the 
ordinary course of a trade or business, and
    (2) Gross income recognized from all other sources, such as, for 
example, from--
    (i) The furnishing of services (whether or not related to the sale 
or lease of property described in subparagraph (1) of this paragraph),
    (ii) Dividends and interest,
    (iii) The sale at a gain of any property not described in 
subparagraph (1) of this paragraph, and
    (iv) Commission transactions as and to the extent described in 
paragraph (e) of this section.
    (b) Nongross receipts items. For purposes of paragraph (a) of this 
section, gross receipts do not include amounts received or accrued by a 
person from--
    (1) The proceeds of a loan or of the repayment of a loan, or
    (2) A receipt of property in a transaction to which section 118 
(relating to contribution to capital) or 1032 (relating to exchange of 
stock for property) applies.
    (c) Nonreduction of total amounts. For purposes of paragraph (a) of 
this section, the total amounts received or accrued by a person are not 
reduced by returns and allowances, costs of goods sold, expenses, 
losses, a deduction for dividends received under section 243, or any 
other deductible amounts.
    (d) Method of accounting. For purposes of paragraph (a) of this 
section, the total amounts received or accrued by a person shall be 
determined under the method of accounting used in computing its taxable 
income. If, for example, a DISC receives advance or installment payments 
for the sale or lease of property described in paragraph (a)(1) of this 
section, for the furnishing of services, or which represent recognized 
gain from the sale of property not described in paragraph (a)(1) of this 
section, any amount of such advance payments is considered to be gross 
receipts of the DISC for the taxable year for which such amount is 
included in the gross income of the DISC.
    (e) Commission transactions. (1) In the case of transactions which 
give rise to a commission on the sale or lease of property or the 
furnishing of services by a principal, the amount recognized by the 
commission agent as gross income from all such transactions shall be the 
gross receipts derived by the principal from the sale or lease of the 
property, or the gross income derived by the principal from the 
furnishing of services, with respect to which the commissions are 
derived. In the case of a commission agent for a related supplier (as 
defined in Sec. 1.994-1(a)(3)(ii)), the gross receipts or gross income 
of such agent shall be determined as if it used the same method of 
accounting as its related supplier. In the case of a commission agent 
for a principal other than a related supplier, the gross receipts or 
gross income of such principal shall be determined as if such principal 
used the same method of accounting as its agent.
    (2) If the commission arrangement provides that the commission agent 
will receive a commission only with respect to sales or leases of export 
property, or the furnishing of services, which result in qualified 
export receipts, the commission agent will not take into account the 
gross receipts or gross income, as the case may be, derived by the 
principal from any transaction for which the commission agent would not 
be entitled to a commission under the commission arrangement.
    (f) Example. The provisions of this section may be illustrated by 
the following example:

    Example. During 1973, M, a related supplier (as defined in Sec. 
1.994-1(a)(3)(ii)) of N, is engaged in the manufacture of machines in 
the United States. N, a calendar year taxpayer,

[[Page 838]]

is engaged in the sale and lease of such machines in foreign countries. 
N furnishes services which are related and subsidiary to its sale and 
lease of such machines. N also acts as a commission agent in foreign 
countries for Z, an unrelated supplier, with respect to Z's sale of 
products. N receives dividends on stock owned by it in a related foreign 
export corporation (as defined in Sec. 1.993-5), interest on producer's 
loans made to M, and proceeds from sales of business assets located 
outside the United States resulting in a recognized gains and losses. 
N's gross receipts for 1973 are $3,550, computed on the basis of the 
additional facts assumed in the table below:

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


[T.D. 7514, 42 FR 55468, Oct. 17, 1977]



Sec. 1.993-7  Definition of United States.

    Under section 993(g), the term ``United States'' includes the 
States, the District of Columbia, the Commonwealth of Puerto Rico, and 
possessions of the United States. For the requirement that a DISC must 
be incorporated and existing under the laws of a State or the District 
of Columbia, see Sec. 1.992-1(a)(1).

[T.D. 7514, 42 FR 55468, Oct. 17, 1977]



Sec. 1.994-1  Inter-company pricing rules for DISC's.

    (a) In general--(1) Scope. In the case of a transaction described in 
paragraph (b) of this section, section 994 permits a person related to a 
DISC to determine the allowable transfer price charged the DISC (or 
commission paid the DISC) by its choice of three methods described in 
paragraph (c)(2), (3), and (4) of this section: The ``4 percent'' gross 
receipts method, the ``50-50'' combined taxable income method, and the 
section 482 method. Under the first two methods, the DISC is entitled to 
10 percent of its export promotion expenses as additional taxable 
income. When the gross receipts method or combined taxable income method 
is applied to a transaction, the Commissioner may not make 
distributions, apportionments, or allocations as provided by section 482 
and the regulations thereunder. For rules as to certain ``incomplete 
transactions'' and for computing combined taxable income, see paragraph 
(c)(5) and (6) of this section. Grouping of transactions for purposes of 
applying the method chosen is provided by paragraph (c)(7) of this 
section. The rules in paragraph (c) of this section are directly 
applicable only in the case of sales or exchanges of export property to 
a DISC for resale, and are applicable by analogy to leases, commissions, 
and services as provided in paragraph (d) of this section. For rules 
limiting the application of the gross receipts method and combined 
taxable income method so that the supplier related to the DISC will not 
incur a loss on transactions, see paragraph (e)(1) of this section. 
Paragraph (e)(2) of this section provides for the applicability of 
section 482 to resales by the DISC to related persons. Paragraph (e)(3) 
of this section provides for the time by which a reasonable estimate of 
the transfer price (including commissions and other payments) should be 
paid. The subsequent determination and further adjustments to transfer 
prices are set forth in paragraph (e)(4) of this section. Export 
promotion expenses are defined in paragraph (f) of this section. 
Paragraph (g) of this section has several examples illustrating the 
provisions of this section. Section 1.994-2 prescribes the marginal 
costing rules authorized by section 994(b)(2).
    (2) Performance of substantial economic functions. The application 
of section 994(a)(1) or (2) does not depend on the extent to which the 
DISC performs substantial economic functions (except with respect to 
export promotion expenses). See paragraph (l) of Sec. 1.993-1.
    (3) Related party and related supplier. For the purposes of this 
section--

[[Page 839]]

    (i) The term ``related party'' means a person which is owned or 
controlled directly or indirectly by the same interests as the DISC 
within the meaning of section 482 and Sec. 1.482-1(a).
    (ii) The term ``related supplier'' means a related party which 
singly engages in a transaction directly with the DISC which is subject 
to the rules of section 994 and this section. However, a DISC may have 
different related suppliers with respect to different transactions. If, 
for example, X owns all the stock of Y, a corporation, and of Z, a DISC, 
and sells a product to Y which is resold to Z, only Y is the related 
supplier of Z, and, thus, only the resale from Y to Z is subject to 
section 994 and this section. If, however, X sells directly to Z and Y 
also sells directly to Z, then, as to the transactions involving direct 
sales to Z, each of X and Y is a related supplier of Z.
    (b) Transactions to which section 994 applies. Section 994(a)(3) may 
be applied, as described in paragraph (a) of this section, to any 
transaction between a related supplier and a DISC. Section 994(a)(1) or 
(2) may be applied, as described in paragraph (a) of this section, to a 
transaction between a related supplier and a DISC only in the following 
cases:
    (1) Where the related supplier sells export property to the DISC for 
resale or where the DISC is commission agent for the related supplier on 
sales by the related supplier of export property to third parties 
whether or not related parties. For purposes of this section, references 
to sales include exchanges.
    (2) Where the related supplier leases export property to the DISC 
for sublease for a comparable period with comparable terms of payment or 
where the DISC is commission agent for the related supplier on leases by 
the related supplier of export property to third parties whether or not 
related parties.
    (3) Where services are furnished by a related supplier which are 
related and subsidiary to any sale or lease by the DISC, acting as 
principal or commission agent, of export property under subparagraph (1) 
or (2) of this paragraph.
    (4) Where engineering or architectural services for construction 
projects located (or proposed for location) outside of the United States 
are furnished by a related supplier where the DISC is acting as 
principal or commission agent with respect to the furnishing of such 
services to a third party whether or not a related party.
    (5) Where the related supplier furnishes managerial services in 
furtherance of the production of qualified export receipts of an 
unrelated DISC where the related DISC is acting as principal or 
commission agent with respect to the furnishing of such services to an 
unrelated DISC.


Transactions are included, for purposes of this paragraph, only if they 
give rise to qualified export receipts (within the meaning of section 
993(a)) in the hands of the related DISC. If a transaction is not 
included in subparagraph (1), (2), (3), (4), or (5) of this paragraph, 
the rules of section 994(a)(1) or (2) do not apply. Thus, for example, 
the rules of section 994(a)(1) or (2) would not apply if a DISC 
purchased export property from its related supplier and leased such 
property to a third party.
    (c) Transfer price for sales of export property--(1) In general. 
Under this paragraph, rules are prescribed for computing the allowable 
price for a transfer from a related supplier to a DISC in the case of a 
sale of export property described in paragraph (b)(1) of this section.
    (2) The ``4-percent'' gross receipts method. Under the gross 
receipts method of pricing, the transfer price for a sale by the related 
supplier to the DISC is the price as a result of which the taxable 
income derived by the DISC from the sale will not exceed the sum of (i) 
4 percent of the qualified export receipts of the DISC derived from the 
sale of the export property (as defined in section 993 (c)) and (ii) 10 
percent of the export promotion expenses (as defined in paragraph (f) of 
this section) of the DISC attributable to such qualified export 
receipts.
    (3) The ``50-50'' combined taxable income method. Under the combined 
taxable income method of pricing, the transfer price for a sale by the 
related supplier to the DISC is the price as a result of which the 
taxable income derived by the DISC from the sale will not exceed the sum 
of (i) 50 percent of

[[Page 840]]

the combined taxable income (as defined in subparagraph (6) of this 
paragraph) of the DISC and its related supplier attributable to the 
qualified export receipts from such sale and (ii) 10 percent of the 
export promotion expenses (as defined in paragraph (f) of this section) 
of the DISC attributable to such qualified export receipts.
    (4) Section 482 method. If the rules of subparagraphs (2) and (3) of 
this paragraph are inapplicable to a sale or a taxpayer does not choose 
to use them, the transfer price for a sale by the related supplier to 
the DISC is to be determined on the basis of the sale price actually 
charged but subject to the rules provided by section 482 and the 
regulations thereunder.
    (5) Incomplete transactions. (i) For purposes of the gross receipts 
and combined taxable income methods, where property (encompassed within 
a transaction or group chosen under subparagraph (7) of this paragraph) 
is transferred by a related supplier to a DISC during a taxable year of 
either the DISC or related supplier, but some or all of such property is 
not sold by the DISC during such year--
    (a) The transfer price of such property sold by the DISC during such 
year shall be computed separately from the transfer price of the 
property not sold by the DISC during such year,
    (b) With respect to such property not sold by the DISC during such 
year, the transfer price paid by the DISC for such year shall be the 
related supplier's cost of goods sold (see subparagraph (6)(ii) of this 
paragraph) with respect to the property, except that, with respect to 
such taxable years ending on or before August 15, 1975, the transfer 
price paid by the DISC shall be at least (but need not exceed) the 
related supplier's cost of goods sold with respect to the property.
    (c) For the subsequent taxable year during which such property is 
resold by the DISC, an additional amount shall be paid by the DISC (to 
be treated as income for such year by the related supplier) equal to the 
excess of the amount which would have been the transfer price under this 
section had the transfer to the DISC by the related supplier and the 
resale by the DISC taken place during the taxable year of the DISC 
during which it resold the property over the amount already paid under 
(b) of this subdivision.
    (d) The time and manner of payment of transfer prices required by 
(b) and (c) of this subdivision shall be determined under paragraphs 
(e)(3), (4), and (5) of this section.
    (ii) For purposes of this paragraph, a DISC may determine the year 
in which it receives property from a related supplier and the year in 
which it sells property in accordance with the method of identifying 
goods in its inventory properly used under section 471 or 472 (relating 
respectively to general rule for inventories and to LIFO inventories). 
Transportation expense of the related supplier in connection with a 
transaction to which this subparagraph applies shall be treated as an 
item of cost of goods sold with respect to the property if the related 
supplier includes the cost of intracompany transportation between its 
branches, divisions, plants, or other units in its cost of goods sold 
(see subparagraph (6)(ii) of this paragraph).
    (6) Combined taxable income. For purposes of this section, the 
combined taxable income of a DISC and its related supplier from a sale 
of export property is the excess of the gross receipts (as defined in 
section 993(f)) of the DISC from such sale over the total costs of the 
DISC and related supplier which relate to such gross receipts. Gross 
receipts from a sale do not include interest with respect to the sale. 
Combined taxable income under this paragraph shall be determined after 
taking into account under paragraph (e)(2) of this section all 
adjustments required by section 482 with respect to transactions to 
which such section is applicable. In determining the gross receipts of 
the DISC and the total costs of the DISC and related supplier which 
relate to such gross receipts, the following rules shall be applied:
    (i) Subject to subdivisions (ii) through (v) of this subparagraph, 
the taxpayer's method of accounting used in computing taxable income 
will be accepted for purposes of determining amounts and the taxable 
year for which items of income and expense (including depreciation) are 
taken into account. See Sec. 1.991-1(b)(2) with respect

[[Page 841]]

to the method of accounting which may be used by a DISC.
    (ii) Cost of goods sold shall be determined in accordance with the 
provisions of Sec. 1.61-3. See sections 471 and 472 and the regulations 
thereunder with respect to inventories. With respect to property to 
which an election under section 631 applies (relating to cutting of 
timber considered as a sale or exchange), cost of goods sold shall be 
determined by applying Sec. 1.631-1(d)(3) and (e) (relating to fair 
market value as of the beginning of the taxable year of the standing 
timber cut during the year considered as its cost).
    (iii) Costs (other than cost of goods sold) which shall be treated 
as relating to gross receipts from sales of export property are (a) the 
expenses, losses, and other deductions definitely related, and therefore 
allocated and apportioned, thereto, and (b) a ratable part of any other 
expenses, losses, or other deductions which are not definitely related 
to a class of gross income, determined in a manner consistent with the 
rules set forth in Sec. 1.861-8.
    (iv) The taxpayer's choice in accordance with subparagraph (7) of 
this paragraph as to the grouping of transactions shall be controlling, 
and costs deductible in a taxable year shall be allocated and 
apportioned to the items or classes of gross income of such taxable year 
resulting from such grouping.
    (v) If an account receivable arising with respect to a sale of 
export property is transferred by the related supplier to a DISC which 
is a member of the same controlled group within the meaning of Sec. 
1.993-1(k) for an amount reflecting a discount from the selling price 
taken into account in computing (without regard to this subdivision) 
combined taxable income of the DISC and its related supplier, then the 
combined taxable income from such sale shall be reduced by the amount of 
the discount.
    (7) Grouping transactions. (i) Generally, the determinations under 
this section are to be made on a transaction-by-transaction basis. 
However, at the annual choice of the taxpayer some or all of these 
determinations may be made on the basis of groups consisting of products 
or product lines.
    (ii) A determination by a taxpayer as to a product or a product line 
will be accepted by a district director if such determination conforms 
to any one of the following standards: (a) A recognized industry or 
trade usage, or (b) the 2-digit major groups (or any inferior 
classifications or combinations thereof, within a major group) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President.
    (iii) A choice by the taxpayer to group transactions for a taxable 
year on a product or product line basis shall apply to all transactions 
with respect to that product or product line consummated during the 
taxable year. However, the choice of a product or product line grouping 
applies only to transactions covered by the grouping and, as to 
transactions not encompassed by the grouping, the determinations are 
made on a transaction-by-transaction basis. For example, the taxpayer 
may choose a product grouping with respect to one product and use the 
transaction-by-transaction method for another product within the same 
taxable year.
    (iv) For rules as to grouping certain related and subsidiary 
services, see paragraph (d)(3)(ii) of this section.
    (d) Rules under section 994(a)(1) and (2) for transactions other 
than sales. The following rules are prescribed for purposes of applying 
the gross receipts method or combined taxable income method to 
transactions other than sales:
    (1) Leases. In the case of a lease of export property by a related 
supplier to a DISC for sublease by the DISC to produce gross receipts, 
for any taxable year the amount of rent the DISC must pay to the related 
supplier shall be determined under the DISC's lease with its related 
supplier but must be computed in a manner consistent with the rules in 
paragraph (c) of this section for computing the transfer price in the 
case of sales and resales of export property under the gross receipts 
method or combined taxable income method. For purposes of applying this 
subparagraph, transactions may not be so grouped on a product or product 
line basis under the rules of paragraph (c)(7)

[[Page 842]]

of this section as to combine in any one group of transactions both 
lease transactions and sale transactions involving the same product or 
product line.
    (2) Commissions. If any transaction to which section 994 applies is 
handled on a commission basis for a related supplier by a DISC and such 
commissions give rise to qualified export receipts under section 
993(a)--
    (i) The amount of the income that may be earned by the DISC in any 
year is the amount, computed in a manner consistent with paragraph (c) 
of this section, which the DISC would have been permitted to earn under 
the gross receipts method, the combined taxable income method, or 
section 482 method if the related supplier had sold (or leased) the 
property or service to the DISC and the DISC in turn sold (or subleased) 
to a third party, whether or not a related party, and
    (ii) The maximum commission the DISC may charge the related supplier 
is the sum of the amount of income determined under subdivision (i) of 
this subparagraph plus the DISC's total costs for the transaction as 
determined under paragraph (c)(6) of this section.
    (3) Receipts from services--(i) Related and subsidiary services 
attributable to the year of the export transaction. The gross receipts 
for related and subsidiary services described in paragraph (b)(3) of 
this section shall be treated as part of the receipts from the export 
transaction to which such services are related and subsidiary, but only 
if, under the arrangement between the DISC and its related supplier and 
the accounting method otherwise employed by the DISC, the income from 
such services is includible for the same taxable year as income from 
such export transaction.
    (ii) Other services. In the case of related and subsidiary services 
to which subdivision (i) of this subparagraph does not apply and other 
services described in paragraph (b)(4) or (5) of this section performed 
by a related supplier (relating respectively to engineering and 
architectural services and certain managerial services), the amount of 
taxable income which the DISC may derive for any taxable year shall be 
determined under the arrangement between the DISC and its related 
supplier and shall be computed in a manner consistent with the rules in 
paragraph (c) of this section for computing the transfer price in the 
case of sales for resale of export property under the gross receipts 
method or combined taxable income method. Related and subsidiary 
services to which subdivision (i) of this subparagraph does not apply 
may be grouped, under the rules for grouping of transactions in 
paragraph (c)(7) of this section, with the products or product lines to 
which they are related and subsidiary, so long as the grouping of 
services chosen is consistent with the grouping of products or product 
lines chosen for the taxable year in which either the product or product 
lines were sold or in which payment for such services is received or 
accrued. The rules for grouping of transactions in paragraph (c)(7) of 
this section shall not apply with respect to the determination of 
taxable income which the DISC may derive from other services described 
in paragraph (b)(4) or (5) of this section performed by a related 
supplier or commissions on such services, and such determination shall 
be made only on a transaction-by-transaction basis.
    (e) Methods of applying paragraphs (c) and (d) of this section--(1) 
Limitation on DISC income (``no loss'' rule)--(i) In general. Except as 
otherwise provided in this subparagraph, neither the gross receipts 
method nor the combined taxable income method may be applied to cause in 
any taxable year a loss to the related supplier, but either method may 
be applied to the extent it does not cause a loss. A loss to a related 
supplier would result if the taxable income of the DISC would exceed the 
combined taxable income of the related supplier and the DISC. If, 
however, there is no combined taxable income of the DISC and the related 
supplier (because, for example, a combined loss is incurred), a transfer 
price (or commission) will not be deemed to cause a loss to the related 
supplier if it allows the DISC to recover an amount not in excess of its 
costs (if any).
    (ii) Special rule for applying ``4 percent'' gross receipts method 
to sales. A

[[Page 843]]

transfer price or commission, determined under the ``4 percent'' gross 
receipts method (determined without regard to subdivision (i) of this 
subparagraph), for a sale of export property referred to in paragraph 
(b)(1) of this section, will not be considered to cause a loss for the 
related supplier if for the DISC's taxable year, the ratio that (a) the 
taxable income of the DISC derived from such sale by using such price or 
commission bears to (b) the DISC's gross receipts from such sale is not 
greater than the ratio that (c) all of the taxable income of the related 
supplier and the DISC from all sales of the same product or product line 
(domestic and foreign) to third parties whether or not related parties 
bears to (d) the total gross receipts of the related supplier and the 
DISC from such sales. For purposes of the preceding sentence, sales 
between the DISC and its related suppliers shall not be taken into 
account under (c) or (d) of this subdivision. For example, assume that 
for a taxable year of a DISC the total costs of the related supplier and 
the DISC with respect to all sales ($150 for domestic and $44 for 
foreign) of a product line are $194 and the total gross receipts of the 
related supplier and the DISC with respect to such sales are $200 so 
that the total taxable income of the related supplier and the DISC with 
respect to such sales is $6. The parties would thus be entitled to 
compute a transfer price determined under the gross receipts method on 
any given sale of product A of such product line by the related supplier 
to the DISC which would allocate to the DISC taxable income equal to not 
more than 3 percent (i.e., $6/$200) of its gross receipts derived from 
its resale of such product. If the DISC were to resell an item of 
product A for $10, the transfer price paid by the DISC to the related 
supplier determined under the gross receipts method could be as low as 
$9.70.
    (iii) Grouping transactions. For purposes of subdivision (i) of this 
subparagraph, the basis for grouping transactions chosen by the taxpayer 
under paragraph (c)(7) of this section for the taxable year shall be 
applied. For purposes of making the computations of subdivision (ii) (c) 
and (d) of this subparagraph, however, the taxpayer may choose any basis 
for grouping transactions permissible under paragraph (c)(7) of this 
section, even though it may not be the same basis as that already chosen 
under paragraph (c)(7) of this section for computing transfer prices or 
commissions to a DISC. If, for example, the taxpayer has chosen to group 
transactions on a product basis for computing transfer prices or 
commissions to a DISC for a taxable year, the taxpayer may still group 
transactions on a product line basis for purposes of computing taxable 
income and total gross receipts under subdivision (ii) (c) and (d) of 
this subparagraph. For a further example, if the taxpayer computes 
taxable income for one group of transactions under the gross receipts 
method and computes taxable income for a second group of transactions 
under the combined taxable income method, the taxpayer may aggregate 
these transactions for purposes of computing taxable income and total 
gross receipts under subdivision (ii) (c) and (d) of this subparagraph.
    (2) Relationship to section 482. In applying the rules under section 
994, it may be necessary to first take into account the price of a 
transfer (or other transaction) between the DISC (or related supplier) 
and a related party which is subject to the arm's length standard of 
section 482. Thus, for example, where a related supplier sells export 
property to a DISC which the related supplier purchased from related 
parties, the costs taken into account in computing the combined taxable 
income of the DISC and the related supplier are determined after any 
necessary adjustment under section 482 of the price paid by the related 
supplier to the related parties. In applying section 482 to a transfer 
by a DISC, however, the DISC and its related supplier are treated as if 
they were a single entity carrying on all the functions performed by the 
DISC and the related supplier with respect to the transaction and the 
DISC shall be allowed to receive under the section 482 standard the 
amount the related supplier would have received had there been no DISC.
    (3) Initial payment of transfer price or commission. (i) The amount 
of a transfer price (or reasonable estimate thereof) actually charged by 
a related supplier

[[Page 844]]

to a DISC, or a sales commission (or reasonable estimate thereof) 
actually charged by a DISC to a related supplier, in a transaction to 
which section 994 applies must be paid no later than 60 days following 
the close of the taxable year of the DISC during which the transaction 
occurred.
    (ii) Payment must be in the form of money, property (including 
accounts receivable from sales by or through the DISC), a written 
obligation which qualifies as debt under the safe harbor rule of Sec. 
1.992-1(d)(2)(ii), or an accounting entry offsetting the account 
receivable against an existing debt owed by the person in whose favor 
the account receivable was established to the person with whom it 
engaged in the transaction. The form of the payment to a DISC need not 
be a qualified export asset under Sec. 1.993-2. However, for the 
requirement that the adjusted basis of the qualified export assets of 
the DISC at the close of its taxable year must equal or exceed 95 
percent of the sum of the adjusted bases of all assets of the DISC at 
the close of its taxable year, see section 992(a)(1)(B).
    (iii) If the district director can demonstrate, based upon the data 
available as of the 60th day after the close of such taxable year, that 
the amount actually paid did not represent a reasonable estimate of the 
transfer price or commission (as the case may be) to be determined under 
section 994 and this section, an indebtedness will be deemed to arise, 
from the person required to make the payment in favor of the person to 
whom the payment is required to be made, in an amount equal to the 
difference between the amount of the transfer price or commission 
determined under section 994 and this section and the amount (if any) 
actually paid and received. Such indebtedness will be deemed to arise as 
of the date the transaction occurred which gave rise to the 
indebtedness, except that, if such transaction occurred in a taxable 
year of the DISC ending on or before August 15, 1975, at the taxpayer's 
option, the indebtedness will be deemed to arise as of the date by which 
payment was required under subdivision (i) of this paragraph (e)(3). 
Such indebtedness owed to a DISC shall be treated as an asset but shall 
not be treated as a trade receivable or other qualified export asset 
(see Sec. 1.993-2(d)(3)) as of the end of the taxable year of the DISC 
in which the indebtedness is deemed to arise.
    (iv)(a) Except with respect to incomplete transactions to which 
paragraph (c)(5)(i)(b) of this section applies, if the amount actually 
paid results in the DISC realizing at least 50 percent of the DISC's 
taxable income from the transaction as reported in its tax return for 
the taxable year the transaction is completed, then the amount actually 
paid shall be deemed to be a reasonable estimate of such transfer price 
or commission.
    (b) With respect to incomplete transactions to which paragraph 
(c)(5)(i)(b) of this section applies and which were initiated during a 
taxable year ending after August 15, 1975, the amount actually paid 
shall be deemed to be a reasonable estimate of such transfer price if 
any one of the following three tests is met:
    (1) The amount actually paid by the DISC to the related supplier in 
respect of the property does not exceed the related supplier's cost of 
goods sold (see paragraph (c)(6)(ii) of this section) with respect to 
the property.
    (2) If the transaction is completed by the date on which the DISC's 
return is required to be filed for the year in which the transaction was 
initiated, the amount actually paid by the DISC to the related supplier 
in respect of the property results in the DISC realizing at least 50 
percent of the DISC's taxable income from the transaction when 
completed.
    (3) The percentage that (i) an amount equal to (a) the amount 
actually paid by the DISC to the related supplier in respect of the 
property minus (b) the related supplier's cost of goods sold with 
respect to the property, bears to (ii) the related supplier's cost of 
goods sold in respect of the property, is not greater than 50 percent of 
the percentage that (iii) the combined taxable income for completed 
transactions of the same group as the property during the DISC's taxable 
year in which the incomplete transaction was initiated, bears to (iv) 
the cost of goods sold of the related supplier and DISC with respect to 
such transactions.

[[Page 845]]

    (c) For purposes of this subdivision (iv), whether the transfer 
price or commission actually paid is deemed a reasonable estimate may be 
determined on the basis for grouping transactions chosen by the taxpayer 
under paragraph (c)(5) and (7) of this section.
    (v) An indebtedness arising under subdivision (iii) of this 
subparagraph shall bear interest at an arm's length rate, computed in 
the manner provided by Sec. 1.482-2(a)(2) from the 61st day after the 
close of the DISC's taxable year in which the transaction occurred which 
gave rise to the indebtedness to the date of payment. The interest so 
computed shall be accrued and included in the taxable income of the 
person to whom the indebtedness is owed for each taxable year during 
which the indebtedness is unpaid.
    (4) Subsequent determination of transfer price or commission. The 
DISC and its related supplier would ordinarily determine under section 
994 and this section the transfer price payable by the DISC (or the 
commission payable to the DISC) for a transaction before the DISC files 
its return for the taxable year of the transaction. After the DISC has 
filed its return, a redetermination of the transfer price (or 
commission) may only be made if permitted by the Code and the 
regulations thereunder. Such a redetermination would include a 
redetermination by reason of an adjustment under section 482 and the 
regulations thereunder or section 861 and Sec. 1.861-8 which affects 
the amounts which entered into the determination of the transfer price 
or commission.
    (5) Procedure for adjustments to transfer price or commission--
(i)(a) If the transfer price (or commission) for a transaction 
determined under section 994 is different from the price (or commission) 
actually charged, the person who received too small a transfer price (or 
commission) or paid too large a transfer price (or commission) shall 
establish (or be deemed to have established), at the date of the 
determination or redetermination under subparagraph (4) of this 
paragraph of the transfer price (or commission) under section 994, an 
account receivable due the DISC from the person with whom it engaged in 
the transaction equal to the difference in amount between the transfer 
price (or commission) so determined and the transfer price (or 
commission) previously paid and received. If the account receivable is 
paid within 90 days after the date it is established (or deemed 
established), then as of the end of the taxable year of the DISC in 
which the transaction occurred which gave rise to the indebtedness, the 
account receivable shall be treated as an asset and, under Sec. 1.993-
2(d)(3) as a trade receivable, and thus as a qualified export asset.
    (b) If, for example, during 1972, a DISC which uses the calendar 
year as its taxable year sold a product which it purchased that year 
from its related supplier and paid a price of $10,000 which price is a 
reasonable estimate under subparagraph (3)(iii) of this paragraph but is 
later determined under section 994 to be $8,000 immediately before the 
DISC filed its return for 1972, the DISC must be paid $2,000 (i.e., 
$10,000-$8,000) by its related supplier or establish an account 
receivable from its related supplier of $2,000. The account receivable 
may be paid without tax consequences, provided that such account 
receivable is paid within 90 days after the date it is established (or 
deemed established). Such account receivable paid within such 90 days 
will be considered to relate to the taxable year in which the 
transaction occurred which gave rise thereto rather than the taxable 
year during which it is established or paid.
    (ii) Payment must be in a form specified in subparagraph (3) of this 
paragraph.
    (iii) If an account receivable of a DISC described in subdivision 
(i) of this paragraph (e)(5) is not paid within 90 days of the date it 
is established (or deemed established), then, as of the end of the 
taxable year of the DISC in which the transaction occurred which gives 
rise to the indebtedness, the account receivable shall be treated as an 
asset except that, if the account receivable is established (or deemed 
established) in a taxable year of the DISC ending on or before August 
15, 1975, at the taxpayer's option, the account receivable shall be 
treated as an asset as of the end of such taxable year. However, under 
Sec. 1.993-2(d)(3), an account receivable referred to in the preceding

[[Page 846]]

sentence shall not be treated as a trade receivable or other qualified 
export asset.
    (iv) An account receivable established in accordance with 
subdivision (i) of this subparagraph shall bear interest at an arm's 
length rate, computed in the manner provided by Sec. 1.482-2(a)(2) from 
the day after the date the account receivable is deemed established to 
the date of payment. The interest so computed shall be accrued and 
included in the taxpayer's taxable income for each taxable year during 
which the account receivable is outstanding.
    (v)(a) In lieu of establishing an account receivable in accordance 
with subdivision (i) of this subparagraph for all or part of an amount 
due a related supplier, the related supplier and DISC are permitted to 
treat all or part of any distribution which was made by the DISC out of 
its previously taxed income with respect to the year to which the 
determination or redetermination relates as an additional payment of 
transfer price or repayment of commission (and not as a distribution) 
made as of the date the distribution was made. Any additional amount 
arising on the determination or redetermination due the related supplier 
after this treatment shall be represented by an account receivable 
established under subdivision (i) of this subparagraph. To the extent 
that a distribution is so treated under this subdivision (v), it shall 
cease to qualify as distribution for any Federal income tax purpose, and 
the DISC's account for previously taxed income shall be adjusted 
accordingly. If all or part of any distribution made to a shareholder 
other than the related supplier is recharacterized under this 
subdivision (v), the related supplier shall establish an account 
receivable from that shareholder for the amount so recharacterized. Such 
account receivable shall be paid in the time and manner set forth in 
this paragraph (e)(5). In order to obtain the relief provided by this 
subdivision (v), the conditions and procedures prescribed by Revenue 
Procedure 84-3 must be met. The provisions of this paragraph (e)(5)(v) 
shall apply to all open taxable years ending after December 31, 1971.
    (b) If, for example, during 1982, a DISC commission from a related 
supplier with respect to a transaction completed in 1980 was 
redetermined to be $1,000 less than the commission actually charged by, 
and paid to, the DISC, the amount of any distribution previously made by 
the DISC from its 1980 previously taxed income to the related supplies 
as a shareholder may, to the extent of $1,000, be treated not as a 
distribution but as a repayment of the commission.
    (vi) The procedure for adjustments to transfer price provided by 
this subparagraph does not apply to incomplete transactions described in 
paragraph (c)(5)(i)(b) of this section. Such procedure will, however, be 
applied to any such transaction with respect to the taxable year in 
which the transaction is completed.
    (6) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. (i) During 1975, a DISC which uses the calendar year as 
its taxable year purchased a product from its related supplier and made 
an initial payment of $8,500. If $8,500 were determined to be the 
transfer price under section 994, the DISC's taxable income from the 
transaction would be $1,000. Immediately before the DISC filed its 
return for 1975, under section 994 it is determined that the transfer 
price is $8,000 and the DISC's taxable income is $1,500. Thus, the 
requirement of a reasonable estimate under subparagraph (3) of this 
paragraph was met because the amount ($8,500) actually paid resulted in 
the DISC realizing taxable income of $1,000 which is not less than 50 
percent of the DISC's taxable income ($1,500) from the transaction as 
determined under section 994.
    (ii) Pursuant to subparagraph (5) of this paragraph, an account 
receivable due the DISC for $500, i.e., $8,500-$8,000, is established on 
September 15, 1976, the date the DISC files its return for 1975, and is 
paid on December 1, 1976. The account receivable for $500 will be 
considered to relate to the taxable year (1975) in which the transaction 
occurred which gave rise thereto and will be a qualified export asset 
under Sec. 1.993-2(d)(3) for the last day of such year.
    Example 2. Assume the same facts as in example 1 except that the 
account receivable for $500 is paid on January 1, 1977. The account 
receivable for $500 will still be considered to relate to the taxable 
year (1975) in which the transaction occurred which gave rise thereto. 
However, such account receivable will be treated as an asset which is 
not

[[Page 847]]

a qualified export asset under Sec. 1.993-2(d)(3) for the last day of 
such year.

    (f) Export promotion expenses--(1) Purpose of expense. (i) In order 
for an expense or cost of a type described in subparagraph (2) of this 
paragraph to be an export promotion expense, the expense or cost must be 
incurred or treated as incurred by the DISC (under subparagraph (7) of 
this paragraph) to advance the sale, lease, or other distribution of 
export property for use, consumption, or distribution outside the United 
States. Costs of services in performing installation (but not assembly) 
on the site and for meeting warranty commitments if such services are 
related and subsidiary (within the meaning of Sec. 1.993-1(d)) to any 
qualified sale, lease, or other distribution of export property by the 
DISC (or with respect to which the DISC received a commission) will be 
considered to advance the sale, lease, or other distribution of export 
property. General and administrative expenses attributable to billing 
customers, other clerical functions of the DISC, or generally operating 
the DISC, will also be considered to advance the sale, lease, or other 
distribution of export property.
    (ii) Where an expense or cost incurred or treated as incurred by the 
DISC qualifies only in part as an export promotion expense, such expense 
or cost must be allocated between the qualified portion and such other 
portion on a reasonable basis. See Sec. 1.994-2(b)(2) for the option of 
the related supplier not to claim expenses as export promotion expenses.
    (2) Types of expenses. The only expenses or costs which may be 
export promotion expenses are those expenses or costs meeting the test 
of subparagraph (1) of this paragraph which constitute--
    (i) Ordinary and necessary expenses of the DISC paid or incurred 
during the DISC's taxable year in carrying on any trade or business, 
allowable as deductions under section 162, such as expenses for market 
studies, advertising, salaries and wages (including contributions or 
compensations deductible under section 404) of sales, clerical, and 
other personnel, rentals on property, sales commissions, warehousing, 
and other selling expenses,
    (ii) A reasonable allowance under section 167 for exhaustion, wear 
and tear, or obsolescence of the property of the DISC,
    (iii) Costs of freight (subject to the limitations of subparagraph 
(4) of this paragraph),
    (iv) Costs of packaging for export (as defined in subparagraph (5) 
of this paragraph), or
    (v) Costs of designing and labeling packages exclusively for export 
markets (under subparagraph (6) of this paragraph).
    (3) Ineligible expenses. Items ineligible to be export promotion 
expenses include, for example, interest expenses, bad debt expenses, 
freight insurance, State and local income and franchise taxes, the cost 
of manufacture or assembly operations, and items of cost of goods sold 
(except as otherwise provided in this paragraph in the case of certain 
freight, packaging, and designing and labeling expenses). Income or 
similar taxes eligible for a foreign tax credit under sections 901 and 
903 are also not eligible to be export promotion expenses.
    (4) Freight expenses--(i) In general. Export promotion expenses 
include one-half of the freight expense (not including insurance) for 
shipping export property aboard a U.S.-flag carrier in those cases where 
law or regulation of the United States or of any State or political 
subdivision thereof or of any agency or instrumentality of any of these 
does not require that the export property be shipped aboard a U.S.-flag 
carrier. For purposes of this paragraph, the term ``freight expense'' 
includes charges paid for c.o.d. service, miscellaneous ground charges, 
such as charges incurred for services normally performed by U.S.-flag 
carriers, charges for services of loading aboard U.S.-flag carriers 
normally performed by such carriers, freight forwarders, or independent 
contractors engaged in loading property, and charges attributable to a 
freight consolidation function normally performed by freight forwarders. 
In order for one-half of freight expenses paid to the owner (or the 
agent of the owner) of a U.S.-flag carrier to be claimed as an export 
promotion expense, the DISC must obtain

[[Page 848]]

a written statement (such as, for example, a bill of lading) from the 
owner (or the agent) disclosing that the export property was shipped 
aboard the owner's U.S.-flag carrier or another U.S.-flag carrier, and 
the DISC must have no reasonable basis for disbelieving such statement 
of the owner (or the agent). For the requirement of a written statement 
from a freight forwarder, see subdivision (iv) of this subparagraph.
    (ii) U.S.-flag carrier defined. For purposes of this paragraph, the 
term ``U.S.-flag carrier'' is an airplane owned and operated by a U.S. 
person or persons (as defined in section 7701(a)(30)) or a ship 
documented under the laws of the United States. Shipment initiated by 
delivery to the U.S. Postal Service shall be considered shipment aboard 
a U.S.-flag carrier, but not if shipped to a place to which mail 
shipments from the United States are ordinarily accomplished by land 
transportation, such as to Canada or Mexico, unless airmail is 
specified.
    (iii) Shipment pursuant to law or regulation. Shipment pursuant to 
law or regulation includes instances where a U.S.-flag carrier must be 
used in order to obtain permission from the Government to make the 
export. If the law or regulation requires a fixed portion of the export 
property to be shipped aboard a U.S.-flag carrier, the freight expense 
on that portion of such export property that was so shipped in order to 
satisfy such requirement cannot qualify as an export promotion expense.
    (iv) Freight forwarders. A payment to a freight forwarder shall be 
considered freight expense within the meaning of this paragraph to the 
extent the forwarder utilizes a U.S.-flag carrier. For purposes of this 
paragraph, the term ``freight forwarder'' includes air freight 
consolidators and carriers owned and operated by U.S. persons utilizing 
U.S.- flag carriers such as non-vessel-owning common carriers. In order 
for one-half of freight expenses paid to a freight forwarder to be 
claimed as export promotion expenses, the DISC must obtain a written 
statement (such as, for example, a bill of lading) from the freight 
forwarder disclosing that the export property was shipped aboard a U.S.-
flag carrier, and the DISC must have no reasonable basis for 
disbelieving such statement of the freight forwarder.
    (v) Freight within the United States. A DISC may not claim as export 
promotion expense any amount that is attributable to carriage of export 
property between points within the United States. If, however, export 
property is carried from the United States to a foreign country on a 
through shipment pursuant to a single bill of lading or similar document 
aboard one or more U.S.-flag carriers, the freight expense of such 
carriage shall not be apportioned between the domestic and foreign 
portions of such carriage, even though a carrier may stop en route 
within the United States or the export property may be shifted from one 
carrier to another, and one-half of such freight expense may be claimed 
as an export promotion expense. Freight expense does not include the 
cost of transporting the export property to the depot of the U.S.-flag 
carrier or freight forwarder for shipment abroad. The expense of 
shipment of export property initiated by delivery to the U.S. Postal 
Service for ultimate delivery outside the United States shall be 
considered as attributable entirely to carriage of such property outside 
the United States.
    (5) Packaging for export. (i) Export promotion expenses include the 
direct and indirect cost of packaging export property (including the 
cost of the package) for export whether or not the packaging is the same 
as domestic packaging. Such packaging costs do not include costs of 
manufacturing (as defined in the regulations under section 993) and 
assembly. Thus, if a DISC buys and packages export property for resale, 
its costs of packaging the export property are export promotion 
expenses. If, however, the process of such packaging by the DISC is 
physically integrated with the process of manufacturing the export 
property by the related supplier, the costs of such packaging are not 
export promotion expenses.
    (ii) The cost of containers leased from a shipping company to which 
the DISC also pays freight for the property packaged is not a cost of 
packaging. However, in such circumstances, one-

[[Page 849]]

half of the rental charge may be allowable as a freight expense if 
permitted under subparagraph (4) of this paragraph.
    (6) Designing and labeling packages. Export promotion expenses 
include the direct and indirect costs of designing and labeling 
packages, including bottles, cans, jars, boxes, cartons, or containers, 
to the extent incurred for export markets. Thus, for example, to the 
extent incurred for supplying export markets, the cost of designing 
labels in a foreign language and the cost of printing such labels are 
export promotion expenses.
    (7) DISC must incur export promotion expenses--(i) In general. In 
order for an expense to be an export promotion expense it must be 
incurred or treated as incurred under this subparagraph by the DISC. For 
example, an expense is incurred by a DISC if the expense results from 
(a) the DISC incurring an obligation to pay compensation to its 
employees, (b) depreciation of property owned by the DISC and used by 
its employees, (c) the DISC incurring an obligation to pay for office 
supplies used by its employees, (d) the DISC incurring an obligation to 
pay space costs for use by its employees, or (e) the DISC incurring an 
obligation to pay other costs supporting efforts by its employees.
    (ii) Payments to independent contractors. A payment to an 
independent contractor, directly or indirectly, is treated as incurred 
by the DISC if the cost of performing the function performed by the 
independent contractor would be considered an export promotion expense 
described in subparagraphs (1) and (2) of this paragraph if performed by 
the DISC, and if, in a case where the services of the independent 
contractor were engaged by a party related to the DISC, such related 
party and such DISC agreed in writing before the contract was entered 
into that a specified portion or all of the contract was for the benefit 
of the DISC and that all of the expenses of the contract (eligible to be 
considered as export promotion expenses) with respect to such portion 
would be borne by the DISC.
    (iii) Expenses incurred by related parties. Reimbursements or other 
payments by a DISC to a related party are export promotion expenses only 
if the expenses of the related party for which reimbursement is made are 
for space in a building actually used by employees of the DISC or for 
export property owned by the DISC. Except as otherwise provided in the 
preceding sentence, expenses incurred by a foreign international sales 
corporation (FISC) or a real property holding company (as defined in 
section 993(e)(1) and (2), respectively) shall not be treated as export 
promotion expenses of its DISC.
    (iv) Selling commissions paid by a DISC. A commission paid by a DISC 
to a person other than a related person, with respect to a transaction 
which gives rise to qualified export receipts of the DISC, is an export 
promotion expense of the DISC. A commission paid by a DISC to a related 
person is not an export promotion expense.
    (v) Sales of promotional material. If a DISC sells promotional 
material to a buyer of export property from the DISC at a price which is 
greater than the costs of the DISC for such material, such costs are not 
export promotion expenses. If, however, the DISC sells promotional 
material at a price which is less than its costs for such material, the 
excess of such costs over such price is an export promotion expense. For 
rules relating to the status of promotional material as qualified export 
assets and export property, see Sec. Sec. 1.993-2 and 1.993-3, 
respectively.
    (vi) An expense may be incurred by the DISC under subdivisions (i) 
through (v) of this subparagraph even if the accounting for and payment 
of such expense is handled by a related party and the DISC reimburses 
the related party for such expenses.
    (8) Incomplete transactions. Expenses eligible to be treated as 
export promotion expenses which are attributable to the sale, lease, or 
other distribution of export property and which are incurred prior to 
the taxable year of sale, lease, or other distribution by the DISC are 
not treated as export promotion expenses until the taxable year of sale, 
lease, or other distribution or until the taxable year in which it is 
first determined that no transaction is reasonably expected to result 
from the expense incurred (whether or not a transaction subsequently 
results).

[[Page 850]]

Thus, for example, if a DISC incurs a packaging cost which is otherwise 
eligible to be treated as an export promotion expense, the DISC may not 
include such charge as an export promotion expense until the year in 
which the export property with respect to which the packaging cost was 
incurred is actually sold by the DISC. If no transaction is reasonably 
expected to result from the packaging cost, such cost should be 
allocated as an export promotion expense to the group of transactions to 
which such cost is most closely related.
    (g) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. J and K are calendar year taxpayers. J, a domestic 
manufacturing company, owns all the stock of K, a DISC for the taxable 
year. During 1972, J manufactures only 100 units of a product (which is 
eligible to be export property as defined in section 993(c)). J enters 
into a written agreement with K whereby K is granted a sales franchise 
with respect to exporting such property and K will receive commissions 
with respect to such exports equal to the maximum amount permitted to be 
received under the intercompany pricing rules of section 994. 
Thereafter, the 100 units are sold for $1,000. J's cost of goods sold 
attributable to the 100 units is $650. J's direct selling expenses so 
attributable are $100. Although J has other deductible expenses, for 
purposes of this example assume that J has no other deductible expenses. 
K pays $230 to independent contractors which qualify as export promotion 
expenses under paragraph (f)(7)(ii) of this section. K does not perform 
functions substantial enough to entitle it to an allocation of income 
which meets the arm's length standard of section 482. The income which K 
may earn under section 994 under the franchise is $20, computed as 
follows:

(1) Combined taxable income:
  (a) K's sales price.................................  .......   $1,000
  (b) Less deductions:
    J's cost of goods sold............................     $650
    J's direct selling expenses.......................      100
    K's export promotion expenses.....................      230
                                                       ---------
        Total deductions..............................  .......      980
                                                                --------
  (c) Combined taxable income.........................  .......       20
                                                                ========
(2) K's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income....................       10
  (b) Plus: 10 percent of K's export promotion expenses (10% of       23
   $230).......................................................
                                                       ----------
  (c) K's profit...............................................       33
                                                       ==========
(3) K's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of K's sales price (4% of $1,000)..............       40
  (b) Plus: 10 percent of K's export promotion expenses (10% of       23
   $230).......................................................
                                                       ----------
  (c) K's profit...............................................       63
                                                                ========
 

    Since combined taxable income ($20) is lower than both K's profit 
under the combined taxable income method ($33) and under the gross 
receipts method ($63), the maximum income K may earn is $20. 
Accordingly, the commissions K may receive from J are $250, i.e., K's 
expenses ($230) plus K's profit ($20).
    Example 2. M and N are calendar year taxpayers. M, a domestic 
manufacturing company, owns all the stock of N, a DISC for the taxable 
year. During 1972, M produces and sells a particular product line of 
export property to N for $75, a price which can be justified as 
satisfying the standard of arm's length price of section 482. N performs 
substantial functions with respect to the transaction and resells the 
export property for $100. M's cost of goods sold attributable to the 
export property is $60. M's direct selling expenses so attributable 
(relating to advertising of the product line in foreign markets) are 
$12. Although M has other deductible expenses, for purposes of this 
example, assume that M has no other deductible expenses. N's expenses 
attributable to resale of the export property are $22 of which $20 are 
export promotion expenses. The maximum profit which N may earn with 
respect to the product line is $6, computed as follows:

(1) Combined taxable income:
  (a) N's sales price.................................  .......     $100
  (b) Less deductions:
    M's cost of goods sold............................      $60
    M's direct selling expenses.......................       12
    N's expenses......................................       22
                                                                --------
      Total deductions................................  .......       94
                                                                --------
  (c) Combined taxable income.........................  .......        6
                                                                ========
(2) N's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income....................        3
  (b) Plus: 10 percent of N's export promotion expenses (10% of        2
   $20)........................................................
                                                       ----------
  (c) N's profit...............................................        5
                                                       ==========
(3) N's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of N's sales price (4% of $100)................        4
  (b) Plus: 10 percent of N's export promotion expenses (10% of        2
   $20)........................................................
                                                       ----------
  (c) N's profit...............................................        6
                                                       ==========
(4) N's profit under section 482 method:
  (a) N's sales price..........................................      100
  (b) Less deductions:
    N's cost of goods sold (price paid by N to M).....       75
    N's expenses......................................       22
                                                                --------

[[Page 851]]

 
      Total deductions................................  .......       97
                                                                --------
  (c) N's profit......................................  .......        3
                                                                ========
 

    Since the gross receipts method results in greater profit to N ($6) 
than does the combined taxable income method ($5) or section 482 method 
($3), and does not exceed combined taxable income ($6), N may earn a 
maximum profit of $6. Accordingly, the transfer price from M to N may be 
readjusted as long as the transfer price is not readjusted below $72, 
computed as follows:

(5) Transfer price from M to N:
  (a) N's sales price...................................  ......    $100
  (b) Less:
    N's expenses........................................     $22
    N's profit..........................................       6
                                                         --------
      Total subtractions................................  ......      28
                                                                 -------
  (c) Transfer price....................................  ......      72
 

    Example 3. Q and R are calendar year taxpayers. Q, a domestic 
manufacturing company, owns all the stock of R, a DISC for the taxable 
year. During 1972, Q produces and sells a product line of export 
property to R for $170, a price which can be justified as satisfying the 
standards of arm's length price of section 482, and R resells the export 
property for $200. Q's cost of goods sold attributable to the export 
property is $115 so that the combined gross income from the sale of the 
export property is $85 (i.e., $200 minus $115). Q's expenses incurred in 
connection with the property sold are $35. Q's deductible overhead and 
other supportive expenses allocable to all gross income are $6. 
Apportionment of these supportive expenses on the basis of gross income 
does not result in a material distortion of income and is a reasonable 
method of apportionment. Q's gross income from sources other than the 
transaction is $170 making total gross income of Q and R (excluding the 
transfer price paid by R) $255 (i.e., $85 plus $170). R's expenses 
attributable to resale of the export property are $20, all of which are 
export promotion expenses. The maximum profit which R may earn with 
respect to the product line is $16, computed as follows:

(1) Combined taxable income:
  (a) R's sales price...................................  ......    $200
  (b) Less deductions:
    (i) Q's cost of goods sold..........................     115
    (ii) Q's expenses incurred in connection with the         35
     property sold......................................
    (iii) Apportionment of Q's supportive
     expenses:
      Q's supportive expenses.................        $6
      Combined gross income from sale of              85
       export property........................
      Total gross income of Q and R...........       255
      Apportionment...........................  (6 x 85)/      2
                                                     255
    (iv) R's expenses.........................  ........      20
                                                         --------
      Total deductions........................  ........  ......     172
                                                                 -------
  (c) Combined taxable income...................................      28
                                               ===========
(2) R's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income.....................      14
  (b) Plus: 10 percent of R's export promotion expenses (10% of        2
   $20).........................................................
                                               -----------
  (c) R's profit................................................      16
                                               ===========
(3) R's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of R's sales price (4% of $200).................       8
  (b) Plus: 10 percent of R's export promotion expenses (10% of        2
   $20).........................................................
                                               -----------
  (c) R's profit................................................      10
                                               ===========
(4) R's profit under section 482 method:
  (a) R's sales price...........................................     200
  (b) Less deductions:
    R's cost of goods sold (price paid by R to Q).......     170
    R's expenses........................................      20
                                               ----------
      Total deductions..................................  ......     190
                                                         ---------
  (c) R's profit........................................  ......      10
                                                                 =======
 

    Since the combined taxable income method results in greater profit 
to R ($16) than does the gross receipts method ($10) or section 482 
method ($10), and does not exceed combined taxable income ($28), R may 
earn a maximum profit of $16. Accordingly, the transfer price from Q to 
R may be readjusted as long as the transfer price is not readjusted 
below $164 computed as follows:

(5) Transfer price from Q to R:
  (a) R's sales price...................................  ......    $200
  (b) Less:
    R's expenses........................................     $20
    R's profit..........................................      16
                                                         --------
      Total.............................................  ......      36
                                                                 -------
  (c) Transfer price....................................  ......     164
                                                                 =======
 

    Example 4. S and T are calendar year taxpayers. S, a domestic 
manufacturing company, owns all the stock of T, a DISC for the taxable 
year. During 1972, S produces and sells 100 units of a particular 
product to T under a written agreement which provides that the transfer 
price between S and T shall be that price which allocates to T the 
maximum permitted to be received under the intercompany pricing rules of 
section 994. Thereafter, the 100 units are sold by T for $950. S's cost 
of goods sold attributable to the 100 units is $650. S's other 
deductible expenses so attributable are $300. Although S has other 
deductible expenses, for purposes of this example, assume that S has no 
deductible expenses not definitely allocable to any item of gross 
income. T's expenses attributable to the resale of the 100 units are 
$50. S chooses not to apply the section 482 method. T may not earn any 
income under

[[Page 852]]

the gross receipts or combined taxable income method with respect to 
resale of the 100 units because combined taxable income is a negative 
figure, computed as follows:

(1) Combined taxable income:
  (a) T's sales price...................................  ......    $950
  (b) Less deductions:
    S's cost of goods sold..............................    $650
    S's expenses........................................     300
    T's expenses........................................      50
                                                         --------
      Total deductions..................................  ......   1,000
                                                                 -------
  (c) Combined taxable income (loss)....................  ......   ($50)
                                                                 =======
 

    Under paragraph (e)(1)(i) of this section, T is permitted to recover 
its expenses attributable to the 100 units ($50) even though such 
recovery results in a loss or increased loss to the related supplier. 
Accordingly, the transfer price from S to T may be readjusted as long as 
the transfer price is not readjusted below $900, computed as follows:

(2) Transfer price from S to T:
  (a) T's sales price...........................................    $950
  (b) Less: T's expenses........................................      50
                                                                 -------
  (c) Transfer price............................................     900
                                                                 =======
 

    Example 5. Assume the same facts as in example 4 except that S 
chooses to apply the section 482 method and that under arm's length 
dealings T would have derived $10 of income. Accordingly, the transfer 
price from S to T may be set at an amount not less than $890, computed 
as follows:

(1) Transfer price from S to T:
  (a) T's sales price...................................  ......    $950
  (b) Less:
    T's expenses........................................     $50
    T's profit..........................................      10
                                                         --------
      Total deductions..................................  ......      60
                                                                 -------
  (c) Transfer price....................................  ......     890
                                                                 =======
 

    Example 6. X and Y are calendar year taxpayers. X, a domestic 
manufacturing company, owns all the stock of Y, a DISC for the taxable 
year. During March 1972, X manufactures a particular product of export 
property which it leases on April 1, 1972, to Y for a term of 1 year at 
a monthly rental of $1,000, a rent which satisfies the standard of arm's 
length rental under section 482. Y subleases the product on April 1, 
1972, for a term of 1 year at a monthly rental of $1,200. X's cost for 
the product leased is $40,000. X's other deductible expenses 
attributable to the product are $900, all of which are incurred in 1972. 
Although X has other deductible expenses, for purposes of this example, 
assume that X has no other deductible expenses. Y's expenses 
attributable to sublease of the export property are $450, all of which 
are incurred in 1972 and are export promotion expenses. X depreciates 
the property on a straight line basis without the use of an averaging 
convention, assuming a useful life of 8 years and no salvage value. The 
profit which Y may earn with respect to the transaction is $2,895 for 
1972 and $1,175 for 1973, computed as follows:

                          computation for 1972
(1) Combined taxable income:
  (a) Y's sublease rental receipts for year ($1,200   ........   $10,800
   x 9 months)......................................
  (b) Less deductions:
    X's depreciation ($40,000 x 1/8 x 9/12).........    $3,750
    X's other expenses..............................       900
    Y's expenses....................................       450
                                                     ----------
      Total deductions..............................  ........     5,100
                                                               ---------
  (c) Combined taxable income.......................  ........     5,700
                                                               =========
(2) Y's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income...................     2,850
  (b) Plus: 10 percent of Y's export promotion expenses (10%          45
   of $450)...................................................
                                                     -----------
  (c) Y's profit..............................................     2,895
                                                     ===========
(3) Y's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of Y's sublease rental receipts for year (4%         432
   of $10,800)................................................
  (b) Plus: 10 percent of Y's export promotion expenses (10%          45
   of $450)...................................................
                                                     -----------
  (c) Y's profit..............................................       477
                                                     ===========
(4) Y's profit under section 482 method:
  (a) Y's sublease rental receipts for year...................   $10,800
  (b) Less deductions:
    Y's lease rental payments for year..............    $9,000
    Y's expenses....................................       450
                                                     ----------
  Total deductions..................................  ........     9,450
                                                               ---------
  (c) Y's profit....................................  ........     1,350
 

    Since the combined taxable income method results in greater profit 
to Y ($2,895) than does the gross receipts method ($477) or section 482 
method ($1,350), Y may earn a profit of $2,895 for 1972. Accordingly, 
the monthly rental payable by Y to X for 1972 may be readjusted as long 
as the monthly rental payable is not readjusted below $828.33, computed 
as follows:

(5) Monthly rental payable by Y to X for 1972:
  (a) Y's sublease rental receipts for year.................  $10,800.00
  (b) Less:
    Y's expenses..................................    450.00
    Y's profit....................................  2,895.00
                                                   ----------
      Total.......................................  ........    3,345.00
                                                             -----------
  (c) Rental payable for 1972...............................    7,455.00
                                                   -----------
  (d) Rental payable each month ($7,455 / 9 months).........      828.33
                                                   ===========
                          computation for 1973
 
(1) Combined taxable income:
  (a) Y's sublease rental receipts for year ($1,200 x 3           $3,600
   months)..................................................
  (b) Less: X's depreciation ($40,000 x 1/8 x 3/12).........       1,250
                                                   -----------

[[Page 853]]

 
  (c) Combined taxable income...............................       2,350
                                                   ===========
(2) Y's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income.................      $1,175
                                                   -----------
  (b) Y's profit............................................       1,175
                                                   ===========
(3) Y's profit under gross receipts method (before
 application of loss limitation):
  (a) 4 percent of Y's sublease rental receipts for year (4%         144
   of $3,600)...............................................
                                                   ===========
  (b) Y's profit............................................         144
                                                   ===========
(4) Y's profit under section 482 method:
  (a) Y's sublease rental receipts for year.................       3,600
  (b) Less: Y's lease rental payments for year..............       3,000
                                                   -----------
  (c) Y's profit............................................         600
 

    Since the combined taxable income method results in greater profit 
to Y ($1,175) than does the gross receipts method ($144) or section 482 
method ($600), Y may earn a profit of $1,175 for 1973. Accordingly, the 
monthly rental payable by Y to X for 1973 may be readjusted as long as 
the monthly rental payable is not readjusted below $808.33, computed as 
follows:

(5) Monthly rental payable by Y to X for 1973:
  (a) Y's sublease rental receipts for year.................   $3,600.00
  (b) Less: Y's profit......................................    1,175.00
                                                             -----------
  (c) Rental payable for 1973...............................    2,425.00
                                                             ===========
  (d) Rental payable for each month ($2,425 / 3 months).....      808.33
                                                             ===========
 


(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7364, 40 FR 29827, July 16, 1975, as amended by T.D. 7435, 41 FR 
43142, Sept. 30, 1976; T.D. 7854, 47 FR 51741, Nov. 17, 1982; T.D. 7984, 
49 FR 40018, Oct. 12, 1984]



Sec. 1.994-2  Marginal costing rules.

    (a) In general. This section prescribes the marginal costing rules 
authorized by section 994(b)(2). If under paragraph (c)(1) of this 
section a DISC is treated for its taxable year as seeking to establish 
or maintain a foreign market for sales of an item, product, or product 
line of export property (as defined in Sec. 1.993-3) from which 
qualified export receipts are derived, the marginal costing rules 
prescribed in paragraph (b) of this section may be applied to allocate 
costs between gross receipts derived from such sales and other gross 
receipts for purposes of computing, under the ``50-50'' combined taxable 
income method of Sec. 1.994-1(c)(3), the combined taxable income of the 
DISC and related supplier derived from such sales. Such marginal costing 
rules may be applied whether or not the related supplier manufactures, 
produces, grows, or extracts (within the meaning of Sec. 1.993-3(c)) 
the export property sold. Such marginal costing rules do not apply to 
sales of export property which in the hands of a purchaser related under 
section 954(d)(3) to the seller give rise to foreign base company sales 
income as described in section 954(d) unless, for the purchaser's year 
in which it resells the export property, section 954(b)(3)(A) is 
applicable or such income is under the exceptions in section 954(b)(4). 
Such marginal costing rules do not apply to leases of property or the 
performance of any services whether or not related and subsidiary 
services (as defined in Sec. 1.994-1(b)(3).
    (b) Marginal costing rules for allocations of costs--(1) In general. 
Marginal costing is a method under which only marginal or variable costs 
of producing and selling a particular item, product, or product line are 
taken into account for purposes of section 994. Where this section is 
applicable, costs attributable to deriving qualified export receipts for 
the DISC's taxable year from sales of an item, product, or product line 
may be determined in any manner the related supplier (as defined in 
Sec. 1.994-1(a)(3)(ii)) chooses, provided that the requirements of both 
subparagraphs (2) and (3) of this paragraph are met.
    (2) Variable costs taken into account. There are taken into account 
in computing the combined taxable income of the DISC and its related 
supplier from sales of an item, product, or product line the following 
costs:
    (i) Direct production costs (as defined in Sec. 1.471-11(b)(2)(i)) 
and
    (ii) Costs which are export promotion expenses, but only if they are 
claimed as export promotion expenses in determining taxable income 
derived by the DISC under the combined taxable income method of Sec. 
1.994-1(c)(3).


At the taxpayer's option, all, a part, or none of the costs which 
qualify as export promotion expenses may be so claimed as export 
promotion expenses.
    (3) Overall profit percentage limitation. As a result of such 
determination of

[[Page 854]]

costs attributable to such qualified export receipts for the DISC's 
taxable year, the combined taxable income of the DISC and its related 
supplier from sales of such item, product, or product line for the 
DISC's taxable year does not exceed gross receipts (determined under 
Sec. 1.993-6) of the DISC derived from such sales, multiplied by the 
overall profit percentage (determined under paragraph (c)(2) of this 
section).
    (c) Definitions--(1) Establishing or maintaining a foreign market. A 
DISC shall be treated for its taxable year as seeking to establish or 
maintain a foreign market with respect to sales of an item, product, or 
product line of export property from which qualified export receipts are 
derived if the combined taxable income computed under paragraph (b) of 
this section is greater than the combined taxable income computed under 
Sec. 1.994-1(c)(6).
    (2) Overall profit percentage. (i) For purposes of this section, the 
overall profit percentage for a taxable year of the DISC for a product 
or product line is the percentage which--
    (a) The combined taxable income of the DISC and its related supplier 
plus all other taxable income of its related supplier from all sales 
(domestic and foreign) of such product or product line during the DISC's 
taxable year, computed under the full costing method, is of
    (b) The total gross receipts (determined under Sec. 1.993-6) from 
all such sales.
    (ii) At the annual option of the related supplier, the overall 
profit percentage for the DISC's taxable year for all products and 
product lines may be determined by aggregating the amounts described in 
subdivision (i) (a) and (b) of this subparagraph of the DISC, and all 
domestic members of the controlled group (as defined in Sec. 1.993-
1(k)) of which the DISC is a member, for the DISC's taxable year and for 
taxable years of such members ending with or within the DISC's taxable 
year.
    (iii) For purposes of determining the amounts in subdivisions (i) 
(b) and (ii) of this subparagraph, a sale of property between a DISC and 
its related supplier or between domestic members of the controlled group 
shall be taken into account only during the DISC's taxable year (or 
taxable year of the member ending within the DISC's taxable year) during 
which the property is ultimately sold to a person which is neither the 
DISC nor such a domestic member.
    (3) Grouping of transactions. (i) In general, for purposes of this 
section, an item, product, or product line is the item or group 
consisting of the product or product line pursuant to Sec. 1.994-
1(c)(7) used by the taxpayer for purposes of applying the intercompany 
pricing rules of Sec. 1.994-1.
    (ii) However, for purposes of determining the overall profit 
percentage under subparagraph (2) of this paragraph, any product or 
product line grouping permissible under Sec. 1.994-1(c)(7) may be used 
at the annual choice of the taxpayer, even though it may not be the same 
item or grouping referred to in subdivision (i) of this subparagraph, as 
long as the grouping chosen for determining the overall profit 
percentage is at least as broad as the grouping referred to in such 
subdivision (i).
    (4) Full costing method. For purposes of this section, the term 
``full costing method'' is the method for determining combined taxable 
income set forth in Sec. 1.994-1(c)(6).
    (d) Application of limitation on DISC income (``no loss'' rule). If 
the marginal costing rules of this section are applied, the combined 
taxable income method of Sec. 1.994-1(c)(3) may not be applied to cause 
in any taxable year a loss to the related supplier, but such method may 
be applied to the extent it does not cause a loss. For purposes of the 
preceding sentence, a loss to a related supplier would result if the 
taxable income of the DISC would exceed the combined taxable income of 
the related supplier and the DISC determined in accordance with 
paragraph (b) of this section. If, however, there is no combined taxable 
income (so determined), see the last sentence of Sec. 1.994-1(e)(1)(i).
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X and Y are calendar year taxpayers. X, a domestic 
manufacturing company, owns all the stock of Y, a DISC for the taxable 
year. During 1973, X manufactures a

[[Page 855]]

product line which is eligible to be export property (as defined in 
Sec. 1.993-3). X enters into a written agreement with Y whereby Y is 
granted a sales franchise with respect to exporting such product line 
from which qualified export receipts will be derived and Y will receive 
commissions with respect to such exports equal to the maximum amount 
permitted to be received under the intercompany pricing rules of section 
994. Commissions are computed using the combined taxable income method 
under Sec. 1.994-1(c)(3). For purposes of applying the combined taxable 
income method, X and Y compute their combined taxable income 
attributable to the product line of export property under the marginal 
costing rules in accordance with the additional facts assumed in the 
table below:

(1) Maximum combined taxable income (determined under
 paragraph (b)(2) of this section):
  (a) Y's gross receipts from export sales....................    $95.00
  (b) Less:
    (i) Direct materials............................     40.00
    (ii) Direct labor...............................     20.00
    (iii) Y's export promotion expenses claimed in        5.00
     determining Y's DISC taxable income............
    (iv) Total deductions...........................     65.00
                                                     ----------
  (c) Maximum combined taxable income.........................     30.00
                                                     ===========
(2) Overall profit percentage limitation (determined under
 paragraph (b)(3) of this section):
  (a) Gross receipts of X and Y from all domestic and foreign     400.00
   sales......................................................
  (b) Less deductions:
    (i) Direct materials............................    160.00
    (ii) Direct labor...............................     80.00
    (iii) Other costs (of which $8 are costs of the      40.00
     DISC including $5 of export promotion expenses
     claimed in determining Y's taxable income).....
                                                     ----------
  (c) Total deductions........................................    280.00
                                                     -----------
  (d) Total taxable income from all sales computed on a full      120.00
   costing method.............................................
                                                     ===========
  (e) Overall profit percentage (line (d) ($120) divided by          30%
   line (a) ($400)) (percent).................................
  (f) Multiply by gross receipts from Y's export sales (line      $95.00
   (1)(a))....................................................
                                                     ===========
  (g) Overall profit percentage limitations...................     28.50
 


Since the overall profit percentage limitation under line (2)(g) 
($28.50) is less than maximum combined taxable income under line (1)(c) 
($30), combined taxable income under marginal costing is limited to 
$28.50. Since under the franchise agreement Y is to earn the maximum 
commission permitted under the intercompany pricing rules of section 
994, combined taxable income on the transactions is $28.50. Accordingly, 
the costs attributable to export sales (other than for direct material, 
direct labor, and export promotion expenses) are $1.50, i.e., line 
(1)(c) ($30) minus line (2)(g) ($28.50). Under the combined taxable 
income method of Sec. 1.994-1 (c)(3), Y will have taxable income 
attributable to the sales of $14.75, i.e., the sum of \1/2\ of combined 
taxable income (1/2 of $28.50) and 10 percent of Y's export promotion 
expenses claimed in determining Y's taxable income (10 percent of $5). 
Accordingly, the commissions Y receives from X are $22.75, i.e., Y's 
costs ($8, see line (2)(b)(iii)) plus Y's profit ($14.75).
    Example 2. (1) Assume the same facts as in example 1, except that 
gross receipts from export sales are only $85 and gross receipts from 
all sales remain at $400. For purposes of applying the combined taxable 
income method, X and Y may compute their combined taxable income 
attributable to the product line of export property under the marginal 
costing rules as follows:

(1) Maximum combined taxable income (determined under paragraph
 (b)(2) of this section):
  (a) Y's gross receipts from export sales.....................   $85.00
  (b) Less:
    (i) Direct materials..............................    40.00
    (ii) Direct labor.................................    20.00
    (iii) Y's export promotion expenses claimed in         5.00
     determining Y's taxable income...................
                                                       ---------
    (iv) Total deductions......................................    65.00
                                                       ----------
  (c) Maximum combined taxable income..........................    20.00
                                                       ==========
(2) Overall profit percentage limitation (determined under
 paragraph (b)(3) of this section):
  (a) Gross receipts from Y's export sales (line (1)(a)).......    85.00
  (b) Multiply by overall profit percentage (as determined in        30%
   example 1) (percent)........................................
                                                       ----------
  (c) Overall profit percentage limitation.....................    25.50
                                                                ========
 


Since maximum combined taxable income under line (1)(c) ($20) is less 
than the overall profit percentage limitation under line (2)(c) 
($25.50), combined taxable income under marginal costing is limited to 
$20. Since under the franchise agreement Y is to earn the maximum 
commission permitted under the intercompany pricing rules of section 
994, combined taxable income on the transactions is $20. Accordingly, no 
costs (other than for direct material, direct labor, and export 
promotion expenses) will be attributed to export sales. Under the 
combined taxable income method of Sec. 1.994-1(c)(3), Y will have 
taxable income attributable to the sales of $10.50, i.e., the sum of \1/
2\ of combined taxable income (1/2 of $20) and 10 percent of Y's export 
promotion expenses claimed in determining Y's taxable income (10 percent 
of $5). Accordingly, the Commissions Y receives from X are $18.50, i.e., 
Y's costs ($8, see line (2)(b)(iii) of example 1) plus Y's profit 
($10.50).
    (2) If export promotion expenses are not claimed in determining 
taxable income of Y under the combined taxable income method, the 
taxable income of Y would be increased

[[Page 856]]

to $12.50 and commissions payable to Y would be increased to $20.50, 
computed as follows:

(3) Maximum combined taxable income (determined under
 paragraph (b)(2) of this section):
  (a) Y's gross receipts from export sales............   $85.00
  (b) Less:
    (i) Direct materials..............................    40.00
    (ii) Direct labor.................................    20.00
                                                       ---------
    (iii) Total deductions............................  .......    60.00
                                                                --------
  (c) Maximum combined taxable income..........................    25.00
                                                       ==========
(4) Overall profit percentage limitation (line (2)(c)).........    25.50
                                                                ========
 

Since maximum combined taxable income under line (3)(c) ($25) is less 
than the overall profit percentage under line (4) ($25.50), combined 
taxable income under marginal costing is limited to $25. Since under the 
franchise agreement Y is to earn the maximum commission permitted under 
the intercompany pricing rules of section 994, combined taxable income 
on the transactions is $25. Accordingly, no costs (other than for direct 
material and direct labor) will be attributed to export sales. Under the 
combined taxable income method of Sec. 1.994-1(c)(3), Y will have 
taxable income attributable to the sales of $12.50, i.e., \1/2\ of 
combined taxable income (\1/2\ of $25). Accordingly, the commissions Y 
receives from X are $20.50, i.e., Y's costs ($8, see line (2)(b)(iii) of 
example 1) plus Y's profit ($12.50).
    Example 3. (1) Assume the same facts as in example 1, except that 
gross receipts from export sales are only $85, gross receipts from all 
sales remain at $400, and Y has costs of $40 consisting of Y's export 
promotion expenses of $35 and costs of $5 other than for direct 
material, direct labor, or export promotion expenses. For purposes of 
applying the combined taxable income method, X and Y may compute their 
combined taxable income attributable to the product line of export 
property under the marginal costing rules as follows:

(1) Maximum combined taxable income (determined under
 paragraph (b)(2) of this section):
  (a) Y's gross receipts from export sales............   $85.00
  (b) Less:
    (i) Direct materials..............................    40.00
    (ii) Direct labor.................................    20.00
    (iii) Y's export promotion expenses claimed in        35.00
     determining Y's taxable income...................
                                                       ---------
    (iv) Total deductions.............................  .......    95.00
                                                                --------
  (c) Maximum combined taxable income (loss)...................  (10.00)
                                                       ==========
(2) Overall profit percentage limitation (as determined in         25.50
 example 2)....................................................
                                                                ========
 


Since maximum combined taxable income under line (1)(c) (which is a loss 
of $10) is less than the overall profit percentage limitation under line 
(2)(c) ($25.50), combined taxable income under marginal costing is a 
loss of $10 and, under the combined taxable income method of Sec. 
1.994-1(c)(3), Y will have no taxable income or loss attributable to the 
sales. Accordingly, the commissions Y receives from X are $40, i.e., Y's 
costs ($40).
    (2) If export promotion expenses are not claimed in determining Y's 
taxable income under the combined taxable income method, the taxable 
income of Y would be increased to $12.50 and commissions payable to Y 
would be increased to $52.50 computed as follows:

(3) Maximum combined taxable income (determined under paragraph   $25.00
 (b)(2) of this section) (line (3)(c) of example 2)............
(4) Overall profit percentage limitation (as determined in         25.50
 example 2)....................................................
 

The results would be the same as in part (2) of example 2, except that 
the commissions Y receives from X are $52.50, i.e., Y's costs ($40) plus 
Y's profit ($12.50).

[T.D. 7364, 40 FR 29836, July 16, 1975; 40 FR 33972, Aug. 13, 1975]



Sec. 1.995-1  Taxation of DISC income to shareholders.

    (a) In general. (1) Under Sec. 1.991-1(a), a corporation which is a 
DISC for a taxable year is not subject to any tax imposed by subtitle A 
of the Code (sections 1 through 1564) for the taxable year, except for 
the tax imposed by chapter 5 thereof (sections 1491 through 1494) on 
certain transfers to avoid tax.
    (2) Under section 995(a), the shareholders of a DISC, or a former 
DISC, are subject to taxation on the earnings and profits of the DISC in 
accordance with the provisions of chapter 1 of the Code generally 
applicable to shareholders, but subject to the modifications provided in 
sections 995, 996, and 997.
    (3) Under Sec. 1.996-3, three divisions of earnings and profits of 
a DISC, or former DISC, are defined: ``accumulated DISC income'', 
``previously taxed income'', and ``other earnings and profits''. Under 
Sec. 1.995-2, certain amounts of the DISC's earnings and profits are 
deemed to be distributed as dividends to shareholders of the DISC at the 
close of the DISC's taxable year in which such earnings were derived. 
Such deemed distributions do not cause a reduction in the DISC's 
earnings and profits, but are taken into account in

[[Page 857]]

Sec. 1.996-3(c) as an increase in previously taxed income. To the 
extent the DISC's earnings and profits are paid out in a subsequent 
distribution which is, under Sec. 1.996-1, treated as made out of such 
``previously taxed income,'' they will not be taxable to the 
shareholders a second time.
    (4) In general, ``accumulated DISC income'' is the earnings and 
profits of the DISC which have not been deemed distributed and which may 
be deferred from taxation so long as they are not actually distributed 
with respect to its stock. However, deferral of taxation on 
``accumulated DISC income'' may be terminated, in whole or in part, in 
the event of: (i) Certain foreign investment attributable to producer's 
loans (see Sec. 1.995-2(a)(5) and Sec. 1.995-5); (ii) revocation of 
the election to be treated as a DISC or other disqualification (see 
Sec. 1.995-3); and (iii) certain dispositions of DISC stock in which 
gain is realized (see Sec. 1.995-4).
    (5) Since a DISC is not taxed on its taxable income, section 246(d) 
and Sec. 1.246-4 provide that the deduction otherwise allowed under 
section 243 shall not be allowed with respect to a dividend from a DISC, 
or former DISC, paid or treated as paid out of accumulated DISC income 
or previously taxed income or with respect to a deemed distribution in a 
qualified year under Sec. 1.995-2(a).
    (b) Amounts and character of amounts includible in shareholder's 
gross income. Each shareholder of a corporation which is a DISC, or 
former DISC, shall include in his gross income--
    (1) Amounts actually distributed to him that are includible in his 
gross income in accordance with paragraph (c) of this section.
    (2) Amounts which, pursuant to Sec. 1.995-2, he is deemed to 
receive as a distribution taxable as a dividend on the last day of each 
of the corporation's taxable years for which it qualifies as a DISC,
    (3) Amounts which, pursuant to Sec. 1.995-3, he is deemed to 
receive as a distribution taxable as a dividend in the event the 
corporation revokes its election to be treated as a DISC or otherwise is 
disqualified as a DISC, and
    (4) Gain realized on certain dispositions of stock in the 
corporation which, under Sec. 1.995-4, is includible in his gross 
income as a dividend.
    (c) Treatment of actual distributions. (1) Except as provided in 
subparagraph (3) of this paragraph, amounts actually distributed to a 
shareholder of a DISC, or former DISC, with respect to his stock are 
includible in his gross income in accordance with section 301.
    (2) Since a deemed distribution does not reduce the earnings and 
profits of a DISC, it does not affect the determination as to whether a 
subsequent actual distribution is a ``dividend'' under section 316(a). 
Since, however, the amount of a deemed distribution increases 
``previously taxed income'', it does affect the determination as to 
whether a subsequent actual distribution is excluded (as described in 
subparagraph (3) of this paragraph) from gross income.
    (3) Under Sec. 1.996-1(c), the amount of any actual distribution 
(including a deficiency distribution made pursuant to Sec. 1.992-3), 
with respect to stock in a DISC, or former DISC, which is treated under 
Sec. 1.996-1 as made out of previously taxed income, is excluded by the 
distributee from gross income, but only to the extent that such amount 
does not exceed the adjusted basis of the distributee's stock. Under 
Sec. 1.996-5(b), that portion of any actual distribution which is 
treated as made out of previously taxed income shall be applied against 
and reduce the adjusted basis of the stock and, to the extent that it 
exceeds the adjusted basis of the stock, it shall be treated as gain 
from the sale or exchange of property.
    (4) A deficiency distribution pursuant to Sec. 1.992-3 may be made 
after the close of the DISC's taxable year with respect to which it is 
made. The determinations as to whether such deficiency distribution is a 
dividend under section 301 and as to which division of earnings and 
profits is the source thereof depend upon the status of the DISC's 
earnings and profits account and divisions thereof at the time the 
distribution is actually made. See Sec. 1.996-1(d) for the priority of 
such deficiency distribution over other actual distributions made during 
the same taxable year.
    (d) Personal holding company income. (1) Any amount includible in a 
shareholder's gross income as a dividend with respect to the stock of a 
DISC, or

[[Page 858]]

former DISC, pursuant to paragraph (b) of this section shall be treated 
as a dividend for all purposes of the Code, except that for purposes of 
determining whether such shareholder is a personal holding company 
within the meaning of section 542 any amount deemed distributed for 
qualified years under Sec. 1.995-2 or upon disqualification under Sec. 
1.995-3, any amount of gain on certain dispositions of DISC stock to 
which Sec. 1.995-4 applies, and any amount treated under Sec. 1.996-1 
as distributed out of accumulated DISC income or previously taxed income 
shall not be treated as a dividend or any other kind of income described 
in section 543(a).
    (2) Notwithstanding subparagraph (1) of this paragraph, the 
shareholder may treat as an item of income described under section 543 
(for example, rents) any amount to which the exception in such 
subparagraph (1) applies, if it establishes to the satisfaction of the 
district director that such amount is attributable to earnings and 
profits derived from such item of income.

[T.D. 7324, 39 FR 35109, Sept. 30, 1974]



Sec. 1.995-2  Deemed distributions in qualified years.

    (a) General rule. Under section 995 (b)(1), each shareholder of a 
DISC shall be treated as having received a distribution taxable as a 
dividend with respect to his stock on the last day of each taxable year 
of the DISC, in an amount which is equal to his pro rata share of the 
sum (as limited by paragraph (b) of this section), of the following 
seven items:
    (1) An amount equal to the gross interest derived by the DISC during 
such year from producer's loans (as defined in Sec. 1.993-4).
    (2) An amount equal to the lower of--
    (i) Any gain recognized by the DISC during such year on the sale or 
exchange of property (other than property which in the hands of the DISC 
is a qualified export asset) which was previously transferred to it in a 
transaction in which the transferor realized gain which was not 
recognized in whole or in part, or
    (ii) The amount of the transferor's gain which was not recognized on 
the previous transfer of the property to the DISC.


For purposes of this subparagraph, each item of property shall be 
considered separately. See paragraph (d) of this section for special 
rules with respect to certain tax-free acquisitions of property by the 
DISC.
    (3) An amount equal to the lower of--
    (i) Any gain recognized by the DISC during such year on the sale or 
exchange of property which in the hands of the DISC is a qualified 
export asset (other than stock in trade or property described in section 
1221(1)) and which was previously transferred to the DISC in a 
transaction in which the transferor realized gain which was not 
recognized in whole or in part, or
    (ii) The amount of the transferor's gain which was not recognized on 
the previous transfer of the property to the DISC and which would have 
been includible in the transferor's gross income as ordinary income if 
its entire realized gain had been recognized upon the transfer.


For purposes of this subparagraph, each item of property shall be 
considered separately. See paragraph (d) of this section for special 
rules with respect to certain tax-free acquisitions of property by the 
DISC.
    (4) For taxable years beginning after December 31, 1975, an amount 
equal to 50 percent of the taxable income of the DISC for the taxable 
years attributable to military property (as defined in Sec. 1.995-6).
    (5) For taxable years beginning after December 31, 1975, the taxable 
income for the taxable year attributable to base period export gross 
receipts (as defined in Sec. 1.995-7).
    (6) The sum of--
    (i)(A) In the case of a corporate share holder, an amount equal to 
57.5 percent of the excess (if any) (one-half for DISCs' taxable years 
beginning before January 1, 1983) of the taxable income of the DISC for 
such year (computed as provided in Sec. 1.991-1(b)(1)) over the sum of 
the amounts deemed distributed for the taxable year in accordance with 
subparagraphs (1), (2), (3), (4) and (5) of this paragraph, or
    (B) In the case of a non-corporate share holder, an amount equal to 
one-half of the excess (if any) of the taxable income of the DISC for 
such year (computed as provided in Sec. 1.991-1(b)(1)) over

[[Page 859]]

the sum of the amounts deemed distributed for the taxable year in 
accordance with subparagraphs (1), (2), (3), (4), and (5) of this 
paragraph.
    (ii)(A) An amount equal to the amount under subdivision (i) of 
paragraph (a)(6) of this section multiplied by the international boycott 
factor as determined under section 999 (c)(1) , or
    (B) In lieu of the amount determined under subdivision (ii)(A) of 
paragraph (a)(6) of this section, the amount described under section 999 
(c)(2) of such international boycott income, and
    (iii) An amount equal to the sum of any illegal bribes, kickbacks, 
or other payments paid by or on behalf of the DISC directly or 
indirectly to an official, employee, or agent in fact of a government. 
An amount is paid by a DISC where it is paid by any officer, director, 
employee, shareholder, or agent of the DISC for the benefit of such 
DISC. For purposes of this section, the principles of section 162 (c) 
and the regulations thereunder shall apply. The fair market value of an 
illegal payment made in the form of property or services shall be 
considered the amount of such illegal payment.
    (7) The amount of foreign investment attributable to producer's 
loans of the DISC, as of the close of the ``group taxable year'' ending 
with such taxable year of the DISC, determined in accordance with Sec. 
1.995-5. The amount of such foreign investment attributable to 
producer's loans so determined for any taxable year of a former DISC 
shall be deemed distributed as a dividend to the shareholders of such 
former DISC on the last day of such taxable year. See Sec. 1.995-3(e) 
for the effect that such deemed distribution has on scheduled 
installments of deemed distributions of accumulated DISC income under 
Sec. 1.995-3(a) upon disqualification.
    (b) Limitation on amount of deemed distributions under section 
995(b)(1). (1) The sum of the amounts described in paragraph (a)(1) 
through (a)(6) of this section which is deemed distributed pro rata to 
the DISC's shareholders a dividend for any taxable year of the 
corporation shall not exceed the DISC's earnings and profits for such 
year.
    (2) The amount of foreign investment attributable to producer's 
loans of the DISC (as described in paragraph (a)(7) of this section) 
which is deemed to be distributed pro rata to the DISC's shareholders as 
dividends for any taxable year of the corporation shall not exceed the 
lower of the corporation's accumulated DISC income at the beginning of 
such year or the corporation's accumulated earnings and profits at the 
beginning of such year (but not less than zero)--
    (i) Increased by any DISC income of the corporation for such year as 
defined in Sec. 1.996-3(b)(2) (i.e., any excess of the DISC's earnings 
and profits for such year over the sum of the amounts described in 
paragraph (a)(1) through (a)(6) of this section), or
    (ii) Decreased by any deficit in the corporation's earnings and 
profits for such year.


Thus, for example, if a DISC has a deficit in accumulated earnings and 
profits at the beginning of a taxable year of $10,000, current earnings 
and profits of $12,000, no amounts described in paragraphs (a)(1) 
through (a)(6) of this section for the year, and foreign investment 
attributable to producer's loans for the taxable year of $5,000, the 
DISC would have a deemed distribution described in paragraph (a)(7) of 
this section of $5,000 for the taxable year. On the other hand, suppose 
the DISC had accumulated earnings and profits of $13,000 at the 
beginning of the taxable year, accumulated DISC income of $10,000 at the 
beginning of the taxable year, a deficit in earnings and profits for the 
taxable year of $12,000, no amounts described in paragraphs (a)(1) 
through (a)(6) of this section for the taxable year, and foreign 
investment attributable to producer's loans for the taxable year of 
$5,000. Under these facts the DISC would have no deemed distribution 
described in paragraph (a)(7) of this section because the corporation 
had no DISC income for the taxable year and the current year's deficit 
in earnings and profits subtracted from the DISC's accumulated DISC 
income at the beginning of the year produces a negative amount. For 
rules relating to the carryover to a subsequent year of the $5,000 of 
foreign investment attributable to producer's loans, see Sec. 1.995-
5(a)(6).
    (3) If, by reason of the limitation in subparagraph (1) of this 
paragraph, less

[[Page 860]]

than the sum of the amounts described in paragraphs (a)(1) through 
(a)(6) of this section is deemed distributed, then the portion of such 
sum which is deemed distributed shall be attributed first to the amount 
described in subparagraph (1) of such paragraph, to the extent thereof; 
second to the amount described in subparagraph (2) of such paragraph, to 
the extent thereof; third to the amount described in subparagraph (3) of 
such paragraph, to the extent thereof; and so forth, and finally to the 
amount described in paragraph (b)(6) of this paragraph.
    (c) Examples. Paragraphs (a) and (b) of this section may be 
illustrated by the following examples:

    Example 1. Y is a corporation which uses the calendar year as its 
taxable year and which elects to be treated as a DISC beginning with 
1972. X is its sole shareholder. In 1972, X transfers certain property 
to Y in exchange for Y's stock in a transaction in which X does not 
recognize gain or loss by reason of the application of section 351(a). 
Included in the property transferred to Y is depreciable property 
described in paragraph (a)(3) of this section on which X realizes, but 
does not recognize by reason of the application of section 1245(b)(3), a 
gain of $20,000. If X had sold such property for cash, the $20,000 gain 
would have been recognized as ordinary income under section 1245. Also 
included in the transfer to Y is 100 shares of stock in a third 
corporation (which is not a related foreign export corporation) on which 
X realizes, but does not recognize, a gain of $5,000. In 1973, Y sells 
such property and recognizes a gain of $25,000 on the depreciable 
property and $8,000 on the 100 shares of stock. Y has accumulated 
earnings and profits at the beginning of 1973 of $5,000, earnings and 
profits for 1973 of $72,000, and taxable income for 1973 of $100,000. At 
the beginning of 1973, Y has $6,000 of accumulated DISC income, no 
previously taxed income, and a deficit of $1,000 of other earnings and 
profits. Under these facts and the additional facts assumed in the table 
below, X is treated as having received a deemed distribution taxable as 
a dividend of $76,000 on December 31, 1973, determined as follows:

(1) Gross interest derived by Y in 1973 from producer's loans..   $7,000
(2) Amount of gain on depreciable property (lower of Y's          20,000
 recognized gain ($25,000) or X's gain not recognized on
 section 1245 property ($20,000))..............................
(3) Amount of gain on stock (lower of X's gain not recognized      5,000
 or Y's recognized gain ($8,000) ($5,000)).....................
(4) One-half excess of taxable income for 1973 over the sum of    34,000
 lines (1), (2), and (3) (1/2 of ($100,000 minus $32,000)).....
                                                                --------
(5) Limitation on lines (1) through (4):
  (a) Sum of lines (1) through (4).............................   66,000
  (b) Earnings and profits for 1973............................   72,000
                                                                --------
  (c) Lower of lines (a) and (b)...............................   66,000
                                                                --------
(6) Amount under paragraph (a)(5) of this section:
    (a) Foreign investment attributable to producer's loans       10,000
     under Sec. 1.995-5......................................
    (b) Sum of the lower of accumulated earnings and profits at   11,000
     beginning of 1973 ($5,000) or accumulated DISC income at
     beginning of 1973 ($6,000) and excess of earnings and
     profits for 1973 over line (5)(c) ($72,000 minus $66,000).
                                                                --------
    (c) Lower of lines (a) and (b).............................   10,000
                                                                --------
(7) Total deemed distribution (sum of lines (5)(c) and (6)(c)).   76,000
                                                                ========
 

    Example 2. Assume the facts are the same as in example 1, except 
that earnings and profits for 1973 amount to only $60,000. Under these 
facts, X is treated as receiving a deemed distribution taxable as a 
dividend of $65,000 on December 31, 1973, determined as follows:

(5) Limitation on lines (1) through (4):
    (a) Line (5)(a) of example 1..............................   $66,000
    (b) Earnings and profits for 1973.........................    60,000
                                                               ---------
    (c) Lower of lines (a) and (b)............................    60,000
                                                               ---------
(6) Amount under paragraph (a)(5) of this section:
    (a) Line (6)(a) of example 1..............................    10,000
    (b) Sum of the lower of accumulated earnings and profits       5,000
     at beginning of 1973 ($5,000) or accumulated DISC income
     at beginning of 1973 ($6,000) plus excess of earnings and
     profits for 1973 over line (5)(c) ($60,000 minus $60,000)
                                                               ---------
    (c) Lower of lines (a) and (b)............................     5,000
                                                               ---------
(7) Total deemed distribution (sum of lines (5)(c) and (6)(c))    65,000
                                                               =========
 

    Example 3. Assume the facts are the same as in example 1, except 
that Y has a deficit in accumulated earnings and profits at the 
beginning of 1973 of $4,000. Such deficit is comprised of accumulated 
DISC income of $1,000, no previously taxed income, and a deficit in 
other earnings and profits of $5,000. Under these facts, X is treated as 
receiving a deemed distribution taxable as a dividend in the amount of 
$72,000 on December 31, 1973, determined as follows:

(5) Limitation on lines (1) through (4):
  (a) Line (5)(a) of example 1................................   $66,000
  (b) Earnings and profits for 1973...........................    72,000
                                                               ---------
  (c) Lower of lines (a) and (b)..............................    66,000
                                                               ---------
(6) Amount under paragraph (a)(5) of this section:
  (a) Line (6)(a) of example 1................................    10,000

[[Page 861]]

 
  (b) Sum of accumulated earnings and profits at beginning of      6,000
   1973 (not less than $0), and excess of earnings and profits
   for 1973 over amount in line (5)(c) ($72,000 minus $66,000)
                                                               ---------
  (c) Lower of lines (a) and (b)..............................     6,000
                                                               ---------
(7) Total deemed distribution sum of lines (5)(c) and (6)(c)..    72,000
                                                               =========
 

    (d) Special rules for certain tax-free acquisitions of property by 
the DISC. (1) For purposes of paragraph (a)(2)(i) and (3)(i) of this 
section, if--
    (i) A DISC acquires property in a first transaction and in a second 
transaction it disposes of such property in exchange for other property, 
and
    (ii) By reason of the application of section 1031 (relating to like-
kind exchanges) or section 1033 (relating to involuntary conversions), 
the basis in the DISC's hands of the other property acquired in such 
second transaction is determined in whole or in part with reference to 
the basis of the property acquired in the first transaction,


then upon a disposition of such other property in a third transaction by 
the DISC such other property shall be treated as though it had been 
transferred to the DISC in the first transaction. Thus, if the first 
transaction is a purchase of the property for cash, then paragraphs 
(a)(2) and (3) of this section will not apply to a sale by the DISC of 
the other property acquired in the second transaction.
    (2) For purposes of paragraphs (a)(2)(i) and (3)(i) of this section, 
if a DISC acquires property in a first transaction and it transfers such 
property to a transferee DISC in a second transaction in which the 
transferor DISC's gain is not recognized in whole or in part, then such 
property shall be treated as though it had been transferred to the 
transferee DISC in the same manner in which it was acquired in the first 
transaction by the transferor DISC. For example, if X and Y both qualify 
as DISC's and X transfers property to Y in a second transaction in which 
gain or loss is not recognized, paragraph (a)(2) or (3) of this section 
does not apply to a sale of such property by Y in a third transaction if 
X had acquired the property in a first transaction by a purchase for 
cash. If, however, X acquired the property from a transferor other than 
a DISC in the first transaction in which the transferor's realized gain 
was not recognized, then paragraph (a)(2) or (3) of this section may 
apply to the sale by Y if the other conditions of such paragraph (a)(2) 
or (3) are met.
    (3) If a DISC acquires property in a second transaction described in 
subparagraph (1) or (2) of this paragraph in which it (or, in the case 
of a second transaction described in subparagraph (2) of this paragraph, 
the transferor DISC) recognizes a portion (but not all) of the realized 
gain, then the amount described in paragraph (a)(2)(ii) or (a)(3)(ii) of 
this section with respect to a disposition by the DISC of such acquired 
property in a third transaction shall not exceed the transferor's gain 
which was not recognized on the first transaction minus the amount of 
gain recognized by the DISC (or transferor DISC) on the second 
transaction.
    (4) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. X and Y are corporations each of which qualifies as a 
DISC and uses the calendar year as its taxable year. In 1972, X acquires 
section 1245 property in a first transaction in which the transferor's 
entire realized gain of $17 is not recognized. In 1973, X transfers such 
property to Y in a second transaction in which X realizes a gain of $20 
of which only $4 is recognized. (On December 31, 1973, X's shareholders 
are treated as having received a deemed distribution of a dividend which 
includes such $4 under paragraph (a)(3) of this section, provided the 
limitation in paragraph (b) of this section is met.) In a third 
transaction in 1974, Y sells such property and recognizes a gain of $25. 
With respect to Y's shareholders on December 31, 1974, the amount 
described in paragraph (a)(3)(ii) of this section would be limited to 
$13, which is the amount of the transferor's gain which was not 
recognized on the first transaction ($17) minus the amount of gain 
recognized by X on the second transaction ($4).
    Example 2. Z is a DISC using the calendar year as its taxable year. 
In a first transaction in 1972, in exchange for its stock, Z acquires 
section 1245 property from A, an individual who is its sole shareholder, 
in a transaction in which A's realized gain of $30 is not recognized by 
reason of the application of section 351(a). In a second transaction in 
1973, Z exchanges such property for other property in a like-kind 
exchange to which section 1031(b) applies and recognizes $10 of a 
realized gain of $35. (On December 31, 1973, A

[[Page 862]]

is treated as having received a deemed distribution of a dividend which 
includes such $10 under paragraph (a)(3) of this section, provided the 
limitation in paragraph (b) of this section is met.) In a third 
transaction in 1974, Z sells the property acquired in the like-kind 
exchange and recognizes a gain of $25. With respect to A on December 31, 
1974, the amount described in paragraph (a)(3)(ii) of this section is 
limited to $20, which is the amount of A's gain which was not recognized 
on the first transaction ($30) minus the amount of gain recognized by Z 
on the second transaction ($10).

    (e) Carry back of net operating loss and capital loss to prior DISC 
taxable year. For purposes of sections 991, 995, and 996, the amount of 
the deduction for the taxable year under section 172 for a net operating 
loss carryback or carryover or under section 1212 for a capital loss 
carryback or carryover shall be determined in the same manner as if the 
DISC were a domestic corporation which had not elected to be treated as 
a DISC. Thus, the amount of the deduction will be the same whether or 
not the corporation was a DISC in the year of the loss or in the year to 
which the loss is carried. For provisions setting forth adjustments to 
the DISC's, or former DISC's, deemed distributions, adjustments to its 
divisions of earnings and profits, and other tax consequences arising 
from such carrybacks, see Sec. 1.996-8.

(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7324, 39 FR 35110, Sept. 30, 1974, as amended by T.D. 7862, 47 FR 
56492, Dec. 17, 1982; T.D. 7984, 49 FR 40018, Oct. 12, 1984]



Sec. 1.995-3  Distributions upon disqualification.

    (a) General rule. Under section 995 (b)(2), a shareholder of a 
corporation which is disqualified from being a DISC, either because 
pursuant to Sec. 1.992-2(e)(2) it revoked its election to be treated as 
a DISC or because it has failed to satisfy the requirements as set forth 
in Sec. 1.992-1 to be a DISC for a taxable year, shall be deemed to 
have received (at the times specified in paragraph (b) of this section) 
distributions taxable as dividends aggregating an amount equal to his 
pro rata share of the accumulated DISC income (as defined in Sec. 
1.996-3(b)) of such corporation which was accumulated during the 
immediately preceding consecutive taxable years for which the 
corporation was a DISC. The pro rata share referred to in the preceding 
sentence shall be determined as of the close of the last of such 
consecutive taxable years for which the corporation was a DISC. See 
Sec. 1.996-7(c) for rules relating to the carryover of, and maintaining 
a separate account for, such accumulated DISC income in certain 
reorganizations.
    (b) Time of receipt of deemed distributions. Distributions described 
in paragraph (a) of this section shall be deemed to be received in equal 
installments on the last day of each of the 10 taxable years of the 
corporation following the year of the disqualification described in 
paragraph (a) of this section, except that in no case may the number of 
equal installments exceed the number of the immediately preceding 
consecutive taxable years for which the corporation was a DISC.
    (c) Transfer of shares. Deemed distributions are includible under 
paragraphs (a) and (b) of this section in a shareholder's gross income 
as a dividend only so long as he continues to hold the shares with 
respect to which the distribution is deemed made. Thus, the transferee 
of such shareholder will include in his gross income under paragraphs 
(a) and (b) of this section the remaining installments of the deemed 
distribution which the transferor would have included in his gross 
income as a dividend had he not transferred the shares. However, if the 
transferee acquires the shares in a transaction in which the 
transferor's gain is treated under Sec. 1.995-4 in whole or in part as 
a dividend, then under Sec. 1.996-4(a) such transferee does not include 
subsequent installments in his gross income to the extent that the 
transferee treats such subsequent installments as made out of previously 
taxed income.
    (d) Effect of requalification. Deemed distributions under paragraphs 
(a) and (b) of this section continue and are includible in gross income 
as dividends by the shareholders whether or not the corporation 
subsequently requalifies and is treated as a DISC.

[[Page 863]]

    (e) Effect of actual distributions and deemed distributions under 
section 995(b)(1)(G). If, during the period a shareholder of a DISC, or 
former DISC, is taking into account deemed distributions under 
paragraphs (a) and (b) of this section, an actual distribution is made 
to him out of accumulated DISC income or a deemed distribution because 
of foreign investment attributable to producer's loans is made under 
Sec. 1.995-2(a)(5) out of accumulated DISC income, such actual or 
deemed distribution shall first reduce the last installment of the 
deemed distributions scheduled to be included in the shareholder's gross 
income as a dividend, and then the preceding scheduled installments in 
reverse order. If deemed distributions are scheduled to be included in 
gross income for two or more disqualifications, an actual distribution 
or a deemed distribution under Sec. 1.995-2 (a)(5) which is treated as 
made out of accumulated DISC income reduces the deemed distributions 
resulting from the earlier disqualification first.
    (f) Examples. This section may be illustrated by the following 
examples:

    Example 1. X Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1972. X 
qualifies as a DISC for taxable years 1972 through 1975, but, pursuant 
to Sec. 1.992-2(e)(2), revokes its election as of January 1, 1976, and 
is disqualified as a DISC. On that date, X has $24,000 of accumulated 
DISC income. X's shareholders will be deemed to receive $6,000 in 
distributions taxable as a dividend on the last day of each of X's four 
succeeding taxable years (1977, 1978, 1979, and 1980).
    Example 2. Assume the same facts as in example 1, except that in 
1978 X makes an actual distribution of $22,000 to its shareholders of 
which $10,000 is treated under Sec. 1.996-1 as made out of accumulated 
DISC income. (The remaining $12,000 of such distribution is treated as 
made out of previously taxed income.) The actual distribution would 
first reduce the $6,000 deemed distribution scheduled for 1980 to zero 
and then reduce the $6,000 deemed distribution scheduled for 1979 to 
$2,000. Thus, X's shareholders include in 1978 $16,000 is gross income 
as dividends ($10,000 of actual distributions and the $6,000 deemed 
distribution scheduled for that year) and $2,000 as a dividend in 1979.
    Example 3. Assume the same facts as in example 2, except that X 
requalifies as a DISC for taxable year 1977 during which it derives 
$7,000 of DISC income (computed after taking into account a deemed 
distribution under Sec. 1.995-2(a)(4) of $7,000), but is again 
disqualified in 1978. In addition X makes an actual distribution in 1977 
equal to the deemed distribution of $7,000. Such actual distribution is 
excluded from gross income under Sec. 1.996-1(c). In 1977. X's 
shareholders include in gross income as dividends the $6,000 deemed 
distribution upon disqualification (in addition to the deemed 
distributions of $7,000 under Sec. 1.995-2 for 1977 when it was treated 
as a DISC). The actual distribution in 1978 still reduces the 
installments resulting from the earlier disqualification. Thus, in 1978, 
X's shareholders include $16,000 in gross income as dividends. In 1979, 
X's shareholders include $9,000 in gross income as dividends (the final 
installment of $2,000 from the earlier disqualification plus the single 
deemed distribution of $7,000 resulting from the later 
disqualification).

[T.D. 7324, 39 FR 35112, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51741, Nov. 17, 1982]



Sec. 1.995-4  Gain on disposition of stock in a DISC.

    (a) Disposition in which gain is recognized--(1) In general. If a 
shareholder disposes, or is treated as disposing, of stock in a DISC, or 
former DISC, then any gain recognized on such disposition shall be 
included in the shareholder's gross income as a dividend, 
notwithstanding any other provision of the Code, to the extent of the 
accumulated DISC income amount (described in paragraph (d) of this 
section). To the extent the recognized gain exceeds the accumulated DISC 
income amount, it is taxable as gain from the sale or exchange of the 
stock.
    (2) Nonapplication of subparagraph (1). The provisions of 
subparagraph (1) of this paragraph do not apply (i) to the extent gain 
is not recognized (such as, for example, in the case of a gift or an 
exchange of stock to which section 354 applies) and (ii) to the amount 
of any recognized gain which is taxable as a dividend (such as, for 
example, under section 301 or 356(a)(2)) or as gain from the sale or 
exchange of property which is not a capital asset. The amount taxable as 
a dividend under section 301 or 356(a)(2) is subject to the rules 
provided in Sec. 1.995-1(c) for the treatment of actual distributions 
by a DISC.
    (b) Disposition in which separate corporate existence of DISC is 
terminated--(1) General. If stock in a corporation

[[Page 864]]

that is a DISC, or former DISC, is disposed of in a transaction in which 
its separate corporate existence as a DISC, or former DISC, is 
terminated, then, notwithstanding any other provision of the Code, an 
amount of realized gain shall be recognized and included in the 
transferor's gross income as a dividend. The realized gain shall be 
recognized to the extent that such gain--
    (i) Would not have been recognized but for the provisions of this 
paragraph, and
    (ii) Does not exceed the accumulated DISC income amount (described 
in paragraph (d) of this section).
    (2) Cessation of separate corporate existence as a DISC, or former 
DISC. For purposes of subparagraph (1) of this paragraph, separate 
corporate existence as a DISC, or former DISC, will be treated as having 
ceased if, as a result of the transaction, there is no separate entity 
which is a DISC and to which is carried over the accumulated DISC income 
and other tax attributes of the DISC, or former DISC, the stock of which 
is disposed of. Thus, for example, if stock in a DISC, or former DISC, 
is exchanged in a transaction described in section 381(a) (relating to 
carryovers in certain corporate acquisitions), the gain realized on the 
transfer of such stock will not be recognized under subparagraph (1) of 
this paragraph if the assets of such DISC, or former DISC, are acquired 
by a corporation which immediately after the acquisition qualifies as a 
DISC. For a further example, if a DISC, or former DISC, is liquidated in 
a transaction to which section 332 (relating to complete liquidations of 
subsidiaries) applies, the transaction will be subject to subparagraph 
(1) of this paragraph if the basis to the transferee corporation of the 
assets acquired on the liquidation is determined under section 334(b)(2) 
(as in effect prior to amendment by the Tax Equity and Fiscal 
Responsibility Act of 1982) or if immediately after such liquidation the 
transferee of such assets does not qualify as a DISC. However, separate 
corporate existence as a DISC, or former DISC, will not be treated as 
having ceased in the case of a mere change in place of organization, 
however effected. See Sec. 1.996-7 for rules for the carryover of the 
divisions of a DISC's earnings and profits to one or more DISC's.
    (c) Disposition to which section 311, 336, or 337 applies--(1) In 
general. If, after December 31, 1976, a shareholder distributes, sells, 
or exchanges stock in a DISC, or former DISC, in a transaction to which 
section 311, 336, or 337 applies, then an amount equal to the excess of 
the fair market value of such stock over its adjusted basis in the hands 
of the shareholder shall, notwithstanding any other provision of the 
Code, be included in gross income of the shareholder as a dividend to 
the extent of the accumulated DISC income amount (described in paragraph 
(d) of this section).
    (2) Nonapplication of subparagraph (1). Subparagraph (1) shall not 
apply if the person receiving the stock in the disposition has a holding 
period for the stock which includes the period for which the stock was 
held by the shareholder disposing of such stock.
    (d) Accumulated DISC income amount--(1) General. For purposes of 
this section, the accumulated DISC income amount is the accumulated DISC 
income of the DISC or former DISC which is attributable to the stock 
disposed of and which was accumulated in taxable years of such DISC or 
former DISC during the period or periods such stock was held by the 
shareholder who disposed of such stock.
    (2) Period during which a shareholder has held stock. For purposes 
of this section, the period during which a shareholder has held stock 
includes the period he is considered to have held it by reason of the 
application of section 1223 and, if his basis is determined in whole or 
in part under the provisions of section 1014(d) (relating to special 
rule for DISC stock acquired from decedent) or section 1022 (relating to 
property acquired from certain decedents who died in 2010), the holding 
period of the decedent. Such holding period is to exclude the day of 
acquisition but include the day of disposition. Thus, for example, if A 
purchases stock in a DISC on December 31, 1972, and makes a gift of such 
stock to B on June 30, 1973, then on December 31, 1974, B will be 
treated as having held the stock for 2 full years. If the basis of the 
stock in C's hands is determined under section 1014(d) upon

[[Page 865]]

a transfer from B's estate on December 31, 1976, by reason of B's death 
on June 30, 1974, then on December 31, 1976, C will be treated as having 
held the stock for 4 full years.
    (e) Accumulated DISC income allocable to shareholder under section 
995(c)(2)--(1) In general. Under this paragraph, rules are prescribed 
for purposes of paragraph (d) of this section as to the manner of 
determining, with respect to the stock of a DISC, or former DISC, 
disposed of, the amount of accumulated DISC income which is attributable 
to such stock and which was accumulated in taxable years of the 
corporation during the period or periods the stock disposed of was held 
or treated under paragraph (d)(2) of this section as held by the 
transferor. Subparagraphs (2), (3), and (4) of this paragraph set forth 
a method of computation which may be employed to determine such amount. 
Any other method may be employed so long as the result obtained would be 
the same as the result obtained under such method.
    (2) Step 1. Determine the increase (or decrease) in accumulated DISC 
income for each taxable year of the DISC, or former DISC, by subtracting 
from the amount of accumulated DISC income (as defined in Sec. 1.996-
3(b)) at the close of each taxable year the amount thereof as of the 
close of the immediately preceding taxable year.
    (3) Step 2. (i) Determine for each taxable year of the DISC, or 
former DISC, the increase (or decrease) in accumulated DISC income per 
share by dividing such increase (or decrease) for the year by the number 
of shares outstanding or deemed outstanding on each day of such year.
    (ii) If the number of shares of stock in the corporation outstanding 
on each day of a taxable year of the DISC, or former DISC, is not 
constant, then the number of such shares deemed outstanding on each day 
of such year shall be the sum of the fractional amounts in respect of 
each share which was outstanding on any day of the taxable year. The 
fractional amount in respect of a share shall be determined by dividing 
the number of days in the taxable year on which such share was 
outstanding (excluding the day the share became outstanding, but 
including the day the share ceased to be outstanding), by the total 
number of days in such taxable year.
    (iii) If for any taxable year of a DISC, or former DISC, the share 
disposed of was not held (or treated under paragraph (d)(2) of this 
section as held) by the disposing shareholder for the entire year, then 
the amount of increase (or decrease) in accumulated DISC income 
attributable to such share for such year is the amount determined as if 
he held the share until the end of such year multiplied by a fraction 
the numerator of which is the number of days in the taxable year on 
which the shareholder held (or under paragraph (d)(2) of this section is 
treated as having held) such share and the denominator of which is the 
total number of days in the taxable year.
    (4) Step 3. Add the amounts computed in step 2 for each taxable year 
of the DISC, or former DISC, in which the shareholder held such share of 
stock.
    (5) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. X Corporation uses the calendar year as its taxable year 
and elects to be a DISC for the first time for 1973. On January 1, 1973, 
X has 20 shares issued and outstanding. A and B each own 10 shares. On 
July 1, 1976, X issues 10 shares to C. On December 31, 1977, A sells his 
10 shares to D and recognizes a gain of $120. Under these facts and 
other facts assumed in the table below, A includes in his gross income 
for 1977 a dividend under paragraph (b) of this section of $61.30 and 
long-term capital gain of $58.70.

----------------------------------------------------------------------------------------------------------------
                                                                                                   (d)--Increase
                                                          (a)--Year   (b)--Increase                  (decrease)
                                                             end      (decrease) in   (c)--Shares    per share
                         Year                            accumulated   accumulated    outstanding   (column (b)
                                                         DISC income   DISC income                   divided by
                                                                                                    column (c))
----------------------------------------------------------------------------------------------------------------
1973..................................................           $80            $80            20          $4.00
1974..................................................            50           (30)            20         (1.50)
1975..................................................            80             30            20           1.50
1976..................................................           100             20        \1\ 25            .80
1977..................................................           140             40            30           1.33
                                                       ---------------------------------------------------------

[[Page 866]]

 
(1) Total increase in accumulated DISC income for each  ............  .............  ............           6.13
 share disposed of (sum of amounts in column (d)).....
Multiply by number of shares disposed of..............  ............  .............  ............             10
                                                       ---------------------------------------------------------
(2) Total amount of accumulated DISC income             ............  .............  ............          61.30
 attributable to A's shares disposed of...............
(3) A's gain..........................................  ............  .............  ............         120.00
(4) Portion of A's gain taxable as a dividend (lower    ............  .............  ............          61.30
 of lines (2) and (3))................................
(5) Portion of A's gain taxable as long-term capital    ............  .............  ............          58.70
 gain (line (3) minus line (4)).......................
----------------------------------------------------------------------------------------------------------------
\1\ Under subparagraph (3)(ii) of this paragraph, the aggregate fractional amounts of the 10 shares issued on
  July 1, 1976, is 5 shares, i.e., 10 shares, multiplied by (183 days/366 days). Thus, the number of shares
  deemed outstanding for 1976 is 25 shares, i.e., 20 shares plus 5 shares.

    Example 2. Assume the same facts as in example 1, except that A 
sells his 10 shares to D on July 1, 1977. Under subparagraph (3)(iii) of 
this paragraph, the amount of increase in accumulated DISC income for 
1977 which is attributable to each share disposed of is limited to $.67, 
i.e., $1.33 multiplied by 182 days/365 days. Therefore, the sum of the 
yearly increases (and decreases) in accumulated DISC income for each 
share is reduced by $.66 (i.e., $1.33 minus $.67). The total increase in 
accumulated DISC income for each share disposed of is $5.47 (i.e., $6.13 
minus $.66). Under these facts, A would include in his gross income for 
1977 a dividend of $54.70 and long-term capital gain of $65.30 
determined as follows:

(1) Total increase in accumulated DISC income for each             $5.47
 share disposed of.........................................
Multiplied by number of shares disposed of.................           10
                                                            ------------
(2) Total amount of accumulated DISC income attributable of        54.70
 to all shares disposed of.................................
(3) A's gain...............................................       120.00
(4) Portion of A's gain taxable as a dividend (lower of            54.70
 lines (2) and (3))........................................
(5) Portion of A's gain taxable as long-term capital gain          65.30
 (line (3) minus line (4)).................................
 

    (f) Effective/applicability date. This section applies on and after 
January 19, 2017. For rules before January 19, 2017, see Sec. 1.995-4 
as contained in 26 CFR part 1 revised as of April 1, 2016.

[T.D. 7324, 39 FR 35112, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51741, Nov. 17, 1982; T.D. 9811, 82 FR 6240, Jan. 19, 2017]



Sec. 1.995-5  Foreign investment attributable to producer's loans.

    (a) In general--(1) Limitation. Under section 995(d), the amount as 
of the close of a ``group taxable year'' (as defined in subparagraph (3) 
of this paragraph) of foreign investment attributable to producer's 
loans of a DISC for purposes of section 995(b)(1)(G) shall be the excess 
(as of the close of such year) of--
    (i) The smallest of--
    (a) The amount of the net increase in foreign assets (as defined in 
paragraph (b) of this section) by domestic and foreign members of the 
controlled group which includes the DISC,
    (b) The amount of the actual foreign investment by the domestic 
members of such group (as determined under paragraph (c) of this 
section), or
    (c) The amount of outstanding producer's loans (as determined under 
Sec. 1.993-4) by such DISC to members of such controlled group, over
    (ii) The amount (determined under Sec. 1.995-2 (a)(5) and (b)(2)) 
of foreign investment attributable to producer's loans treated under 
section 995(b)(1)(G) as deemed distributions by the particular DISC 
taxable as dividends for prior taxable years of that particular DISC.


Thus, for example, if the shareholders of a DISC which uses the calendar 
year as its taxable year (and which is a member of a controlled group in 
which all of the members use the calendar year as their taxable year) 
are treated under section 995(b)(1)(G) as receiving foreign investment 
attributable to producer's loans of a DISC of $0 in 1972, $10 in 1973, 
and $30 in 1974, or a total of $40, and if the smallest of the amounts 
described in subdivision (i) of this subparagraph at the end of 1975 is 
$90, then the amount of the foreign investment attributable to 
producer's loans of a DISC at the end of 1975 is $50, i.e., the

[[Page 867]]

excess (as of the close of 1975) of the smallest of the amounts 
described in subdivision (i) of this subparagraph ($90) over the sum of 
the amounts of foreign investment attributable to producer's loans 
treated under section 995(b)(1)(G) as deemed distributions by the DISC 
taxable as dividends for prior taxable years of the DISC ($40). If the 
separate corporate existence of the DISC as to which the amount 
described in subdivision (ii) of this subparagraph relates ceases to 
exist within the meaning of Sec. 1.995-4(c)(2), then such amount shall 
no longer be taken into account by the group for any purpose. For 
inclusion of amounts because of certain corporate acquisitions, see 
paragraph (d) of this section.
    (2) Controlled group; domestic and foreign member. For purposes of 
this section--
    (i) The term ``controlled group'' has the meaning assigned to such 
term by Sec. 1.993-1(k).
    (ii) The term domestic member means a domestic corporation which is 
a member of a controlled group, and the term foreign member means a 
foreign corporation which is a member of a controlled group.
    (3) Group taxable year. (i) The term group taxable year refers 
collectively to the taxable year of the DISC and to the taxable year of 
each corporation in the controlled group which includes the DISC ending 
with or within the taxable year of the DISC. Thus, for example, if a 
corporation has a subsidiary which uses the calendar year as its taxable 
year and which elects to be treated as a DISC, and if the parent has a 
taxable year ending on October 31, the ``group taxable year'' for 1973 
would refer to calendar year 1973 for the DISC and to the parent's 
taxable year ending October 31, 1973.
    (ii) In cases in which the DISC makes a return for a short taxable 
year, that is, for a taxable year consisting of a period of less than 12 
months, pursuant to section 443 and the regulations thereunder, or Sec. 
1.991-1(b)(3), the following rules shall apply--
    (a) In the case of a change in the annual accounting period of the 
DISC resulting in a short taxable year, the group taxable year refers 
collectively to the short taxable year and to the taxable year of each 
corporation in the controlled group which includes the DISC ending with 
or within the short taxable year.
    (b) In the case of a DISC which is in existence during only part of 
what would otherwise be its taxable year, the group taxable year refers 
collectively to the short period during which the DISC was in existence 
and to the taxable year of each corporation in the controlled group 
which includes the DISC ending with or within the 12-month period ending 
on the last day of the short period.
    (iii) With respect to periods prior to the first taxable year for 
which a member of the group qualified (or is treated) as a DISC, each 
group taxable year shall be determined under subdivision (i) of this 
subparagraph as if such member was in existence, it qualified as a DISC, 
and its taxable year ended on that date corresponding to the date such 
member's first taxable year ended after it qualified (or is treated) as 
a DISC whether or not the corporation which qualifies (or is treated) as 
a DISC used the same taxable year before it so qualified (or is so 
treated). Thus, for example, if a corporation which is organized on 
March 3, 1975, uses the calendar year as its taxable year, and is a 
member of a controlled group which does not include a DISC, first 
qualifies (or is treated) as a DISC for calendar year 1975, then the 
term ``group taxable year'' with respect to years prior to 1975 refers 
collectively to such prior calendar years and to the taxable year of 
each corporation in the group ending with or within such prior calendar 
years.
    (iv) For special rules in the case of a group which includes more 
than one DISC, see paragraph (g) of this section.
    (4) Amounts determined for prior years. Unless the 3-year limitation 
is properly elected under subparagraph (5) of this paragraph, the 
amounts described in paragraphs (b) (relating to net increase in foreign 
assets) and (c) (relating to actual foreign investments by domestic 
members) of this section reflect, as of the close of a group taxable 
year, amounts for all taxable years of members of the group beginning 
after December 31, 1971 (and amounts arising after December 31, 1971, or 
such other

[[Page 868]]

date prescribed in paragraph (b)(7) of this section), provided that such 
amounts relate to such group taxable year and preceding group taxable 
years. Thus, for example, if all members of a controlled group use the 
calendar year as the taxable year, and 1980 is the first taxable year 
for which any member of the group qualifies (or is treated) as a DISC, 
then, unless the 3-year limitation is elected under subparagraph (5) of 
this paragraph, the amounts described in paragraphs (b) and (c) of this 
section will be taken into account beginning with the dates specified in 
the preceding sentence. For rules as to carryovers on certain corporate 
acquisitions and reorganizations, see paragraph (d) of this section.
    (5) Three-year elective limitation. (i) A DISC may elect to take 
into account only amounts described in paragraphs (b) (relating to net 
increase in foreign assets) and (c) (relating to actual foreign 
investment by domestic members) of this section for the 3 taxable years 
of each member immediately preceding its taxable year included in that 
first group taxable year which includes a member's first taxable year 
during which it qualifies (or is treated) as a DISC. For purposes of the 
preceding sentence, determinations shall be made by reference to the 
taxable year of the issuer or transferor (as the case may be). If an 
election is made under this subdivision, the offset for uncommitted 
transitional funds under paragraph (b)(7) of this section is not 
allowed. If an election is made under this subdivision, the 3-year 
limitation applies to amounts described in paragraphs (b)(4) and (c)(1) 
and (2) of this section.
    (ii) An election under subdivision (i) of this subparagraph shall 
not apply with respect to amounts which must be carried over under 
paragraph (d) of this section in the case of certain corporate 
acquisitions and reorganizations.
    (iii) An election under subdivision (i) of this subparagraph shall 
be made by the DISC attaching to its first return, filed under section 
6011(e)(2), a statement to the effect that the 3-year limitation is 
being elected under Sec. 1.995-5(a)(5)(i).
    (6) Cumulative basis. Pursuant to section 995(d)(5), all 
determinations of amounts specified in this section are to be made on a 
cumulative basis from the 1st year (or date) provided for in this 
section. Thus, each such determination shall take into account a net 
increase or a net decrease during the year, as the case may be. However, 
if the 3-year limitation is elected under subparagraph (5) of this 
paragraph, then only amounts with respect to periods specified in such 
subparagraph (5) are amounts taken into account for years before a 
member of the group qualifies (or is treated) as a DISC. The 
computations described in this section may be made in any way chosen by 
the DISC (including a corporation being tested as to whether it 
qualifies as a DISC), provided such method results in the amount 
prescribed by this section.
    (7) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. X Corporation, which uses the calendar year as its taxable 
year, is a member of a controlled group (within the meaning of 
subparagraph (2) of this paragraph). X elects to be treated as a DISC 
beginning with 1972. The amount of foreign investment attributable to 
X's producer's loans treated under section 995(b)(1)(G) as a 
distribution taxable as a dividend as of the close of each group taxable 
year with respect to each taxable year of X from 1972 through 1975 are 
set forth in the table below, computed on the basis of the facts assumed 
(the amounts on lines (1), (2), (3), and (5) being running balances):

------------------------------------------------------------------------
         Taxable year of X             1972      1973     1974     1975
------------------------------------------------------------------------
(1) Net increase (or decrease) in       ($30)      $10     $100     $150
 foreign assets since January 1,
 1972, at close of group taxable
 year..............................
(2) Actual foreign investment at           20       60       80      140
 close of group taxable year.......
(3) Outstanding producer's loans of         0       40       90      120
 X (the DISC) as of the close of
 group taxable year................
                                    ====================================
(4) Smallest of lines (1), (2), or          0       10       80      120
 (3) (not less than zero)..........
(5) Less section 995(b)(1)(G)               0        0       10       80
 deemed distributions for prior
 taxable years (sum of lines (5)
 and (6) from prior year)..........
                                    ------------------------------------

[[Page 869]]

 
(6) Section 995(b)(1)(G) deemed             0       10       70       40
 distribution as of close of
 taxable year......................
------------------------------------------------------------------------

    (b) Net increase in foreign assets--(1) In general. (i) The term net 
increase in foreign assets when used in this section means the excess 
for the controlled group (as of the close of the group taxable year) of 
(a) the investment in foreign assets to be taken into account under 
subparagraph (2) of this paragraph over (b) the aggregate of the five 
offsets allowed by subparagraphs (3) through (7) of this paragraph.
    (ii) No amount described in this paragraph (other than amounts 
described in subparagraphs (4) and (7) of this paragraph) with respect 
to a member of the group (or foreign branch of a member) shall be taken 
into account unless it is attributable to a taxable year of such member 
beginning after December 31, 1971. For a 3-year elective limitation with 
respect to the first taxable year for which a member qualifies (or is 
treated) as a DISC, see paragraph (a)(5) of this section. For manner of 
determining amounts on a cumulative basis, see paragraph (a)(6) of this 
section.
    (2) Investments made in foreign assets. (i) For purposes of 
subparagraph (1) of this paragraph, there shall be taken into account as 
investment in foreign assets the aggregate of the amounts expended 
(within the meaning of subdivision (ii) of this subparagraph) during the 
period described in subparagraph (1)(ii) of this paragraph by all 
members of the controlled group which includes the DISC to acquire 
assets described in section 1231(b) (determined without regard to any 
holding period therein provided) which are located outside the United 
States (as defined in Sec. 1.993-7) reduced by the aggregate of the 
amounts received by all such members of the controlled group from the 
sale, exchange, or involuntary conversion of such assets described in 
section 1231(b) which are located outside the United States. For 
purposes of this section, amounts expended for assets which are 
qualified export assets (as defined in Sec. 1.993-2) of a DISC (or 
which would be qualified export assets if owned by a DISC) shall not be 
taken into account. Thus, for example, if a DISC acquires a qualified 
export asset located outside the United States, the asset is not to be 
taken into account for purposes of determining the net increase in 
foreign assets.
    (ii) As used in subdivision (i) of this subparagraph, the term 
amounts expended (or amounts received) means the amount of any money or 
the fair market value (on the date of acquisition, sale, exchange, or 
involuntary conversion) of any property (other than money) used to 
acquire (or received for) the assets described in such subdivision (i).
    (iii) For purposes of this subparagraph, an asset (other than an 
aircraft or vessel) is considered as located outside the United States 
if it was used predominantly outside the United States during the group 
taxable year. The determination as to whether such an asset is used 
predominantly outside the United States during the group taxable year in 
which it was acquired or sold, exchanged, or involuntarily converted 
shall be made by applying the rules of Sec. 1.993-3(d) except that an 
aircraft described in section 48(a)(2)(B)(i) or a vessel described in 
section 48(a)(2)(B)(iii) shall be considered located in the United 
States and all other aircraft or vessels shall be considered located 
outside the United States. Thus, for example, if a member of a 
controlled group which includes a DISC acquires a vessel which is 
documented under the laws of a foreign country, the amount expended to 
acquire that vessel is an amount described in subdivision (i) of this 
subparagraph.
    (iv) Examples. The provisions of this subparagraph may be 
illustrated by the following examples:

    Example 1. X Corporation, which uses the calendar year as its 
taxable year, is a domestic member of a controlled group (within the 
meaning of paragraph (a)(2) of this section). During 1972, in a 
transaction to which section 1031 applies, X acquires a warehouse 
located outside the United States and having a fair market value of 
$100. As consideration, X transfers $20 in cash and a warehouse located 
within the United States and having a fair market value of $80. Under 
these facts, $100 will be taken into account as investment in foreign 
assets.

[[Page 870]]

    Example 2. The facts are the same as in example 1, except that the 
warehouse transferred by X as consideration is located outside the 
United States. Under these facts, only $20 will be taken into account as 
investment in foreign assets because the amount expended for such assets 
(i.e., $100) is reduced by the fair market value of any property located 
outside the United States received in exchange for such assets (i.e., 
$80).

    (3) Depreciation with respect to all foreign assets of a controlled 
group. (i) An offset allowed by this subparagraph is the depreciation 
(determined under subdivision (ii) of this subparagraph) or depletion 
(determined under subdivision (iii) of this subparagraph) attributable 
to taxable years of the member beginning after December 31, 1971, with 
respect to all of the group's foreign assets described in subparagraph 
(2) of this paragraph including such assets acquired prior to the date 
provided in such subparagraph (2), and without regard to whether the 3-
year election in paragraph (a)(5) of this section is made. Thus, for 
example, depreciation for a taxable year of a member beginning after 
December 31, 1971, with respect to an asset described in section 1231(b) 
which is located outside of the United States and which was acquired 
during a taxable year of the member beginning before January 1, 1972, is 
an offset allowed by this subparagraph. For a further example, 
depreciation with respect to a qualified export asset is not such an 
offset.
    (ii) The depreciation taken into account under subdivision (i) of 
this subparagraph shall be--
    (a) In the case of an asset owned by a domestic member, only the 
amount allowed under section 167(b)(1) (relating to the allowance of the 
straight-line method of depreciation) and Sec. 1.162-11 (b) (relating 
to amortization in lieu of depreciation), but not the amount allowed 
under section 179 (relating to the additional first-year depreciation 
allowance).
    (b) In the case of an asset owned by a foreign member, the 
depreciation and amortization (referred to in (a) of this subdivision) 
allowable for purposes of computing earnings and profits under 
subparagraph (5)(i) of this paragraph.
    (iii) The depletion taken into account under subdivision (i) of this 
subparagraph shall be limited to cost depletion computed under sections 
611 and 612 and the regulations thereunder. Thus, percentage depletion 
is not to be taken into account in computing the offset under this 
subparagraph.
    (4) Amount of outstanding stock or debt. (i) An offset allowed by 
this subparagraph is the outstanding amount of stock (including treasury 
stock) or debt obligations of any member of the group issued, sold, or 
exchanged after December 31, 1971, by any member (whether or not the 
same member) to persons who (on the date of such issuance, sale, or 
exchange) were neither United States persons (within the meaning of 
section 7701(a)(30)) nor members of the group: Provided, That, in the 
case of a debt obligation, such obligation is not repaid within 12 
months after such issuance, sale, or exchange. Thus, for example, if 
stock is issued to a member of the group before January 1, 1972, and 
after December 31, 1971, it is sold to a person who is neither a United 
States person nor a member of the group, an offset allowed by this 
subparagraph includes the outstanding amount of such stock. For purposes 
of this subparagraph, foreign branches of United States banks are not 
considered to be United States persons.
    (ii) The outstanding amount of stock or debt obligations shall be 
determined in accordance with the following provisions:
    (a) The outstanding amount of stock or debt obligations described in 
subdivision (i) of this subparagraph is equal to the net amount 
described in (b) of this subdivision reduced (but not below zero) by the 
amount described in (c) of this subdivision.
    (b) The net amount described in this subdivision (b) is the excess 
of (1) the aggregate of the amount of money and the fair market value of 
property (other than money) transferred by persons who are not members 
of the group and who are not U.S. persons as consideration for such 
stock and debt obligations over (2) fees and commission expenses borne 
by the issuer or transferror with respect to their issuance, sale, or 
exchange.
    (c) The amount described in this subdivision (c) is the aggregate 
amount of

[[Page 871]]

money and fair market value of property (other than money) distributed 
to such persons on distributions in respect of such stock from other 
than earnings and profits or on distributions in redemption of such 
stock and the amount of principal paid pursuant to such debt 
obligations.
    (d) For purposes of this subdivision (ii), in the case of a 
redemption, the stock or debt redeemed shall be charged against the 
earliest of such stock or debt issued, sold, or exchanged in order to 
determine the amount by which the balance of outstanding stock or debt 
is to be reduced. For purposes of this subparagraph, the fair market 
value of property received as consideration shall be determined as of 
the date the transaction occurs, and a contribution to capital within 
the meaning of section 118 shall be treated as the issuance of stock.
    (iii) The provisions of subdivision (i) of this subparagraph apply 
regardless of the treatment under the Code of the transaction in which 
the stock or debt was issued, sold, or exchanged. Thus, for example, if 
X Corporation, a member of a controlled group which includes a DISC, 
acquires from a nonresident alien individual in exchange solely for X's 
voting stock all of the stock of Y Corporation pursuant to a 
reorganization as defined in section 368(a)(1)(B), the fair market value 
of the Y stock on the date of the exchange would be an offset allowed by 
this subparagraph.
    (iv) The provisions of this subparagraph may be illustrated by the 
following example:

    Example. X Corporation is a member of a controlled group (within a 
meaning of paragraph (a)(2) of this section) every member of which uses 
the calendar year as its taxable year. On January 1, 1972, X issues in a 
public offering its stock to persons described in subdivision (i) of 
this subparagraph who, in the aggregate, pay $1,000 as consideration. X 
pays $100 in underwriting fees. On the same date, X receives $425 upon 
issuing a $500 debt obligation to such persons at a discount of $75 and 
pays $25 in underwriting fees. On December 31, 1972, the offset allowed 
under this subparagraph is $1,300, i.e., ($1,000 minus $100) plus ($425 
minus $25). If, during 1973, X makes a distribution of $150 (not in 
redemption) from other than earnings and profits with respect to such 
stock, then the offset is reduced to $1,150.

    (5) Earnings and profits. (i) An offset allowed by this subparagraph 
is one-half the aggregate of the earnings and profits accumulated for 
all taxable years beginning after December 31, 1971, computed (without 
regard to any distributions from earnings and profits by a foreign 
corporation to a domestic corporation in accordance with Sec. 1.964-1 
(relating to a controlled foreign corporation's earnings and profits), 
of each foreign member of the group which is controlled directly or 
indirectly (as determined under the principles of section 958 and the 
regulations thereunder) by a domestic member of the group and each 
foreign branch of a domestic member of the group (computed as if the 
branch were a foreign corporation). The DISC is bound by any action on 
behalf of a foreign member that was taken pursuant to Sec. 1.964-
1(c)(3) or by any failure to take action by or on behalf of a foreign 
member within the time specified in Sec. 1.964-1(c)(6). With respect to 
a foreign member for which action was not previously required under 
Sec. 1.964-1(c)(6) to be taken, the DISC may take action on behalf of 
such member by attaching a statement to that effect to the return of the 
DISC under section 6011(e)(2) for the first taxable year during which it 
qualifies (or is treated) as a DISC and there is outstanding a 
producer's loan made by such DISC to a member of the controlled group 
which includes the DISC.
    (ii) If the aggregate of the accumulated earnings and profits 
described in subdivision (i) of this subparagraph is a deficit, the 
amount allowable as an offset under this subparagraph is zero.
    (6) Royalties and fees. An offset allowed by this subparagraph is 
one-half the royalties and fees paid by foreign members of the group to 
domestic members of the group and by foreign branches of domestic 
members of the group to domestic members of the group during the taxable 
years of such members beginning after December 31, 1971.
    (7) Uncommitted transitional funds. (i) An offset allowed by this 
subparagraph for the uncommitted transitional funds of the group is the 
sum described in subdivision (ii) of this subparagraph of the amount of 
certain capital raised

[[Page 872]]

under the foreign direct investment program and the amounts described in 
subdivision (iv) of this subparagraph of certain foreign excess working 
capital held on October 31, 1971.
    (ii) The amount described in this subdivision of certain capital 
raised under the foreign direct investment program is the excess (if 
any) of--
    (a) The amount of the offset allowed by subparagraph (4) of this 
paragraph, determined, however, with respect to the stock and debt 
obligations of domestic members of the group outstanding on December 31, 
1971 (including amounts treated as stock outstanding by reason of a 
contribution to capital), whether or not outstanding after such date, 
which were issued, sold, or exchanged on or after January 1, 1968, by 
any member (whether or not the same member) to persons who (on the date 
of such issuance, sale, or exchange) were neither United States persons 
(within the meaning of section 7701(a)(30)) nor members of the group, 
but only to the extent the taxpayer establishes that such amount 
constitutes a long-term borrowing (see 15 CFR 1000.324 \1\) for purposes 
of the foreign direct investment program (see 15 CFR part 1000 \1\), 
over
---------------------------------------------------------------------------

    \1\ Editorial Note: 15 CFR part 1000 was removed at 39 FR 30481, 
Aug. 23, 1974.
---------------------------------------------------------------------------

    (b) The amount (determined under paragraph (c) of this section) of 
actual foreign investment by the domestic members of the group during 
the portion of the period such stock or debt obligations have been 
outstanding prior to January 1, 1972, such determination to be made by 
substituting January 1, 1968, for the December 31, 1971, date specified 
in such paragraph (c) and by not taking into account the earnings and 
profits described in paragraph (c)(3) of this section.


For purposes of this subparagraph, foreign branches of United States 
banks are not considered to be United States persons.
    (iii)(a) A taxpayer may establish that an amount under subdivision 
(ii) (a) of this subparagraph constitutes a long-term borrowing for 
purposes of the foreign direct investment program by keeping records 
sufficient to demonstrate that appropriate reports were filed with the 
Office of Foreign Direct Investment of the Department of Commerce with 
respect to the foreign borrowing or by any other method satisfactory to 
the district director.
    (b) The amounts described in subdivision (ii) (a) of this 
subparagraph include amounts with respect to which an election under 
section 4912(c), to subject certain obligations of a United States 
person to the interest equalization tax, has been made: Provided, That 
the obligations to which such amounts relate were issued by an 
``overseas financing subsidiary'' described in 15 CFR part 1000 \1\ and 
were assumed by a United States person from such overseas financing 
subsidiary. Thus, for example, if an overseas financing subsidiary 
issues its notes to a foreign person in 1968, and such notes are assumed 
by its United States parent in 1973, which parent elects under section 
4912(c) to have the notes subject to the interest equalization tax, then 
the amount of money received by the subsidiary is an amount described in 
subdivision (ii)(a) of this subparagraph.
    (iv) The amount described in this subdivision of foreign excess 
working capital is the amount of liquid assets held by the foreign 
members of such group and foreign branches of domestic members of such 
group on October 31, 1971 (whether or not so held after such date) in 
excess of their reasonable working capital needs (as defined in Sec. 
1.993-2 (e)) on that date, but only to the extent not included in 
subdivision (ii) of this subparagraph. For purposes of this subdivision, 
the term liquid assets means money, bank deposits (not including time 
deposits), and indebtedness of any kind (including time deposits) which 
on the day acquired had a maturity of 2 years or less.
    (8) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. X Corporation, which uses the calendar year as its taxable 
year is a member of a controlled group (within the meaning of paragraph 
(a)(2) of this section). X elects to be treated as a DISC beginning with 
1972. The amount of net increase in foreign assets of the group at the 
close of each group taxable year with respect to each taxable year of X 
from 1972 through 1975 are set forth in the table below, computed on the 
basis of

[[Page 873]]

the facts assumed (the amounts on each line being running balances):

------------------------------------------------------------------------
          Taxable year of X             1972     1973     1974     1975
------------------------------------------------------------------------
(1) Investment in foreign assets....     $150     $165     $260     $300
                                     ===================================
(2) Depreciation with respect to           20       40       60       80
 foreign assets of group............
(3) Amount of stock or debt                30       30       30       30
 outstanding issued after December
 31, 1971...........................
(4) One-half earnings and profits of       40       70      100      130
 foreign members....................
(5) Royalties and fees paid by             10       15       20       20
 foreign members to domestic members
(6) Uncommitted transitional funds..       10       10       10       10
                                     -----------------------------------
(7) Sum of lines (2) through (6)....      110      165      220      270
                                     -----------------------------------
(8) Net increase in foreign assets         40        0       40       30
 (line (1) minus line (6))..........
------------------------------------------------------------------------

    (c) Actual foreign investment by domestic members. For purposes of 
determining the limitation in paragraph (a) of this section, the amount 
of the actual foreign investment by domestic members of a controlled 
group is the sum (as of the close of the group taxable year) determined 
on a cumulative basis (see paragraph (a)(6) of this section) of--
    (1) Outstanding stock or debt (including contributions to capital). 
The outstanding amount (determined in accordance with the principles of 
paragraph (b)(4)(ii) of this section, applied with respect to stock or 
debt obligations described in this subparagraph) of stock (including 
treasury stock) or debt obligations (other than normal trade 
indebtedness) of foreign members of the group issued, sold, or exchanged 
after December 31, 1971, by any person (whether or not a member) which 
is not a domestic member to domestic members of the group: Provided, 
That the outstanding amount of debt obligations of any foreign member 
shall be the greater of such amount outstanding at the close of the 
taxable year of such member or the highest such amount outstanding at 
any time during the immediately preceding 90 days,
    (2) Transfers to foreign branches. The amount of money or the fair 
market value of property (other than money) transferred by domestic 
members of the group after December 31, 1971, to foreign branches of 
such members in transactions which would, if the branch were a 
corporation, be in consideration for the sale of stock or debt 
obligations of (or a contribution of capital to) such foreign branches 
(as determined under subparagraph (1) of this paragraph), and
    (3) Earnings and profits of foreign members. One-half of the 
earnings and profits (computed in accordance with paragraph (b)(5) of 
this section for purposes of computing net increase in foreign assets) 
of foreign members of the group which are controlled directly or 
indirectly (as determined under the principles of section 958 and the 
regulations thereunder) by a domestic member of the group and foreign 
branches (treated for this purpose as a corporation) of domestic members 
of the group accumulated during the taxable years of such foreign 
members (or branches) beginning after December 31, 1971, or, if later, 
the taxable year referred to in paragraph (a)(5)(i) of this section if 
the 3-year election provided for in such paragraph (a)(5)(i) is made.
    (d) Carryovers on certain corporate acquisitions and 
reorganizations--(1) Certain corporate acquisitions. (i) If--
    (a) A member of a controlled group (``first controlled group'') 
acquires in a transaction to which section 381 applies the assets of a 
corporation which is a member of a second controlled group or acquires 
stock in such a corporation pursuant to a reorganization as defined in 
section 368(a)(1)(B) to which section 361 applies, or
    (b) A member or combination of members of the first controlled group 
acquire in a transaction not described in (a) of this subdivision a 
majority interest (as defined in paragraph (e)(2) of this section) in 
the stock of a corporation which is a member of a second controlled 
group which includes a DISC so that such DISC after the acquisition is a 
member of the new controlled group,


then, for purposes of computing foreign investment attributable to 
producer's loans with respect to the new controlled group as constituted 
after such acquisition, all amounts described in

[[Page 874]]

paragraphs (a) through (c) of this section, including the amount 
specified in paragraph (a)(1)(ii) of this section (relating to amounts 
treated under section 995(b)(1)(G) as deemed distributions by the DISC 
taxable as dividends for prior taxable years of the DISC), with respect 
to members of the second controlled group which become members of the 
new controlled group shall carry over to such new controlled group. For 
purposes of this subdivision (i), a controlled group may consist of only 
one member. With respect to certain transactions involving foreign 
corporations, see section 367.
    (ii) If a member or combination of members of a controlled group, 
immediately after an acquisition of stock to which subdivision (i) of 
this subparagraph applies, do not control the total combined voting 
power (determined under Sec. 1.957-1(b)) of the corporation whose stock 
was acquired, proper apportionment consistent with the principles of 
paragraph (e)(5) of this section shall be made with respect to amounts 
to which paragraphs (a) through (c) of this section apply.
    (iii)(a) If subdivision (i) of this subparagraph applies, then for 
purposes of determining the application of the 3-year elective 
limitation provided for in paragraph (a)(5) of this section, the rules 
in (b), (c), and (d) of this subdivision (iii) apply.
    (b) If both the ``first controlled group'' and the ``second 
controlled group'' (as those terms are defined in subdivision (i) of 
this subparagraph) include a DISC, and a DISC in either group has 
elected the 3-year limitation provided in paragraph (a)(5) of this 
section, then only those amounts taken into account under such paragraph 
(a)(5) by the electing DISC or DISC's shall be taken into account.
    (c) If one of the groups includes a DISC and the other does not, and 
if the DISC has elected the 3-year limitation provided in paragraph 
(a)(5) of this section, then, for purposes of computing foreign 
investment attributable to producer's loans with respect to the new 
controlled group as constituted after the acquisition, all amounts 
described in paragraphs (a) through (c) of this section with respect to 
members of the controlled group which did not include the DISC shall 
carry over to such new controlled group, but only to the extent provided 
in such paragraph (a)(5), computed as if the group taxable year in which 
the acquisition occurred was the first group taxable year which includes 
a member's first taxable year during which it qualifies (or is treated) 
as a DISC.
    (d) If (c) of this subdivision (iii) applies, except that the DISC 
has not elected the 3-year limitation provided in paragraph (a)(5) of 
this section, then the DISC in the new controlled group as constituted 
after the acquisition may, with respect to members of the controlled 
group which did not include the DISC, make the election provided in such 
paragraph (a)(5), and treat the year in which the acquisition occurred 
as if it were the first group taxable year which includes a member's 
first taxable year during which it qualifies (or is treated) as a DISC.
    (iv) If a majority interest, or an interest in addition to a 
majority interest, is acquired in a transaction other than a transaction 
described in subdivision (i) of this subparagraph, then the rules in 
paragraph (e) of this section (relating to the acquisition of the 
foreign assets of a corporation) apply.
    (2) Corporation ceasing to be a member. As of the date a corporation 
which is a member of a controlled group ceases to be a member of such 
group, the amounts of such group described in paragraphs (a) through (c) 
of this section will be reduced by such amounts which are attributable 
to the corporation which is no longer a member of the group.
    (e) Acquisition of a majority interest in a corporation--(1) In 
general. If paragraph (d)(1)(i) of this section (relating to certain 
corporate acquisitions in which all amounts described in paragraphs (a) 
through (c) of this section carry over) does not apply, then, for 
purposes of determining under paragraph (b)(2) of this section the 
investments made in foreign assets by a controlled group, the 
acquisition of a majority interest (as defined in subparagraph (2) of 
this paragraph) or an interest in addition to a majority interest in a 
corporation by any member or

[[Page 875]]

combination of members of the controlled group is considered an 
acquisition of the assets (to the extent provided in subparagraph (5) of 
this paragraph) of the acquired corporation by the group, including the 
assets of any foreign corporation in which the acquired corporation owns 
a majority interest (to the extent provided in subparagraph (5) of this 
paragraph). For the rules concerning the date upon which an acquisition 
of a majority interest is considered to have occurred, see subparagraph 
(3) of this paragraph.
    (2) Majority interest. For purposes of this section, a majority 
interest is more than 50 percent of the total combined voting power of 
all classes of a corporation's stock entitled to vote, as determined 
under Sec. 1.957-1(b).
    (3) Acquisition date. For purposes of this paragraph, an acquisition 
of a majority interest shall be considered to have occurred on the day 
on which the combined voting power of the group first reached the 
percentage required in subparagraph (2) of this paragraph.
    (4) Valuation of assets. For purposes of this section, the amount of 
a corporation's assets deemed acquired is the fair market value of the 
assets on the date a majority interest, or an interest in addition to a 
previously held majority interest, is acquired.
    (5) Apportionment in the case of the acquisition of less than all of 
the voting stock. (i) If the acquisition described in subparagraph (1) 
of this paragraph of a majority interest is of less than 100 percent of 
the total combined voting power of all classes of stock of the acquired 
corporation entitled to vote, then for purposes of subparagraph (1) of 
this paragraph the amount of the foreign assets of the corporation 
deemed acquired as of the day the majority interest is considered 
acquired shall be an amount equal to the fair market value of all of the 
corporation's foreign assets described in paragraph (b)(2) of this 
section as of such day multiplied by the percentage of the total 
combined voting power (determined under Sec. 1.957-1(b)) held by 
members of the group on the day the majority interest is considered 
acquired.
    (ii) If any member or combination of members of the controlled group 
hold a majority interest in a corporation, then for purposes of 
subparagraph (1) of this paragraph the acquisition of additional 
combined voting power by members of the controlled group shall be 
considered an acquisition of its foreign assets described in paragraph 
(b)(2) of this section in an amount equal to the fair market value of 
all such assets held by the foreign corporation on the date of the 
acquisition, multiplied by the increase (expressed in percentage points) 
in total combined voting power (as determined under Sec. 1.957-1(b)) 
which occurred.
    (6) Examples. The application of this paragraph may be illustrated 
by the following examples:

    Example 1. M Corporation uses the calendar year as its taxable year. 
On November 18, 1973, M acquires from A, an individual United States 
person, for $1 million cash all 10,000 shares of the voting stock of N, 
a foreign corporation. N's only asset is a warehouse located in France 
with a fair market value on the date of acquisition of $1 million. Under 
subparagraph (1) of this paragraph, the controlled group of which M is a 
member is considered to have expended $1 million for the acquisition of 
foreign assets described in paragraph (b)(2) of this section.
    Example 2. The facts are the same as in example 1, except that on 
November 18, 1973, M acquires only 80 percent of N's voting stock. M is 
considered to have expended $800,000 for the acquisition of assets 
described in paragraph (b)(2) of this section, computed as follows:

(1) Fair market value of N's foreign assets described in      $1,000,000
 paragraph (b)(2) of this section..........................
(2) Multiply by percentage of total combined voting power             .8
 of all classes of N stock entitled to vote acquired by M..
                                                            ------------
(3) Amount considered expended.............................     $800,000
                                                            ============
 

    Example 3. The facts are the same as in example 2, except that 
individual A is not a United States person, and M acquires the 80 
percent of N voting stock in exchange for cash of $100,000 and M stock 
having a fair market value on the date of the acquisition of $700,000. M 
is considered to have acquired assets described in paragraph (b)(2) of 
this section in the amount of $800,000 (see computations in example 2) 
and to have an offset under paragraph (b)(4) of this section (relating 
to outstanding stock or debt) of $700,000 (the fair market value of the 
M stock transferred to A who is not a United States person). However, 
the controlled group of which

[[Page 876]]

M is a member is not considered to have acquired any other amounts 
described in paragraphs (a) through (c) of this section with respect to 
N for taxable years prior to the taxable year of N during which the 
acquisition occurred.
    Example 4. P Corporation, which uses the calendar year as its 
taxable year, is a member of a controlled group which includes a DISC. 
During 1973, P acquires from B, an individual United States person, for 
cash, 30 percent of the total combined voting power of all classes of 
stock entitled to vote of Q, a foreign corporation. All of Q's assets 
are assets described in paragraph (b)(2) of this section. No additional 
interest in Q is acquired by members of the group during 1973. The 
controlled group of which Q is a member is not considered to have made 
any investments in foreign assets described in such paragraph (b)(2) as 
of the close of 1973.
    Example 5. Assume the same facts as in example 4. Assume further 
that during 1974, R Corporation, a member of the controlled group which 
includes P, acquires for cash 40 percent of the total combined voting 
power of all classes of stock of Q entitled to vote as follows: 20 
percent on July 31, and 20 percent on December 31. Thus, on December 31, 
1974, members of the controlled group own 70 percent of Q's voting power 
(30 + 20 + 20) and on that date are considered to have acquired a 
majority interest in Q. The fair market value of Q's assets on December 
31, 1974, is $5 million. The group is considered to have expended 
$3,500,000 for the acquisition of assets described in paragraph (b)(2) 
of this section computed as follows:

(1) Fair market value of Q's foreign assets described in      $5,000,000
 paragraph (b)(2) of this section as of the date the
 acquisition is deemed to have occurred under subparagraph
 (3) of this paragraph (December 31, 1974).................
(2) Multiply by percentage of total combined voting power             .7
 of all classes of Q stock entitled to vote held by members
 of the group on such date.................................
                                                            ------------
                                                              $3,500,000
                                                            ============
 

    Example 6. The facts are the same as in example 5. Assume further 
that on July 15, 1975, P acquires the remaining 30 percent of the total 
combined voting power of all classes of Q stock entitled to vote, and on 
such date the fair market value of Q's assets is $5,500,000. The group 
is considered to have expended $5,150,000 for the acquisition of assets 
described in paragraph (b)(2) of this section as of the close of 1975, 
computed as follows:

(1) Amount of prior years' investment......................   $3,500,000
                                                            ============
(2) Investment during 1975:
  (a) Fair market value of Q's foreign assets described in    $5,500,000
   paragraph (b)(2) of this section on July 15, 1975.......
  (b) Multiply by additional percentage acquired of total             .3
   combined voting power of all classes of Q stock entitled
   to vote.................................................
                                                            ------------
  (c) Investment during 1975...............................   $1,650,000
                                                            ============
(3) Amount considered expended for foreign assets described   $5,150,000
 in paragraph (b)(2) of this section by reason of the
 acquisition of Q stock....................................
 

    (f) Records. A DISC shall keep or be readily able to produce such 
permanent books of account or records as are sufficient to establish the 
transactions and amounts described in this section. Where applicable, 
such books of account or records shall be cumulative and shall show 
transactions and amounts of the members of the controlled group which 
includes the DISC which occurred prior to the date the DISC qualified 
(or is treated) as a DISC.
    (g) Multiple DISC's--(1) Allocation among DISC's. In the case of a 
controlled group which includes more than one DISC, the amounts 
described in paragraphs (b) and (c) of this section shall be allocated 
among the DISC's in order to determine the limitation in paragraph (a) 
of this section. Each DISC's allocable portion of these amounts shall be 
equal to the total of such amounts multiplied by a fraction the 
numerator of which is the individual DISC's outstanding producer's loans 
to members of the group, and the denominator of which is the aggregate 
amounts of outstanding producer's loans to members of the group by all 
DISC's which are members of the group.
    (2) Different taxable years. If all of the DISC's which are members 
of the controlled group do not have the same taxable year, then one such 
DISC shall on behalf of all such DISC's elect to make all computations 
under section 995(d) as if all DISC's that are members of the group use 
the same taxable year as the actual taxable year of any one of the 
DISC's. The election as to which DISC's taxable year is to be used shall 
be made by the electing DISC attaching to its first return, filed under 
section 6011(e)(2), a statement indicating which such taxable year will 
be used. Once such an election is made it may not be revoked until such 
time as all of the DISC's which are members of the group use the same 
taxable year. If this

[[Page 877]]

subparagraph applies, books and records must be kept by the group which 
are adequate to show the necessary computations under section 995(d).
    (3) This paragraph may be illustrated by the following example:

    Example. Corporation X and corporation Y are members of the same 
controlled group and each has elected to be treated as a DISC. X uses a 
taxable year ending March 31, and Y uses a taxable year ending November 
30. Notwithstanding the fact that all other members of the group use the 
calendar year as their taxable year, all computations for purposes of 
determining the amount of foreign investment attributable to producer's 
loans under section 995(d) must be made as if both DISC's use a taxable 
year ending either March 31 (X's taxable year) or November 30 (Y's 
taxable year).

[T.D. 7324, 39 FR 35114, Sept. 30, 1974, as amended by T.D. 7420, 41 FR 
20655, May 20, 1976; T.D. 7854, 47 FR 51742, Nov. 17, 1982]



Sec. 1.995-6  Taxable income attributable to military property.

    (a) Gross income attributable to military property. For purposes of 
section 995(b)(3)(A)(i), the term ``gross income which is attributable 
to military property'' includes income from the sale, exchange, lease, 
or rental of military property (as described in paragraph (c) of this 
section). The term also includes gross income from the performance of 
services which are related and subsidiary (as defined in Sec. 1.993-
1(d)) to any qualified sale, exchange, lease, or rental of military 
property. Where gross income cannot be determined on an item by item 
basis, the gross income with respect to those items not so determinable 
shall be apportioned. Such apportionment shall be accomplished using 
appropriate facts and circumstances, so that the gross income 
apportioned to sale of military property bears a reasonably close 
factual relationship to the actual gross income earned on such sales. 
The apportionment shall be based on methods which include the fair 
market value of property sold or exchanged, the fair rental value of any 
leaseholds granted, the fair market value of any related or subsidiary 
services performed in connection with such sale or leases or methods 
based on gross receipts or costs of goods sold, where appropriate.
    (b) Deductions. For purposes of section 995(b)(3)(A)(ii), deductions 
shall be properly allocated and apportioned to gross income, described 
in paragraph (a) of this section, in accordance with the rules of Sec. 
1.861-8. These deductions include all applicable deductions from gross 
income provided under part VI of subchapter B of chapter 1 of the Code.
    (c) Military property. For purposes of this section, the term 
military property means any property which is an arm, ammunition, or 
implement of war designated in the munitions list published pursuant to 
section 38 of the International Security Assistance and Arms Export 
Control Act of 1976 (22 U.S.C. 2778 which superseded 22 U.S.C. 1934) and 
the regulations thereunder (22 CFR 121.01).
    (d) Illustration. The principles of this section may be illustrated 
by the following example:
    Example. X Corporation elects to be a DISC for the first time in 
1976. X has taxable income of $50,000, of which $30,000 is attributable 
to military property and $10,000 to interest on producer's loans. The 
total deemed distributions with respect to X are as follows:

(1) Gross interest from Producer's loans in 1976.............    $10,000
(2) 50 percent of the taxable income of the DISC attributable     15,000
 to military property in 1976................................
(3) One-half of the excess of taxable income for 1976 over        12,500
 the sum of lines (1) and (2) (\1/2\ of ($50,000 minus
 $25,000))...................................................
(4) Total deemed distributions (sum of total lines (1), (2),      37,500
 and (3))....................................................
 


(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7984, 49 FR 40019, Oct. 12, 1984]



Sec. 1.996-1  Rules for actual distributions and certain deemed
distributions.

    (a) General rule. Under section 996(a)(1), any actual distribution 
(other than a distribution described in paragraph (b) of this section or 
to which Sec. 1.995-4 applies) to a shareholder by a DISC, or former 
DISC, which is made out of earnings and profits shall be treated as 
made--
    (1) First, out of ``previously taxed income'' (as defined in Sec. 
1.996-3(c)) to the extent thereof,
    (2) Second, out of ``accumulated DISC income'' (as defined in Sec. 
1.996-3(b)) to the extent thereof, and

[[Page 878]]

    (3) Third, out of ``other earnings and profits'' (as defined in 
Sec. 1.996-3(d)) to the extent thereof.
    (b) Rules for qualifying distributions and deemed distributions 
under section 995(b)(1)(G)--(1) In general. Except as provided in 
subparagraph (2), any actual distribution to meet qualification 
requirements made pursuant to Sec. 1.992-3 and any deemed distribution 
pursuant to Sec. 1.995-2(a)(5) (relating to foreign investment 
attributable to producer's loans) which is made out of earnings and 
profits shall be treated as made--
    (i) First, out of ``accumulated DISC income'' (as defined in Sec. 
1.996-3(b)) to the extent thereof.
    (ii) Second, out of ``other earnings and profits'' (as defined in 
Sec. 1.996-3(d)) to the extent thereof, and
    (iii) Third, out of ``previously taxed income'' (as defined in Sec. 
1.996-3(c)) to the extent thereof.
    (2) Special rule. For taxable years beginning after December 31, 
1975, paragraph (b)(1) of this section shall apply to one-half of the 
amount of an actual distribution made pursuant to Sec. 1.992-3 to 
satisfy the condition of Sec. 1.992-1(b) (the gross receipts test) and 
paragraph (a) of this section shall apply to the remaining one-half of 
such amount.
    (c) Exclusion from gross income. Under section 996(a)(3), amounts 
distributed out of previously taxed income shall be excluded by the 
distributee from gross income. However, see Sec. 1.996-5(b) for 
treatment as gain from the sale or exchange of property of the portion 
of an actual distribution out of previously taxed income to the extent 
it exceeds the adjusted basis of the stock with respect to which the 
distribution is made.
    (d) Priority of distributions. Under section 996(c), for purposes of 
determining their treatment under paragraphs (a), (b), and (c) of this 
section, distributions made during a taxable year shall be treated as 
being made in the following order--
    (1) Deemed distributions under Sec. Sec. 1.995-2 and 1.995-3.
    (2) Actual distributions to meet qualification requirements made 
pursuant to Sec. 1.992-3 in the order in which they are made, and
    (3) Other actual distributions in the order in which they are made.


Thus, the treatment of any distribution shall be determined after the 
divisions of earnings and profits have been properly adjusted by taking 
into account distributions of higher priority which are made or deemed 
made during the same taxable year.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. Y Corporation, which uses the calendar year as its 
taxable year elects to be treated as a DISC beginning with 1972. During 
1973, Y makes a cash distribution of $100 to X Corporation, Y's sole 
shareholder. For 1973, Y has no earnings and profits. As of the 
beginning of 1973, Y has $300 of accumulated earnings and profits, which 
consist of $70 of accumulated DISC income, $40 of previously taxed 
income, and $190 of other earnings and profits. The entire $100 
distribution is a dividend under section 316. However, $40 thereof is 
treated as made out of previously taxed income and is thus excluded from 
gross income. Accordingly, only $60 is treated as distributed out of 
accumulated DISC income and includible in gross income. See Sec. 1.246-
4 for the inapplicability of the dividend received deduction with 
respect to the entire distribution of $100.
    Example 2. Assume the same facts as in example 1, except that the 
cash distribution is designated as a distribution to meet qualification 
requirements made pursuant to Sec. 1.992-3. Under these facts, X 
includes the entire distribution in its gross income as a dividend. Of 
the $100 distributed, $70 is treated as made out of accumulated DISC 
income and the remaining $30 is treated as made out of other earnings 
and profits. The dividend received deduction under section 243 is 
available only with respect to such $30.
    Example 3. Y Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1972. As of 
the end of 1975, Y had failed to meet the gross receipts test for that 
year. In 1975 Y had $100 of taxable income, $80 of which was 
attributable to qualified export receipts and $20 of which was 
attributable to receipts that did not qualify as qualified export 
receipts. As of the beginning of 1976, Y had $300 of accumulated 
earnings and profits, which consisted of $70 of accumulated DISC income, 
$40 of previously taxed income, and $190 of other earnings and profits. 
In 1976 Y makes a cash distribution of $20 pursuant to Sec. 1.992-3 in 
order to satisfy the gross receipts test for 1975. For 1976 Y has no 
earnings and profits and no deemed distributions. The entire $20 
distribution is a dividend under section 316. Under Sec. 1.996-1(b)(2), 
half of the $20 cash distribution is treated pursuant to Sec. 1.996-
1(b)(1) and half is treated pursuant to Sec. 1.996-1(a).

[[Page 879]]

Thus, $10 is treated as distributed out of accumulated DISC income and 
is includible in gross income. The other $10 is treated as made out of 
previously taxed income and is thus excluded from gross income. As of 
the beginning of 1977, Y has $280 of accumulated earnings and profits, 
which consists of $60 of accumulated DISC income, $30 of previously 
taxed income, and $190 of other earnings and profits.

[T.D. 7324, 39 FR 35120, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51742, Nov. 17, 1982]



Sec. 1.996-2  Ordering rules for losses.

    (a) In general. Under section 996(b), if for any taxable year a 
DISC, or a former DISC, incurs a deficit in earnings and profits, such 
deficit shall be charged--
    (1) First, to other earnings and profits (as defined in Sec. 1.996-
3(d)) to the extent thereof,
    (2) Second, to accumulated DISC income (as defined in Sec. 1.996-
3(b)) to the extent thereof, subject to the special rule in paragraph 
(b) of this section,
    (3) Third, to previously taxed income (as defined in Sec. 1.996-
3(c)) to the extent thereof, and
    (4) To the extent that the amount of such deficit exceeds the sum of 
the amounts charged in accordance with subparagraphs (1), (2), and (3) 
of this paragraph, to other earnings and profits (as defined in Sec. 
1.996-3(d)).


Thus, the excess deficit charged to other earnings and profits under 
subparagraph (4) of this paragraph will create a deficit therein in the 
amount of such excess. To determine the amount of any division of 
earnings and profits for the purpose of determining under Sec. 1.996-1 
the treatment of any actual and certain deemed distributions, the 
portion of a deficit in earnings and profits chargeable under this 
paragraph to such division prior to such distribution shall be 
determined in a manner consistent with the rules in Sec. 1.316-2(b) for 
determining the amount of earnings and profits available on the date of 
any distribution.
    (b) Deficits subsequent to a disqualification. A deficit in earnings 
and profits of a DISC, or former DISC, shall not be charged to 
accumulated DISC income which has been determined is to be deemed 
distributed to the shareholders pursuant to Sec. 1.995-3 as a result of 
a revocation of election or other disqualification. Thus, in accordance 
with paragraph (a) of this section as modified by this paragraph, a 
deficit incurred by a former DISC following such a revocation or 
disqualification shall be charged first to other earnings and profits 
and then to previously taxed income with any balance being charged to 
other earnings and profits and creating a deficit therein. The preceding 
sentence shall also apply in the case of a deficit incurred by a DISC 
which has no accumulated DISC income accumulated during its current 
taxable year and all immediately preceding consecutive taxable years for 
which it was a DISC. If as a result of the application of this paragraph 
the amount of a deficit in other earnings and profits exceeds the amount 
of a deficit in accumulated earnings and profits, then upon any 
subsequent actual distribution the deficit in other earnings and profits 
shall be reduced by the lower of (1) the amount of such actual 
distribution chargeable to accumulated DISC income or previously taxed 
income or (2) the amount of such excess.
    (c) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X Corporation, which uses the calendar year as its 
taxable year, becomes a DISC beginning with 1976. In addition to other 
facts assumed in the table below, X incurs a deficit in earnings and 
profits for 1979 of $70. Such deficit is charged to the divisions of X's 
earnings and profits pursuant to paragraph (a) of this section in the 
manner set forth in such table.

------------------------------------------------------------------------
                                                                  Other
                                       Accumulated  Previously  earnings
                                       DISC income     taxed       and
                                                      income     profits
------------------------------------------------------------------------
Balance January 1, 1976..............  ...........  ..........      $50
Increase for 1976....................        $10          $8
Increase for 1977....................         10           8
Increase for 1978....................         10           8
                                      ----------------------------------
  Balance January 1, 1979............         30          24         50
Deficit for 1979 of $70:
  Charge No. 1.......................  ...........  ..........     (50)
  Charge No. 2.......................       (20)
                                      ----------------------------------
    Balance January 1, 1980..........         10    ..........        0
------------------------------------------------------------------------

    Example 2. Assume the same facts as in example 1, except that 
effective for taxable years beginning with 1979, X revokes its election 
to be treated as a DISC. Under Sec. 1.995-3,

[[Page 880]]

X has $30 of accumulated DISC income which is to be deemed distributed 
$10 per year in 1980, 1981, and 1982. The deficit in earnings and 
profits for 1979 is charged to the divisions of X's earnings and profits 
pursuant to paragraph (b) of this section in the manner set forth in the 
table below:

------------------------------------------------------------------------
                                                                  Other
                                       Accumulated  Previously  earnings
                                       DISC income     taxed       and
                                                      income     profits
------------------------------------------------------------------------
Balance January 1, 1979..............        $30         $24        $50
Deficit for 1979 of $70:.............
  Charge No. 1.......................  ...........  ..........     (50)
  Charge No. 2.......................  ...........      (20)
                                      ----------------------------------
    Balance January 1, 1980..........         30           4          0
------------------------------------------------------------------------

    Example 3. Assume the same facts as in example 2, except that the 
deficit in earnings and profits for 1979 is $120. Assume further that 
for 1980, 1981, and 1982, during which years X's shareholders are 
receiving scheduled installments of the deemed distributions of 
accumulated DISC income under Sec. 1.995-3, X, a former DISC, has 
neither earnings and profits nor a deficit in earnings and profits. The 
$120 deficit for 1979 is charged to the divisions of X's earnings and 
profits pursuant to paragraph (b) of this section in the manner set 
forth in the table below:

----------------------------------------------------------------------------------------------------------------
                                                                                             Other
                                                                  Accumulated  Previously  earnings  Accumulated
                                                                  DISC income     taxed       and      earnings
                                                                                 income     profits  and profits
----------------------------------------------------------------------------------------------------------------
Balance January 1, 1979.........................................        $30         $24        $50        $104
Deficit for 1979 of $120........................................  ...........  ..........  ........      (120)
  Charge No. 1..................................................  ...........  ..........     (50)
  Charge No. 2..................................................  ...........      (24)
  Charge No. 3..................................................  ...........  ..........     (46)
                                                                 -----------------------------------------------
    Balance January 1, 1980.....................................         30           0       (46)        (16)
Deemed distributions in 1980 under Sec. 1.995-3...............       (10)          10
                                                                 -----------------------------------------------
    Balance January 1, 1981.....................................         20          10       (46)        (16)
----------------------------------------------------------------------------------------------------------------

    Example 4. Assume the same facts as in example 3, except that on 
December 31, 1980, X makes an actual distribution of $10 out of 
previously taxed income. On January 1, 1981, X has $20 of accumulated 
DISC income, no previously taxed income, and a deficit of $36 in other 
earnings and profits. The deficit of $16 in accumulated earnings and 
profits remains the same.

[T.D. 7324, 39 FR 35120, Sept. 30, 1974]



Sec. 1.996-3  Divisions of earnings and profits.

    (a) In general. For purposes of sections 991 through 997, the 
earnings and profits of a DISC, or former DISC, shall be treated as 
composed of the following three divisions:
    (1) Accumulated DISC income (as defined in paragraph (b) of this 
section),
    (2) Previously taxed income (as defined in paragraph (c) of this 
section), and
    (3) Other earnings and profits (as defined in paragraph (d) of this 
section),
    (b) Accumulated DISC income defined. (1) Accumulated DISC income is 
that portion of a corporation's earnings and profits which were derived 
during taxable years for which it qualified as a DISC and which were 
deferred from taxation. Accumulated DISC income as of the close of each 
taxable year of the corporation is--
    (i) The amount of accumulated DISC income as of the close of the 
immediately preceding taxable year increased by,
    (ii) The amount of DISC income for the year (as determined in 
subparagraph (2) of this paragraph) and reduced (but not below zero) by,
    (iii) The items enumerated in subparagraph (3) of this paragraph.
    (2) Under section 996(f)(1), DISC income is (i) the earnings and 
profits derived by the corporation during a taxable year for which such 
corporation is a DISC minus (ii) amounts deemed distributed under Sec. 
1.995-2 other than the amount of foreign investment attributable to 
producer's loans described in Sec. 1.995-2(a)(5). For example, the 
earnings and profits of a DISC for a taxable year include any amounts 
includible in such DISC's gross income pursuant to section 951(a) 
(relating to controlled foreign corporations). Deemed distributions 
under Sec. 1.995-2(a)(5) are taken into account under subparagraph (3) 
of this paragraph as a reduction in computing accumulated DISC income.
    (3) The accumulated DISC income (as increased by DISC income for the 
year determined under subparagraph (2) of this paragraph) is reduced by 
each of the following items in the following order:
    (i) Any amount deemed distributed for such year under Sec. 1.995-3 
(relating to

[[Page 881]]

deemed distributions upon disqualification),
    (ii) Any amount of foreign investment attributable to producer's 
loans deemed distributed for such year under Sec. 1.995-2(a)(5) to the 
extent it is charged to accumulated DISC income under Sec. 1.996-
1(b)(1)(i),
    (iii) The amount of any adjustment to accumulated DISC income for 
such year under Sec. 1.966-4(b)(1), and
    (iv) To the extent they are treated, under Sec. 1.996-1 (a) or (b) 
(relating to ordering rules for distributions), as made out of 
accumulated DISC income, the amounts of any actual qualifying 
distributions pursuant to Sec. 1.992-3 in the order in which they are 
made, and thereafter by the amounts of any other actual distributions in 
the order in which they are made, except that, prior to each actual 
distribution, accumulated DISC income shall be reduced by the portion of 
any deficit in earnings and profits for the taxable year chargeable at 
that time under Sec. 1.996-2(a)(2) to accumulated DISC income.
    (4) Every distribution or other reduction in accumulated DISC income 
pursuant to subparagraph (3) of this paragraph shall be charged to the 
most recently accumulated DISC income.
    (c) Previously taxed income. Under section 996(f)(2), previously 
taxed income as of the close of each taxable year of the corporation is 
an amount equal to--
    (1) The sum of--
    (i) The amount of previously taxed income as of the close of the 
immediately preceding taxable year,
    (ii) Amounts deemed distributed for the current year under Sec. 
1.995-2 (relating to deemed distributions in qualified years),
    (iii) Amounts deemed distributed for the current year under Sec. 
1.995-3 (relating to deemed distributions upon disqualification),
    (iv) With respect to a distribution in redemption to which Sec. 
1.996-4(b)(1) applies, an amount equal to the excess (if any) of (a) the 
amount of the reduction under Sec. 1.996-4(b)(1) in accumulated DISC 
income over (b) the reduction in the corporation's earnings and profits 
(see section 312(e)), and
    (v) Any amount by which accumulated DISC income is reduced under 
paragraph (b)(3)(ii) of this section by reason of a deemed distribution 
as a dividend, under Sec. 1.995-2(a)(5), of an amount of foreign 
investment attributable to producer's loans,
    (2) Decreased (but not below zero), to the extent they are treated, 
under Sec. 1.996-1 (a) or (b) (relating to ordering rules for 
distributions), as made out of previously taxed income, by the amounts 
of any actual qualifying distributions pursuant to Sec. 1.992-3 in the 
order in which they are made, and thereafter by the amounts of any other 
actual distributions in the order in which they are made, except that, 
prior to any actual distribution, previously taxed income shall be 
reduced by the portion of any deficit in earnings and profits for the 
taxable year chargeable at that time under Sec. 1.996-2(a)(3) to 
previously taxed income.
    (d) Other earnings and profits. Under section 996(f)(3), other 
earnings and profits consist of earnings and profits other than 
accumulated DISC income and previously taxed income described 
respectively in paragraphs (b) and (c) of this section. Other earnings 
and profits as of the close of each taxable year of the corporation is 
(subject to paragraph (e) of this section) an amount equal to the amount 
of other earnings and profits as of the close of the immediately 
preceding taxable year decreased (if necessary, below zero) in the 
following order by--
    (1) To the extent they are treated, under Sec. 1.996-1 (a) or (b) 
(relating to ordering rules for distributions), as made out of other 
earnings and profits, the amounts of any actual qualifying distributions 
pursuant to Sec. 1.992-3 in the order in which they are made, and 
thereafter the amounts of any other actual distributions in the order in 
which they are made, except that, prior to any actual distribution, 
other earnings and profits shall be reduced by the portion of any 
deficit in earnings and profits for the taxable year chargeable at that 
time under Sec. 1.996-2(a)(1) to other earnings and profits, and
    (2) With respect to a distribution in redemption to which Sec. 
1.996-4(b)(1) applies, an amount equal to the excess (if any) of (a) the 
reduction in the corporation's earnings and profits (see section 312(e)) 
over (b) the amount of the

[[Page 882]]

reduction under Sec. 1.996-4(b)(1) in accumulated DISC income.
    (e) Distributions in kind. (1) For purposes of determining, under 
paragraphs (b), (c), and (d) of this section, the amount by which any 
division of earnings and profits is reduced by reason of a distribution 
of property (other than money or the DISC's, or former DISC's, own 
obligations), the amount of such distribution is the fair market value 
of such property at the time of the distribution.
    (2) For any taxable year in which the DISC makes a distribution of 
such property, the amount of other earnings and profits determined under 
paragraph (d) of this section (without regard to this subparagraph) 
shall be--
    (i) Increased by the excess (if any) of the amount of such 
distribution treated as a dividend under section 316(a) over the 
adjusted basis of such property, and
    (ii) Decreased by the excess (if any) of the adjusted basis of such 
property over the amount of such distribution treated as a dividend 
under section 316 (a).


Each item of property shall be considered separately for purposes of 
making the adjustment under this subparagraph.
    (f) Examples. The provisions of Sec. Sec. 1.996-1, 1.996-2, and 
this section may be illustrated by the following examples:

    Example 1. M Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1974. During 
1975, M derives no earnings and profits and makes no deemed or actual 
distributions, except that on December 31, 1975, M's shareholders are 
treated as having received a dividend distribution of $100 under Sec. 
1.995-2 (a)(5) (relating to foreign investment attributable to 
producer's loans). M's earnings and profits are adjusted as shown on 
line (2) of the table below on the basis of facts assumed therein.

----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                                  earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1975...................................         $450         $100        $250        $100
(2) Adjustments (see paragraphs (b)(3)(ii) and (c)(1)(v) of               0        (100)         100           0
 this section)................................................
                                                               -------------------------------------------------
(3) Balance January 1, 1976...................................          450            0         350         100
----------------------------------------------------------------------------------------------------------------

    Example 2. N Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1972. During 
1973, N derives no earnings and profits for the year and makes no deemed 
or actual distributions, except that A, a shareholder, realized $200 of 
gain upon receiving an actual cash distribution of $300 in redemption of 
N stock having an adjusted basis of $100 in his hands. The redemption is 
treated as an exchange under section 302(a) but, under section 995(c), A 
includes the $200 of gain in his gross income as a dividend. Assuming 
that, under section 312(e), $240 is properly chargeable to capital 
account of N and that, under Sec. 1.996-4(b), accumulated DISC income 
is reduced by $200, N's accounts are adjusted on line (2) of the table 
below on the basis of facts assumed therein.

----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                       Capital    earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1973.........................    $2,000         $400         $300        $100           0
(2) Adjustments (see Sec. 1.996-4(b) and paragraph     (240)         (60)        (200)         140           0
 (c)(1)(iv) of this section)........................
                                                     -----------------------------------------------------------
(3) Balance January 1, 1974.........................     1,760          340          100         240           0
----------------------------------------------------------------------------------------------------------------

    Example 3. P Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1973. During 
1974, P derives no earnings and profits for the year and makes no deemed 
or actual distributions, except for a distribution to B, its sole 
shareholder, of property with a fair market value of $100 and an 
adjusted basis in P's

[[Page 883]]

hands of $40. Under Sec. 1.996-1(a)(1), B treats the entire amount of 
the distribution as being made out of previously taxed income and, under 
Sec. 1.996-1(c), excludes it from his gross income. P's earnings and 
profits, divisions are adjusted on lines (2) and (3) of the table below 
on the basis of facts assumed therein.

----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                                  earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1974...................................         $200          $80        $120           0
(2) Adjustment under paragraphs (c)(2) and (e)(1) this section         (40)            0       (100)           0
(3) Adjustment under paragraph (e)(2)(i) of this section......            0            0           0         $60
                                                               -------------------------------------------------
(4) Balance January 1, 1975...................................          160           80          20          60
----------------------------------------------------------------------------------------------------------------

    Example 4. Q Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1974. On 
January 1, 1975, Q has accumulated earnings and profits of $1,200 and, 
during 1975, Q incurs a deficit in earnings and profits of $365. The 
amount of such deficit incurred as of any date before the close of 1975 
cannot be shown. On July 1, 1975, Q makes a cash distribution of $650, 
with respect to its stock to C, Q's sole shareholder. C subsequently 
transfers by gift all of his Q stock to D. On December 31, 1975, Q makes 
a cash distribution of $650, with respect to its stock, to D. Under 
these facts and additional facts assumed in the table below, C is 
treated as having received a dividend of $650 of which $320 is treated 
as distributed out of previously taxed income and excluded from gross 
income. D is treated as receiving a dividend of $186. Adjustments to Q's 
earnings and profits accounts are illustrated in the table below:

----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                                  earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1975...................................       $1,200         $800        $320         $80
(2) Portion of 1975 deficit of $365 chargeable as of June 30,         (181)        (101)           0        (80)
 1975, pursuant to Sec. 1.996-2(a)..........................
                                                               -------------------------------------------------
(3) Balance July 1, 1975......................................        1,019          699         320           0
(4) $650 distributed to C on July 1, 1975.....................        (650)        (330)       (320)           0
(5) Portion of 1975 deficit of $365 chargeable as of December         (183)        (183)           0           0
 30, 1975, pursuant to Sec. 1.996-2(a)......................
                                                               -------------------------------------------------
(6) Balance December 31, 1975.................................         $186         $186           0           0
(7) $650 distributed to D on December 31, 1975 \1\............        (186)        (186)           0           0
                                                               -------------------------------------------------
(8) Balance January 1, 1976...................................            0            0           0           0
----------------------------------------------------------------------------------------------------------------
\1\ $60 treated as return of capital pursuant to section 301(c)(2).

    Example 5. (1) Facts. R Corporation, which uses the calendar year as 
its taxable year elects to be treated as a DISC beginning with 1972. X 
Corporation is its sole shareholder. At the beginning of 1974, R has a 
deficit in earnings and profits of $60 all of which is composed of 
``other earnings and profits''. For 1974, R has earnings and profits of 
$80 before reduction for any distributions and taxable income of $70. On 
June 15, 1974, R makes a cash distribution to X of $60, with respect to 
its stock, to which section 301 applies. On August 15, 1974, R makes a 
cash distribution to X of $30 designated as a distribution to meet 
qualification requirements pursuant to Sec. 1.992-3. Under Sec. 1.995-
2(a), X is deemed to receive, on December 31, 1974, a distribution of a 
dividend of $35, i.e., one-half of R's taxable income of $70. The tax 
consequences of these facts to X and their effect on R's earnings and 
profits are set forth in the subsequent subparagraphs of this example.
    (2) Dividend treatment of actual distributions. Since R had $80 of 
earnings and profits for 1974 and a deficit in accumulated earnings and 
profits at the beginning of 1974, only $80 of the actual distributions 
($90) are treated as dividends under sections 301(c)(1) and 316(a)(2). 
($10 of the actual distribution, which is not treated as a dividend is 
treated in the manner specified in section 301(c) (2) and (3).) Thus, 
under Sec. 1.316-2(b), $26.67 of the actual qualifying distribution 
made on August 15, 1974 ($30 x $80/$90), and $53.33 of the actual 
distribution made on June 15, 1974 ($60 x $80/$90), are considered made 
out of earnings and profits.
    (3) Priority of distributions. Under Sec. 1.996-1(d), for purposes 
of adjusting the divisions of R's earnings and profits and determining

[[Page 884]]

the treatment of subsequent distributions, the sequence in which each 
distribution is treated as having been made is--
    (i) First, the deemed distribution of $35,
    (ii) Second, the actual qualifying distribution of $30 made on 
August 15, 1974, pursuant to Sec. 1.992-3, and
    (iii) Finally, the actual distribution of $60 made on June 15, 1974.
    (4) Treatment and effect of deemed distribution. Under Sec. 1.995-
2(a), on December 31, 1974, X includes the deemed distribution of $35 in 
its gross income as a dividend. Under paragraph (c)(1)(ii) of this 
section, R's previously taxed income is increased by $35 as shown on 
line (3) of the table in subparagraph (7) of this example. Under 
paragraph (b)(1)(ii) and (2) of this section, accumulated DISC income is 
increased by $45 of DISC income, i.e., R's earnings and profits for 
1974, $80, minus the deemed distribution of $35, as shown on line (4) of 
the table.
    (5) Treatment and effect of actual qualifying distribution of $30. 
As indicated in subparagraph (2) of this example, $26.67 of the $30 
qualifying distribution on August 15, 1974, is treated as made out of 
earnings and profits for 1974. Under Sec. 1.996-1(b)(1)(i), the entire 
$26.67 is treated as distributed out of accumulated DISC income. Thus, 
on August 15, 1974, X includes $26.67 in its gross income as a dividend. 
No deduction is allowable under section 243. Under paragraph (b)(3)(iv) 
of this section, R's accumulated DISC income is reduced by $26.67 as 
shown on line (6) of the table in subparagraph (7) of this example.
    (6) Treatment and effect of actual distribution of $60. As indicated 
in subparagraph (2) of this example, $53.33 of the $60 distribution on 
June 15, 1974, is treated as made out of earnings and profits for 1974. 
Under Sec. 1.996-1(a), the $53.33 is treated as distributed out of 
previously taxed income to the extent thereof, $35, and then out of 
accumulated DISC income, $18.33. Thus, on June 15, 1974, X includes 
$18.33 in its gross income as a dividend. Under Sec. 1.996-1(c), the 
distribution of $35 out of previously taxed income is excluded from 
gross income. No deduction is allowable under section 243 with respect 
to the actual distribution of $53.33. Under paragraph (b)(3)(iv) of this 
section, accumulated DISC income is reduced by $18.33 and, under 
paragraph (c)(2) of this section, previously taxed income is reduced by 
$35, as shown on line (7) of the table in subparagraph (7) of this 
example.
    (7) Summary. The effects on earnings and profits and the divisions 
of earnings and profits are summarized in the following table:

----------------------------------------------------------------------------------------------------------------
                                                   Earnings   Accumulated                Previously     Other
                                                 and profits    earnings   Accumulated     taxed       earnings
                                                   for year   and profits  DISC income     income    and profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1974....................  ...........     ($60.00)  ...........  ...........     ($60.00)
(2) Earnings and profits for year before              $80.00
 reduction for distributions...................
(3) Deemed distribution of $35 to X on December  ...........  ...........  ...........       $35.00
 31, 1974, under Sec. 1.995-2(a).............
(4) DISC income for 1974 of $45 as defined in    ...........  ...........       $45.00
 paragraph (b)(2) of this section (line 2 ($80)
 minus line 3 ($35))...........................
                                                ----------------------------------------------------------------
(5) Balance before actual distributions........        80.00      (60.00)        45.00        35.00      (60.00)
(6) Qualifying distribution of $30 to X on           (26.67)  ...........      (26.67)
 August 15, 1974, pursuant to Sec. 1.992-3...
(7) Actual distribution to P of $60 on June 15,      (53.33)  ...........      (18.33)      (35.00)
 1974..........................................
                                                ----------------------------------------------------------------
(8) Balance January 1, 1975....................            0      (60.00)            0  ...........      (60.00)
----------------------------------------------------------------------------------------------------------------

    Example 6. Assume the facts are the same as in example 5, except 
that at the beginning of 1974 R's accumulated earnings and profits 
amount to $60 consisting of accumulated DISC income of $20, previously 
taxed income of $10, and other earnings and profits of $30. In addition, 
on August 1, 1974, X transfers all R's stock to Y Corporation in a 
reorganization described in section 368(a)(1)(B) in which under section 
354 X recognizes no gain or loss. Under these facts, X includes in its 
gross income for 1974 a dividend of $15 which is attributable to the 
actual distribution of $60 paid out of earnings and profits on June 15, 
1974. X excludes from gross income the balance of the $60 distribution 
($45) paid out of earnings and profits because, under Sec. 1.996-1(a), 
it is treated as paid out of previously taxed income. Y includes in its 
gross income for 1974 a dividend of $65 of which $35 is attributable to 
the deemed distribution of a dividend to Y on December 31, 1974, under 
Sec. 1.995-2(a) and $30 is attributable to the qualifying distribution 
paid out of earnings and profits to Y on August 15, 1974. The 
adjustments to R's earnings and profits are summarized in the following 
table:

[[Page 885]]



----------------------------------------------------------------------------------------------------------------
                                                   Earnings   Accumulated                Previously     Other
                                                 and profits    earnings   Accumulated     taxed       earnings
                                                   for year   and profits  DISC income     income    and profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1974....................  ...........          $60          $20          $10          $30
(2) Earnings and profits for year before                 $80
 reduction for distributions...................
(3) Deemed distribution of $35 to Y on December  ...........  ...........  ...........           35
 31, 1974, under Sec. 1.995-2(a).............
(4) DISC income for 1974 of $45 as defined in    ...........  ...........           45
 paragraph (b)(2) of this section (line 2 ($80)
 minus line 3 ($35))...........................
                                                ----------------------------------------------------------------
(5) Balance before actual distributions........           80           60           65           45           30
(6) Qualifying distribution of $30 to Y on           (26.67)       (3.33)         (30)
 August 15, 1974, pursuant to Sec. 1.992-3...
(7) Actual distribution to X of $60 on June 15,      (53.33)       (6.67)         (15)         (45)
 1974..........................................
                                                ----------------------------------------------------------------
(8) Balance January 1, 1975....................  ...........           50           20            0           30
----------------------------------------------------------------------------------------------------------------

    (g) DISCs having corporate and noncorporate shareholders. In the 
case of a DISC having one or more corporate shareholders but less than 
all of its shareholders subject to the special rules of section 
291(a)(4), relating to certain deferred DISC income as a corporate 
preference item, accumulated DISC income and previously taxed income of 
the DISC are divided between the corporate shareholders, as a class, and 
the other shareholders, as a class, in proportion to amounts of DISC 
income not deemed distributed and amounts deemed distributed to each 
class. Subsequent taxation of actual and qualifying distributions shall 
be based upon this division. Thus, if a DISC is owned 50 percent by 
corporate shareholders and 50 percent by individual shareholders and has 
undistributed taxable income of $2,000 for its year, the division is 
made as follows:

Corporate shareholders:
    Previously taxed income (57.5% of $2,000 / 2)..........         $575
    Accumulated DISC income (42.5% of $2,000 / 2)..........          425
Individual shareholders:
    Previously taxed income (50% of $2,000 / 2)............          500
    Accumulated DISC income (50% of $2,000 / 2)............          500
 


(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat. 917, 26 U.S.C. 7805))

[T.D. 7324, 39 FR 35121, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51742, Nov. 17, 1982; T.D. 7984, 49 FR 40024, Oct. 12, 1984]



Sec. 1.996-4  Subsequent effect of previous disposition of DISC stock.

    (a) Shareholder adjustment for previously taxed income. (1) Under 
section 996(d)(1), except as provided in subparagraph (2) of this 
paragraph, if--
    (i) Gain with respect to a share of stock of a DISC, or former DISC, 
is treated under Sec. 1.995-4 as a dividend, and
    (ii) With respect to such share, any person subsequently receives an 
actual distribution made out of accumulated DISC income, or a deemed 
distribution made, pursuant to Sec. 1.995-3, by reason of 
disqualification, out of accumulated DISC income,


then such person shall treat such distribution in the same manner as a 
distribution from previously taxed income (and thus excludable from 
gross income under Sec. 1.996-1(c)) to the extent that the gain 
referred to in subdivision (i) of this subparagraph exceeds the 
aggregate amount of any other distributions with respect to such share 
which were treated under this subparagraph as made from previously taxed 
income.
    (2) In applying subparagraph (1) of this paragraph with respect to a 
share of stock in a DISC, or former DISC, the gain referred to in 
subparagraph (1)(i) of this paragraph does not include any gain to a 
shareholder on a redemption of such share which qualifies as an exchange 
under section 302(a) or any gain on a disposition of such share prior to 
such redemption. Distributions described in subparagraph (1)(ii) of this 
paragraph do not include a distribution in a redemption which qualifies 
as an

[[Page 886]]

exchange under section 302(a). For adjustments to accumulated DISC 
income by reason of dividend treatment under Sec. 1.995-4 with respect 
to gain upon a redemption of DISC stock to which section 302(a) applies 
and upon a prior disposition of such stock, see paragraph (b) of this 
section.
    (3) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. In 1974, under Sec. 1.995-4, A, a shareholder of a DISC, 
on the sale of his DISC stock to B, is required to treat $20 of his gain 
as a dividend. The DISC has no previously taxed income and $40 of 
accumulated DISC income. Subsequently in the same year, B, the purchaser 
of the stock, receives an actual dividend distribution of $15 with 
respect to such stock which, under Sec. 1.996-1(a), is treated as made 
out of accumulated DISC income. The amounts of the DISC's previously 
taxed income and accumulated DISC income were not adjusted by reason of 
the $20 treated as a dividend on the prior sale. However, even though 
the DISC had no previously taxed income, the purchaser would treat the 
$15 as though it had been paid out of previously taxed income and, 
therefore would not include the $15 in gross income. If in 1975, B 
receives another actual distribution of $9 with respect to such stock, 
$5 (i.e., $20 dividend on A's sale less the $15 distribution to B in 
1974 which was treated under subparagraph (1) of this paragraph as made 
from previously taxed income) is treated as made from previously taxed 
income and excluded from gross income. The result would be the same if, 
on January 1, 1975, B had transferred such stock to C by gift and the $9 
distribution had been made to C.

    (b) Corporate adjustment upon redemption. (1) Under section 
996(d)(2), if by reason of Sec. 1.995-4 gain on a redemption of stock 
in a DISC, or former DISC, is included in the shareholder's gross income 
as a dividend, then the accumulated DISC income shall be reduced by an 
amount equal to the sum of--
    (i) The amount of gain on such redemption which, under Sec. 1.995-
4, is treated as a dividend, and
    (ii) The amount of any gain with respect to such redeemed stock 
which, under Sec. 1.995-4, was treated as a dividend on a disposition 
prior to such redemption minus the amount of distributions with respect 
to such stock which have been treated as made out of previously taxed 
income by reason of the application of paragraph (a)(1) of this section.
    (2) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. The entire stock of a DISC, which uses the calendar year 
as its taxable year, has been owned equally by A, B, C, and D since it 
was organized. At the close of 1976, when the DISC has $100 of 
accumulated DISC income, it redeems all of A's shares in a transaction 
qualifying as an exchange under section 302(a) and A, under Sec. 1.995-
4, includes $25 in his gross income as a dividend. The redemption has 
the effect of reducing accumulated DISC income by $25 to $75.
    Example 2. Assume the same facts as in example 1 except that the 
stock of the DISC has not been held equally by A, B, C, and D since its 
organization. A purchased his shares from X in 1974 in a transaction in 
which X, under Sec. 1.995-4, included in his gross income $30 as a 
dividend. In 1975, A receives a distribution of $10 out of accumulated 
DISC income which, under paragraph (a)(1) of this section, is treated as 
made out of previously taxed income. Under these facts, the redemption 
of A's stock in 1976 has the effect of reducing accumulated DISC income 
by $45 to $55 determined as follows:

(a) Accumulated DISC income.......................  .........       $100
(b) Minus sum of:
  (1) Dividend on redemption of A's stock.........        $25
  (2) Excess of dividend on X's sale ($30) over           $20
   distribution to A treated as made out of
   previously taxed income ($10)..................
    Total.........................................  .........         45
                                                              ----------
(c) Accumulated DISC income on 12/31/76......................         55
 


[T.D. 7324, 39 FR 35121, Sept. 30, 1974]



Sec. 1.996-5  Adjustment to basis.

    (a) Addition to basis. Under section 996(e)(1) amounts representing 
deemed distributions as provided in section 995(b) shall increase the 
basis of the stock with respect to which the distribution is made.
    (b) Reductions of basis. Under section 996(e)(2), the portion of an 
actual distribution treated as made out of previously taxed income shall 
reduce the basis of the stock with respect to which it is made and, to 
the extent that it exceeds the adjusted basis of such stock, shall be 
treated as gain from the sale or exchange of property. In the case of 
stock includible in the gross estate of a decedent for which an election 
is made under section 2032 (relating to alternate valuation), this 
paragraph shall not apply to any distribution made after the date of the

[[Page 887]]

decendent's death and before the alternate valuation date provided by 
section 2032. See section 1014(d) for a special rule for determining the 
basis of stock in a DISC, or former DISC, acquired from a decedent.

[T.D. 7324, 39 FR 35124, Sept. 30, 1974]



Sec. 1.996-6  Effectively connected income.

    In the case of a shareholder who is a nonresident alien individual 
or a foreign corporation, trust, or estate, amounts taxable as dividends 
by reason of the application of Sec. 1.995-4 (relating to gain on 
disposition of stock in a DISC), amounts treated under Sec. 1.996-1 as 
distributed out of accumulated DISC income, and amounts deemed 
distributed under Sec. 1.995-2(a) (1) through (4) shall be treated as 
gains and distributions which are effectively connected with the conduct 
of a trade or business conducted through a permanent establishment of 
such shareholder within the United States, and shall be subject to tax 
in accordance with the provisions of section 871(b) and the regulations 
thereunder in the case of nonresident alien individuals, trusts, or 
estates, or section 882 and the regulations thereunder in the case of 
foreign corporations. In no case, however shall other income of such 
shareholder be taxable as effectively connected with the conduct of a 
trade or business through a permanent establishment in the United States 
solely because of the application of this section.

[T.D. 7324, 39 FR 35124, Sept. 30, 1974]



Sec. 1.996-7  Carryover of DISC tax attributes.

    (a) In general. Carryover of a DISC's divisions of earnings and 
profits to acquiring corporations in nontaxable transactions shall be 
subject to rules generally applicable to other corporate tax attributes. 
For example, a DISC which acquires the assets of another DISC in a 
transaction to which section 381(a) applies shall succeed to, and take 
into account, the divisions of the earnings and profits of the 
transferor DISC in accordance with section 381(c)(2).
    (b) Allocation of divisions of earnings and profits in corporate 
separations. (1) If one DISC transfers part of its assets to a 
controlled DISC in a transaction to which section 368(a)(1)(D) applies 
and immediately thereafter the stock of the controlled DISC is 
distributed in a distribution or exchange to which section 355 (or so 
much of section 356 as relates to section 355) applies, then--
    (i) The earnings and profits of the distributing DISC immediately 
before the transaction shall be allocated between the distributing DISC 
and the controlled DISC in accordance with the provisions of Sec. 
1.312-10.
    (ii) Each of the divisions of such earnings and profits, namely 
previously taxed income, accumulated DISC income, and other earnings and 
profits, shall be allocated between the distributing DISC and the 
controlled DISC on the same basis as the earnings and profits are 
allocated.
    (iii) Any assets of the distributing DISC whose status as qualified 
export assets is limited by its accumulated DISC income (e.g., 
producer's loans described in Sec. 1.993-4, Export-Import Bank and 
other obligations described in Sec. 1.993-2(h), and financing 
obligations described in Sec. 1.993-2(i)) shall be treated as having 
been allocated, for the purpose of determining the classification of 
such assets in the hands of the distributing DISC or the controlled 
DISC, on the same basis as the earnings and profits are allocated 
regardless of how such assets are actually allocated.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. On January 1, 1974, P Corporation transfers part of its 
assets to S Corporation, a newly organized subsidiary of P, in a 
transaction described in section 368(a)(1)(D) and distributes all the S 
stock in a transaction which qualifies under section 355. Immediately 
before such transfer, P had earnings and profits of $120,000 of which 
$100,000 constitutes accumulated DISC income. The unpaid balance of P's 
producer's loans is $80,000 all of which is retained by P. Pursuant to 
Sec. 1.312-10, 25 percent of P's accumulated DISC income is allocated 
to S (i.e., $25,000). P's producer's loans will be treated as allocated 
to S in the same proportion. Accordingly, for purposes of determining, 
under Sec. 1.993-4(a)(3), the amount of producer's loans which S is 
entitled to make, S is treated as having an unpaid balance of producer's 
loans of $20,000 (i.e., 25% x $80,000) and P is treated as having an 
unpaid balance of $60,000 (i.e., 75% x $80,000).


[[Page 888]]


    (c) Accumulated DISC income accounts of separate DISC's maintained 
after corporate combination. If two or more DISC's combine to form a new 
DISC, or if the assets of one DISC are acquired by another DISC, in a 
transaction described in section 381(a), accumulated DISC income of the 
acquired DISC or DISC's shall carry over and be taken into account by 
the acquiring or new DISC, except that a separate account shall be 
maintained for the accumulated DISC income of any DISC scheduled to be 
received as a deemed distribution by its shareholders under Sec. 1.995-
3 (relating to deemed distributions upon disqualification). If, as a 
part of such transaction, the stock of the DISC which has accumulated 
DISC income scheduled to be deemed distributed is exchanged for stock of 
the acquiring or new DISC to which such accumulated DISC income is 
carried over and which maintains a separate account, then such 
accumulated DISC income shall be deemed distributed pro rata to 
shareholders of the acquiring or new DISC on the basis of stock 
ownership immediately after the exchange.

[T.D. 7324, 39 FR 35125, Sept. 30, 1974]



Sec. 1.996-8  Effect of carryback of capital loss or net operating 
loss to prior DISC taxable year.

    (a) Under Sec. 1.995-2(e), the deduction under section 172 for a 
net operating loss carryback or under section 1212 for a capital loss 
carryback is determined as if the DISC were a domestic corporation which 
had not elected to be treated as a DISC. A carryback of a net operating 
loss or of a capital loss of any corporation which reduces its taxable 
income for a preceding taxable year for which it qualified as a DISC 
will have the consequences enumerated in paragraphs (b) through (e) of 
this section.
    (b) For such preceding taxable year, the amount of a deemed 
distribution of one-half of certain taxable income described in Sec. 
1.995-2(a)(4) will ordinarily be reduced in effect (but not below zero) 
by one-half of the sum of the amount of the deduction under section 172 
for such year for net operating loss carrybacks and the amount of the 
deduction under section 1212 for such year for capital loss carrybacks.
    (c) The amount of reduction in the deemed distribution under 
paragraph (b) of this section will have the effect of increasing the 
limitation, provided in Sec. 1.995-2(b)(2), on the amount of foreign 
investment attributable to producer's loans which is deemed distributed 
under Sec. 1.995-2(a)(5).
    (d) If the amount of a deemed distribution for a preceding taxable 
year is reduced as described in paragraph (b) of this section, then for 
such preceding taxable year the previously taxed income (as defined in 
Sec. 1.996-3(c)) shall be decreased by the amount of such reduction and 
the accumulated DISC income (as defined in Sec. 1.996-3(b)) shall be 
increased by the amount of such reduction. Such adjustments shall be 
made as of the time the deemed distribution for such preceding taxable 
year is treated as having occurred. See Sec. 1.996-1(d) for the 
priority of such deemed distribution in relation to other distributions 
made in that preceding taxable year.
    (e) The amount and treatment of any actual distribution made in such 
preceding taxable year or a year subsequent to such preceding year, and 
the treatment of gain on a disposition (in any such year) of the DISC's 
stock to which Sec. 1.995-4 applies, shall be properly adjusted to 
reflect the adjustments to previously taxed income and accumulated DISC 
income described in paragraph (d) of this section.

[T.D. 7324, 39 FR 35125, Sept. 30, 1974]



Sec. 1.997-1  Special rules for subchapter C of the Code.

    (a) For purposes of applying the provisions of sections 301 through 
395 of the Code, any distribution in property to a corporation by a 
DISC, or former DISC, which is made out of previously taxed income or 
accumulated DISC income shall be treated as a distribution in the same 
amount as if such distribution of property were made to an individual, 
and have a basis, in the hands of the recipient corporation, equal to 
such amount treated as having been distributed.
    (b) This section may be illustrated by the following example:

    Example. X Corporation is the sole shareholder of Y Corporation 
which is a DISC. Y makes an actual distribution of property to

[[Page 889]]

X with respect to X's stock in Y. The property has a basis of $50 and a 
fair market value of $100. The distribution is treated as made out of 
accumulated DISC income under section 996(a) and is taxable as a 
dividend under section 301(c)(1). Even though X is a corporation, the 
amount of the distribution is $100 notwithstanding the provisions of 
section 301(b)(1)(B) and the basis the property in X's hands is $100 
notwithstanding the provisions of section 301(d)(2).

[T.D. 7324, 39 FR 35125, Sept. 30 1974]



Sec. Sec. 1.998-1.1000  [Reserved]

[[Page 891]]



                              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 893]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2021)

                      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 894]]

     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 895]]

    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  U.S. International Development Finance 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 896]]

     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  Agricultural Marketing Service (Federal Grain 
                Inspection Service, Fair Trade Practices Program), 
                Department of Agriculture (Parts 800--899)

[[Page 897]]

        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  (Parts 1600--1699) [Reserved]
      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  (Parts 2200--2299) [Reserved]
       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 898]]

         L  Rural Business-Cooperative Service, Rural Housing 
                Service, and Rural Utilities Service, Department 
                of Agriculture (Part 5001)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (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  Agricultural Marketing Service (Fair Trade Practices 
                Program), 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  (Parts 900--999) [Reserved]
         X  Bureau of Consumer Financial Protection (Parts 1000--
                1099)

[[Page 899]]

        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research, Department of the 
                Treasury (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)

[[Page 900]]

      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)
      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]

[[Page 901]]

                     Title 20--Employees' Benefits

         I  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 1--199)
        II  Railroad Retirement Board (Parts 200--399)
       III  Social Security Administration (Parts 400--499)
        IV  Employees' Compensation Appeals Board, Department of 
                Labor (Parts 500--599)
         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  United States Agency for Global Media (Parts 500--599)
       VII  U.S. International Development Finance 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)

[[Page 902]]

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)
        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)
       III  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 1300--1399)

                Title 24--Housing and Urban Development

            Subtitle A--Office of the Secretary, Department of 
                Housing and Urban Development (Parts 0--99)
            Subtitle B--Regulations Relating to Housing and Urban 
                Development
         I  Office of Assistant Secretary for Equal Opportunity, 
                Department of Housing and Urban Development (Parts 
                100--199)
        II  Office of Assistant Secretary for Housing-Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 200--299)
       III  Government National Mortgage Association, Department 
                of Housing and Urban Development (Parts 300--399)
        IV  Office of Housing and Office of Multifamily Housing 
                Assistance Restructuring, Department of Housing 
                and Urban Development (Parts 400--499)
         V  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 500--599)
        VI  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 600--699) [Reserved]
       VII  Office of the Secretary, Department of Housing and 
                Urban Development (Housing Assistance Programs and 
                Public and Indian Housing Programs) (Parts 700--
                799)
      VIII  Office of the Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Section 8 Housing Assistance 
                Programs, Section 202 Direct Loan Program, Section 
                202 Supportive Housing for the Elderly Program and 
                Section 811 Supportive Housing for Persons With 
                Disabilities Program) (Parts 800--899)
        IX  Office of Assistant Secretary for Public and Indian 
                Housing, Department of Housing and Urban 
                Development (Parts 900--1699)
         X  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Interstate Land Sales 
                Registration Program) [Reserved]
       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)

[[Page 903]]

      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

                           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--799)

                   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)

[[Page 904]]

                            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)
        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)

[[Page 905]]

        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)
      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  Department of Defense, 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  Great Lakes St. 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

[[Page 906]]

         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)
        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)

[[Page 907]]

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

                       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)
        IX  Federal Permitting Improvement Steering Council (Part 
                1900)

          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  (Parts 103-001--104-099) [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]

[[Page 908]]

            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)
       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

[[Page 909]]

        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)
         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        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)

[[Page 910]]

       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)

           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) [Reserved]
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)

[[Page 911]]

        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)

                       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)

[[Page 912]]

        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

[[Page 913]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2021)

                                                  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, VIII, IX, X, XI; 9, 
                                                  II
Agricultural Research Service                     7, V
Agriculture, Department of                        2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, VIII, IX, X, XI; 9, 
                                                  II
  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
  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 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
Appalachian Regional Commission                   5, IX
Architectural and Transportation Barriers         36, XI
   Compliance Board
[[Page 914]]

Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI; 38, II
Army, Department of                               32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Benefits Review Board                             20, VII
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase from People Who Are
  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 Hazard Investigation Board    40, VI
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
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
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII
  Army Department                                 32, V; 33, II; 36, III; 
                                                  48, 51
  Defense Acquisition Regulations System          48, 2
  Defense Intelligence Agency                     32, I
  Defense Logistics Agency                        32, I, XII; 48, 54

[[Page 915]]

  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy, Department of                             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, II
  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

[[Page 916]]

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 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 Permitting Improvement Steering Council   40, IX
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
  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

[[Page 917]]

  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, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office 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
Indian Arts and Crafts Board                      25, II
Indian Health Service                             25, V
Industry and Security, Bureau of                  15, VII

[[Page 918]]

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 Development Finance Corporation,    5, XXXIII; 22, VII
     U.S.
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
  Benefits Review Board                           20, VII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Federal Acquisition Regulation                  48, 29
  Federal Contract Compliance Programs, Office    41, 60
       of
  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV

[[Page 919]]

  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, VI
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
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; 47, II
National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
   Administration
[[Page 920]]

National Transportation Safety Board              49, VIII
Natural Resource Revenue, Office of               30, XII
Natural Resources Conservation Service            7, VI
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
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, IV, XXXV; 45, VIII
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
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 and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Contracts, Department of Labor             41, 50
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 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, and     32, XXIV; 47, II
     National Security Council
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II
Selective Service System                          32, XVI
Small Business Administration                     2, XXVII; 13, I
Smithsonian Institution                           36, V
Social Security Administration                    2, XXIII; 20, III; 48, 23
Soldiers' and Airmen's Home, United States        5, XI
Special Counsel, Office of                        5, VIII
Special Education and Rehabilitative Services,    34, III
     Office of
State, Department of                              2, VI; 22, I; 28, XI
  Federal Acquisition Regulation                  48, 6

[[Page 921]]

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 Agency for Global Media             22, V
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 923]]







                      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
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1.50A-1....................................................    1545-0895
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1.50A-6....................................................    1545-0895
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1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
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1.108(i)-1.................................................    1545-2147
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1.132-9(b).................................................    1545-1676
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1.142(f)(4)-1..............................................    1545-1730
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1.149(e)-1.................................................    1545-0720
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1.151-1....................................................    1545-0074
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1.152-4....................................................    1545-0074
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1.163-10T..................................................    1545-0074
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1.163(d)-1.................................................    1545-1421
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1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
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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
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1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
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1.170A-13(f)...............................................    1545-1464
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1.179B-1T..................................................    1545-2076
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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
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1.274-5T...................................................    1545-0074
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1.274-6....................................................    1545-0139
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1.274-6T...................................................    1545-0074
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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
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1.336-2....................................................    1545-2125
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1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
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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
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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
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1.381(c)(5)-1..............................................    1545-0123
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1.381(c)(6)-1..............................................    1545-0123
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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
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1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1120
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1.382-11...................................................    1545-2019
1.382-91...................................................    1545-1260
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1.383-1....................................................    1545-0074
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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
1.451-6....................................................    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
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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
1.506-1....................................................    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
1.529A-2...................................................    1545-2293
1.529A-5...................................................    1545-2262
1.529A-6...................................................    1545-2262
1.529A-7...................................................    1545-2262
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

[[Page 928]]

 
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
1.751-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0941
1.752-2....................................................    1545-1905
1.752-5....................................................    1545-1090
1.752-7....................................................    1545-1843
1.754-1....................................................    1545-0099
1.755-1....................................................    1545-0099
1.761-2....................................................    1545-1338
1.801-1....................................................    1545-0123
                                                               1545-0128
1.801-3....................................................    1545-0123
1.801-5....................................................    1545-0128
1.801-8....................................................    1545-0128
1.804-4....................................................    1545-0128
1.811-2....................................................    1545-0128
1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
1.818-4....................................................    1545-0128
1.818-5....................................................    1545-0128
1.818-8....................................................    1545-0128
1.819-2....................................................    1545-0128
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    1545-1027
1.826-1....................................................    1545-1027
1.826-2....................................................    1545-1027
1.826-3....................................................    1545-1027
1.826-4....................................................    1545-1027
1.826-6....................................................    1545-1027
1.831-3....................................................    1545-0123
1.832-4....................................................    1545-1227
1.832-5....................................................    1545-0123
1.848-2(g)(8)..............................................    1545-1287
1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
1.851-2....................................................    1545-1010
1.851-4....................................................    1545-0123
1.852-1....................................................    1545-0123
1.852-4....................................................    1545-0123
                                                               1545-0145
1.852-6....................................................    1545-0123
                                                               1545-0144
1.852-7....................................................    1545-0074
1.852-9....................................................    1545-0074
                                                               1545-0123
                                                               1545-0144
                                                               1545-0145
                                                               1545-1783
1.852-11...................................................    1545-1094
1.853-3....................................................    1545-2035
1.853-4....................................................    1545-2035
1.854-2....................................................    1545-0123
1.855-1....................................................    1545-0123
1.856-2....................................................    1545-0123
                                                               1545-1004
1.856-6....................................................    1545-0123
1.856-7....................................................    1545-0123
1.856-8....................................................    1545-0123
1.857-8....................................................    1545-0123
1.857-9....................................................    1545-0074
1.858-1....................................................    1545-0123
1.860-2....................................................    1545-0045
1.860-4....................................................    1545-0045
                                                               1545-1054
                                                               1545-1057
1.860E-1...................................................    1545-1675
1.860E-2(a)(5).............................................    1545-1276
1.860E-2(a)(7).............................................    1545-1276
1.860E-2(b)(2).............................................    1545-1276
1.860G-2...................................................    1545-2110
1.861-2....................................................    1545-0089
1.861-3....................................................    1545-0089
1.861-4....................................................    1545-1900
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
                                                               1545-1072
1.861-18...................................................    1545-1594
1.863-1....................................................    1545-1476
1.863-3....................................................    1545-1476
                                                               1545-1556
1.863-3A...................................................    1545-0126
1.863-4....................................................    1545-0126
1.863-7....................................................    1545-0132
1.863-8....................................................    1545-1718
1.863-9....................................................    1545-1718
1.864-4....................................................    1545-0126
1.871-1....................................................    1545-0096
1.871-6....................................................    1545-0795
1.871-7....................................................    1545-0089
1.871-10...................................................    1545-0089
                                                               1545-0165
1.874-1....................................................    1545-0089
1.881-4....................................................    1545-1440
1.882-4....................................................    1545-0126
1.883-0....................................................    1545-1677

[[Page 929]]

 
1.883-1....................................................    1545-1677
1.883-2....................................................    1545-1677
1.883-3....................................................    1545-1677
1.883-4....................................................    1545-1677
1.883-5....................................................    1545-1677
1.884-0....................................................    1545-1070
1.884-1....................................................    1545-1070
1.884-2....................................................    1545-1070
1.884-2T...................................................    1545-0126
                                                               1545-1070
1.884-4....................................................    1545-1070
1.884-5....................................................    1545-1070
1.892-1T...................................................    1545-1053
1.892-2T...................................................    1545-1053
1.892-3T...................................................    1545-1053
1.892-4T...................................................    1545-1053
1.892-5T...................................................    1545-1053
1.892-6T...................................................    1545-1053
1.892-7T...................................................    1545-1053
1.897-2....................................................    1545-0123
                                                               1545-0902
1.897-3....................................................    1545-0123
1.897-5T...................................................    1545-0902
1.897-6T...................................................    1545-0902
1.901-2....................................................    1545-0746
1.901-2A...................................................    1545-0746
1.901-3....................................................    1545-0122
1.902-1....................................................    1545-0122
                                                               1545-1458
1.904-1....................................................    1545-0121
                                                               1545-0122
1.904-2....................................................    1545-0121
                                                               1545-0122
1.904-3....................................................    1545-0121
1.904-4....................................................    1545-0121
1.904-5....................................................    1545-0121
1.904-7....................................................    1545-2104
1.904-7T...................................................    1545-2104
1.904(f)-1.................................................    1545-0121
                                                               1545-0122
1.904(f)-2.................................................    1545-0121
1.904(f)-3.................................................    1545-0121
1.904(f)-4.................................................    1545-0121
1.904(f)-5.................................................    1545-0121
1.904(f)-6.................................................    1545-0121
1.904(f)-7.................................................    1545-1127
1.905-2....................................................    1545-0122
1.905-3T...................................................    1545-1056
1.905-4T...................................................    1545-1056
1.905-5T...................................................    1545-1056
1.911-1....................................................    1545-0067
                                                               1545-0070
1.911-2....................................................    1545-0067
                                                               1545-0070
1.911-3....................................................    1545-0067
                                                               1545-0070
1.911-4....................................................    1545-0067
                                                               1545-0070
1.911-5....................................................    1545-0067
                                                               1545-0070
1.911-6....................................................    1545-0067
                                                               1545-0070
1.911-7....................................................    1545-0067
                                                               1545-0070
1.913-13...................................................    1545-0067
1.921-1T...................................................    1545-0190
                                                               1545-0884
                                                               1545-0935
                                                               1545-0939
1.921-2....................................................    1545-0884
1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
1.931-1....................................................    1545-0074
                                                               1545-0123
1.934-1....................................................    1545-0782
1.935-1....................................................    1545-0074
                                                               1545-0087
                                                               1545-0803
1.936-1....................................................    1545-0215
                                                               1545-0217
1.936-4....................................................    1545-0215
1.936-5....................................................    1545-0704
1.936-6....................................................    1545-0215
1.936-7....................................................    1545-0215
1.936-10(c)................................................    1545-1138
1.937-1....................................................    1545-1930
1.952-2....................................................    1545-0126
1.953-2....................................................    1545-0126
1.954-1....................................................    1545-1068
1.954-2....................................................    1545-1068
1.955-2....................................................    1545-0123
1.955-3....................................................    1545-0123
1.955A-2...................................................    1545-0755
1.955A-3...................................................    1545-0755
1.956-1....................................................    1545-0704
1.956-2....................................................    1545-0704
1.959-1....................................................    1545-0704
1.959-2....................................................    1545-0704
1.960-1....................................................    1545-0122
1.962-2....................................................    1545-0704
1.962-3....................................................    1545-0704
1.964-1....................................................    1545-0126
                                                               1545-0704
                                                               1545-1072
                                                               1545-2104
1.964-3....................................................    1545-0126
1.970-2....................................................    1545-0126
1.985-2....................................................    1545-1051
                                                               1545-1131
1.985-3....................................................    1545-1051
1.987-1....................................................    1545-2265
1.987-3....................................................    1545-2265
1.987-9....................................................    1545-2265
1.987-10...................................................    1545-2265
1.988-0....................................................    1545-1131
1.988-1....................................................    1545-1131
1.988-2....................................................    1545-1131
1.988-3....................................................    1545-1131
1.988-4....................................................    1545-1131
1.988-5....................................................    1545-1131
1.988-6....................................................    1545-1831
1.992-1....................................................    1545-0190
                                                               1545-0938
1.992-2....................................................    1545-0190
                                                               1545-0884
                                                               1545-0938
1.992-3....................................................    1545-0190
                                                               1545-0938
1.992-4....................................................    1545-0190
                                                               1545-0938
1.993-3....................................................    1545-0938
1.993-4....................................................    1545-0938
1.994-1....................................................    1545-0938
1.995-5....................................................    1545-0938
1.1001-1...................................................    1545-1902
1.1012-1...................................................    1545-0074
                                                               1545-1139
1.1014-4...................................................    1545-0184
1.1015-1...................................................    1545-0020
1.1017-1...................................................    1545-1539
1.1031(d)-1T...............................................    1545-1021
1.1033(a)-2................................................    1545-0184
1.1033(g)-1................................................    1545-0184
1.1039-1...................................................    1545-0184

[[Page 930]]

 
1.1041-1T..................................................    1545-0074
1.1041-2...................................................    1545-1751
1.1042-1T..................................................    1545-0916
1.1044(a)-1................................................    1545-1421
1.1045-1...................................................    1545-1893
1.1060-1...................................................    1545-1658
                                                               1545-1990
1.1071-1...................................................    1545-0184
1.1071-4...................................................    1545-0184
1.1081-4...................................................    1545-0028
                                                               1545-0046
                                                               1545-0123
1.1081-11..................................................    1545-2019
1.1082-1...................................................    1545-0046
1.1082-2...................................................    1545-0046
1.1082-3...................................................    1545-0046
                                                               1545-0184
1.1082-4...................................................    1545-0046
1.1082-5...................................................    1545-0046
1.1082-6...................................................    1545-0046
1.1083-1...................................................    1545-0123
1.1092(b)-1T...............................................    1545-0644
1.1092(b)-2T...............................................    1545-0644
1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
1.1211-1...................................................    1545-0074
1.1212-1...................................................    1545-0074
1.1221-2...................................................    1545-1480
1.1231-1...................................................    1545-0177
                                                               1545-0184
1.1231-2...................................................    1545-0177
                                                               1545-0184
1.1231-2...................................................    1545-0074
1.1232-3...................................................    1545-0074
1.1237-1...................................................    1545-0184
1.1239-1...................................................    1545-0091
1.1242-1...................................................    1545-0184
1.1243-1...................................................    1545-0123
1.1244(e)-1................................................    1545-0123
                                                               1545-1447
1.1245-1...................................................    1545-0184
1.1245-2...................................................    1545-0184
1.1245-3...................................................    1545-0184
1.1245-4...................................................    1545-0184
1.1245-5...................................................    1545-0184
1.1245-6...................................................    1545-0184
1.1248-7...................................................    1545-0074
1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
1.1250-1...................................................    1545-0184
1.1250-2...................................................    1545-0184
1.1250-3...................................................    1545-0184
1.1250-4...................................................    1545-0184
1.1250-5...................................................    1545-0184
1.1251-1...................................................    1545-0184
1.1251-2...................................................    1545-0074
                                                               1545-0184
1.1251-3...................................................    1545-0184
1.1251-4...................................................    1545-0184
1.1252-1...................................................    1545-0184
1.1252-2...................................................    1545-0184
1.1254-1(c)(3).............................................    1545-1352
1.1254-4...................................................    1545-1493
1.1254-5(d)(2).............................................    1545-1352
1.1258-1...................................................    1545-1452
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
1.1275-3...................................................    1545-0887
                                                               1545-1353
                                                               1545-1450
1.1275-4...................................................    1545-1450
1.1275-6...................................................    1545-1450
1.1287-1...................................................    1545-0786
1.1291-9...................................................    1545-1507
1.1291-10..................................................    1545-1304
                                                               1545-1507
1.1294-1T..................................................    1545-1002
                                                               1545-1028
1.1295-1...................................................    1545-1555
1.1295-3...................................................    1545-1555
1.1298-3...................................................    1545-1507
1.1301-1...................................................    1545-1662
1.1311(a)-1................................................    1545-0074
1.1361-1...................................................    1545-0731
                                                               1545-1591
                                                               1545-2114
1.1361-3...................................................    1545-1590
1.1361-5...................................................    1545-1590
1.1362-1...................................................    1545-1308
1.1362-2...................................................    1545-1308
1.1362-3...................................................    1545-1308
1.1362-4...................................................    1545-1308
1.1362-5...................................................    1545-1308
1.1362-6...................................................    1545-1308
1.1362-7...................................................    1545-1308
1.1362-8...................................................    1545-1590
1.1363-2...................................................    1545-1906
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
1.1377-1...................................................    1545-1462
1.1378-1...................................................    1545-1748
1.1383-1...................................................    1545-0074
1.1385-1...................................................    1545-0074
                                                               1545-0098
1.1388-1...................................................    1545-0118
                                                               1545-0123
1.1397E-1..................................................    1545-1908
1.1398-1...................................................    1545-1375
1.1398-2...................................................    1545-1375
1.1402(a)-2................................................    1545-0074
1.1402(a)-5................................................    1545-0074
1.1402(a)-11...............................................    1545-0074
1.1402(a)-15...............................................    1545-0074
1.1402(a)-16...............................................    1545-0074
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
1.1402(e)-1A...............................................    1545-0168
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
1.1441-1...................................................    1545-1484
1.1441-2...................................................    1545-0795
1.1441-3...................................................    1545-0165
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1.1502-5...................................................    1545-0257
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1.1502-9A..................................................    1545-0121
1.1502-13..................................................    1545-0123
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1.1502-16..................................................    1545-0123
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1.1502-20..................................................    1545-1774
1.1502-21..................................................    1545-1237
1.1502.21T.................................................    1545-0123
1.1502-31..................................................    1545-1344
1.1502-32..................................................    1545-1344
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1.1502-33..................................................    1545-1344
1.1502-35..................................................    1545-1828
1.1502-36..................................................    1545-2096
1.1502-47..................................................    1545-0123
1.1502-75..................................................    1545-0025
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1.1502-76..................................................    1545-1344
1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
                                                               1545-1046
1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
1.1502-96..................................................    1545-1218
1.1503-2...................................................    1545-1583
1.1503-2A..................................................    1545-1083
1.1503(d)-1................................................    1545-1946
1.1503(d)-3................................................    1545-1946
1.1503(d)-4................................................    1545-1946
1.1503(d)-5................................................    1545-1946
1.1503(d)-6................................................    1545-1946
1.1552-1...................................................    1545-0123
1.1561-3...................................................    1545-0123
1.1563-1...................................................    1545-0123
                                                               1545-0797
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1.1563-3...................................................    1545-0123
1.5000A-3..................................................    1545-0074
1.5000A-4..................................................    1545-0074
1.5000C-2..................................................    1545-0096
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1.5000C-3..................................................    1545-0096
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1.5000C-4..................................................    1545-1223
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1.6001-1...................................................    1545-0058
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1.6011-1...................................................    1545-0055
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1.6011-2...................................................    1545-0055
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1.6011-3...................................................    1545-0238
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1.6011-4...................................................    1545-1685
1.6012-1...................................................    1545-0067
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1.6012-2...................................................    1545-0047
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1.6012-3...................................................    1545-0047
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1.6013-2...................................................    1545-0091
1.6013-6...................................................    1545-0074
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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
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1.6033-3...................................................    1545-0052
1.6034-1...................................................    1545-0092
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1.6035-2...................................................    1545-0704
1.6037-1...................................................    1545-0130
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1.6038-2...................................................    1545-1617
                                                               1545-2020
1.6038-3...................................................    1545-1617
1.6038A-2..................................................    1545-1191
1.6038A-3..................................................    1545-1191
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1.6038B-1..................................................    1545-1617
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1.6038B-1T.................................................    1545-0026
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1.6038B-2..................................................    1545-1617
1.6039-2...................................................    1545-0820
1.6041-1...................................................    1545-0008
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1.6041-2...................................................    1545-0008
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1.6041-3...................................................    1545-1148
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1.6041-6...................................................    1545-0008
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1.6042-3...................................................    1545-0295
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1.6044-5...................................................    1545-0118
1.6045-1...................................................    1545-0715
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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
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1.6046-2...................................................    1545-0704
1.6046-3...................................................    1545-0704
1.6046A....................................................    1545-1646
1.6047-1...................................................    1545-0119
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1.6047-2...................................................    1545-2234
1.6049-1...................................................    1545-0112
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1.6049-4...................................................    1545-0096
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1.6049-6...................................................    1545-0096
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1.6050A-1..................................................    1545-0115
1.6050B-1..................................................    1545-0120
1.6050D-1..................................................    1545-0120
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1.6050E-1..................................................    1545-0120
1.6050H-1..................................................    1545-0901
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1.6050H-2..................................................    1545-0901
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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
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1.6060-1...................................................    1545-0074
1.6060-1(a)(1).............................................    1545-1231
1.6061-1...................................................    1545-0123
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1.6065-1...................................................    1545-0123
1.6071-1...................................................    1545-0123
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1.6081-1...................................................    1545-0066
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1.6081-2...................................................    1545-0148
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1.6081-3...................................................    1545-0233
1.6081-4...................................................    1545-0188
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1.6081-6...................................................    1545-0148
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1.6081-7...................................................    1545-0148
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1.6091-3...................................................    1545-0089
1.6107-1...................................................    1545-0074
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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
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1.6411-1...................................................    1545-0098
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1.6411-2...................................................    1545-0098
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1.6411-3...................................................    1545-0098
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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
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1.6851-1...................................................    1545-0086
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1.6851-2...................................................    1545-0086
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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
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5c.44F-1...................................................    1545-0619
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5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720
5f.6045-1..................................................    1545-0715
6a.103A-2..................................................    1545-0123
                                                               1545-0720
6a.103A-3..................................................    1545-0720
7.465-1....................................................    1545-0712
7.465-2....................................................    1545-0712
7.465-3....................................................    1545-0712
7.465-4....................................................    1545-0712
7.465-5....................................................    1545-0712
7.936-1....................................................    1545-0217
7.999-1....................................................    1545-0216
7.6039A-1..................................................    1545-0015
7.6041-1...................................................    1545-0115
11.410-1...................................................    1545-0710
11.412(c)-7................................................    1545-0710
11.412(c)-11...............................................    1545-0710
12.7.......................................................    1545-0190
12.8.......................................................    1545-0191
12.9.......................................................    1545-0195
14a.422A-1.................................................    1545-0123
15A.453-1..................................................    1545-0228
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

[[Page 935]]

 
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(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
31.3511-1..................................................    1545-2266
31.6001-1..................................................    1545-0798
31.6001-2..................................................    1545-0034
                                                               1545-0798
31.6001-3..................................................    1545-0798
31.6001-4..................................................    1545-0028
31.6001-5..................................................    1545-0798
31.6001-6..................................................    1545-0029
                                                               1459-0798
31.6011(a)-1...............................................    1545-0029
                                                               1545-0034
                                                               1545-0035
                                                               1545-0059
                                                               1545-0074
                                                               1545-0256
                                                               1545-0718
                                                               1545-2097
31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               1545-0718
                                                               1545-1413
                                                               1545-2097
31.6011(a)-5...............................................    1545-0028
                                                               1545-0718
                                                               1545-2097
31.6011(a)-6...............................................    1545-0028
31.6011(a)-7...............................................    1545-0074
31.6011(a)-8...............................................    1545-0028
31.6011(a)-9...............................................    1545-0028
31.6011(a)-10..............................................    1545-0112
31.6011(b)-1...............................................    1545-0003
31.6011(b)-2...............................................    1545-0029
31.6051-1..................................................    1545-0008
                                                               1545-0182
                                                               1545-0458
                                                               1545-1729
31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008

[[Page 936]]

 
31.6053-1..................................................    1545-0029
                                                               1545-0062
                                                               1545-0064
                                                               1545-0065
                                                               1545-1603
31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
                                                               1545-0714
31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6060-1(a)(1)............................................    1545-1231
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413
31.6302-3..................................................    1545-1413
31.6302-4..................................................    1545-1413
31.6302(c)-2...............................................    1545-0001
                                                               1545-0257
31.6302(c)-2A..............................................    1545-0955
31.6302(c)-3...............................................    1545-0257
31.6402(a)-2...............................................    1545-0256
                                                               1545-2097
31.6413(a)-1...............................................    1545-0029
                                                               1545-2097
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
                                                               1545-2097
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
                                                               1545-2097
32.1.......................................................    1545-0029
                                                               1545-0415
32.2.......................................................    1545-0029
35a.3406-2.................................................    1545-0112
35a.9999-5.................................................    1545-0029
36.3121(l)(1)-1............................................    1545-0137
36.3121(l)(1)-2............................................    1545-0137
36.3121(l)(3)-1............................................    1545-0123
36.3121(1)(7)-1............................................    1545-0123
36.3121(1)(10)-1...........................................    1545-0029
36.3121(1)(10)-3...........................................    1545-0029
36.3121(1)(10)-4...........................................    1545-0257
40.6060-1(a)(1)............................................    1545-1231
40.6107-1..................................................    1545-1231
40.6302(c)-3(b)(2)(ii).....................................    1545-1296
40.6302(c)-3(b)(2)(iii)....................................    1545-1296
40.6302(c)-3(e)............................................    1545-1296
40.6302(c)-3(f)(2)(ii).....................................    1545-1296
41.4481-1..................................................    1545-0143
41.4481-2..................................................    1545-0143
41.4483-3..................................................    1545-0143
41.6001-1..................................................    1545-0143
41.6001-2..................................................    1545-0143
41.6001-3..................................................    1545-0143
41.6060-1(a)(1)............................................    1545-1231
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6107-1..................................................    1545-1231
41.6109-1..................................................    1545-0143
41.6151(a)-1...............................................    1545-0143
41.6156-1..................................................    1545-0143
41.6161(a)(1)-1............................................    1545-0143
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
                                                               1545-0236
44.6060-1(a)(1)............................................    1545-1231
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6107-1..................................................    1545-1231
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4375-1..................................................    1545-2238
46.4376-1..................................................    1545-2238
46.4701-1..................................................    1545-0023
                                                               1545-0257
48.4041-4..................................................    1545-0023
48.4041-5..................................................    1545-0023
48.4041-6..................................................    1545-0023
48.4041-7..................................................    1545-0023
48.4041-9..................................................    1545-0023
48.4041-10.................................................    1545-0023
48.4041-11.................................................    1545-0023
48.4041-12.................................................    1545-0023
48.4041-13.................................................    1545-0023
48.4041-19.................................................    1545-0023
48.4041-20.................................................    1545-0023
48.4041-21.................................................    1545-1270
48.4042-2..................................................    1545-0023
48.4052-1..................................................    1545-1418
48.4061(a)-1...............................................    1545-0023
48.4061(a)-2...............................................    1545-0023
48.4061(b)-3...............................................    1545-0023
48.4064-1..................................................    1545-0014
                                                               1545-0242
48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
                                                               1545-1074
                                                               1545-1087
48.4081-2..................................................    1545-1270
                                                               1545-1418
48.4081-3..................................................    1545-1270
                                                               1545-1418
                                                               1545-1897
48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
48.4082-7..................................................    1545-1418
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723

[[Page 937]]

 
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
48.4216(a)-2...............................................    1545-0023
48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0014
                                                               1545-0023
48.4223-1..................................................    1545-0023
                                                               1545-0257
                                                               1545-0723
48.6302(c)-1...............................................    1545-0023
                                                               1545-0257
48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
                                                               1545-0723
48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               1545-1087
48.6416(b)(2)-4............................................    1545-0723
48.6416(b)(3)-1............................................    1545-0723
48.6416(b)(3)-2............................................    1545-0723
48.6416(b)(3)-3............................................    1545-0723
48.6416(b)(4)-1............................................    1545-0723
48.6416(b)(5)-1............................................    1545-0723
48.6416(c)-1...............................................    1545-0723
48.6416(e)-1...............................................    1545-0023
                                                               1545-0723
48.6416(f)-1...............................................    1545-0023
                                                               1545-0723
48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
                                                               1545-0723
48.6420-2..................................................    1545-0162
                                                               1545-0723
48.6420-3..................................................    1545-0162
                                                               1545-0723
48.6420-4..................................................    1545-0162
                                                               1545-0723
48.6420-5..................................................    1545-0162
                                                               1545-0723
48.6420-6..................................................    1545-0162
                                                               1545-0723
48.6421-0..................................................    1545-0162
                                                               1545-0723
48.6421-1..................................................    1545-0162
                                                               1545-0723
48.6421-2..................................................    1545-0162
                                                               1545-0723
48.6421-3..................................................    1545-0162
                                                               1545-0723
48.6421-4..................................................    1545-0162
                                                               1545-0723
48.6421-5..................................................    1545-0162
                                                               1545-0723
48.6421-6..................................................    1545-0162
                                                               1545-0723
48.6421-7..................................................    1545-0162
                                                               1545-0723
48.6424-0..................................................    1545-0723
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
                                                               1545-0162
                                                               1545-0723
48.6427-2..................................................    1545-0162
                                                               1545-0723
48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
                                                               1545-0224
                                                               1545-0225
                                                               1545-0226
                                                               1545-0230
                                                               1545-0257
                                                               1545-0912
49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-0257
                                                               1545-1153
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
                                                               1545-0196
53.4942(a)-1...............................................    1545-0052
53.4942(a)-2...............................................    1545-0052
53.4942(a)-3...............................................    1545-0052
53.4942(b)-3...............................................    1545-0052
53.4945-1..................................................    1545-0052
53.4945-4..................................................    1545-0052
53.4945-5..................................................    1545-0052
53.4945-6..................................................    1545-0052
53.4947-1..................................................    1545-0196
53.4947-2..................................................    1545-0196
53.4948-1..................................................    1545-0052
53.4958-6..................................................    1545-1623
53.4961-2..................................................    1545-0024
53.4963-1..................................................    1545-0024
53.6001-1..................................................    1545-0052
53.6011-1..................................................    1545-0049
                                                               1545-0052
                                                               1545-0092
                                                               1545-0196

[[Page 938]]

 
53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066
                                                               1545-0148
53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
54.4975-7..................................................    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
156.6011-1.................................................    1545-1049
156.6060-1(a)(1)...........................................    1545-1231
156.6081-1.................................................    1545-1049
156.6107-1.................................................    1545-1231
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6060-1(a)(1)...........................................    1545-1231
157.6081-1.................................................    1545-1824
157.6107-1.................................................    1545-1231
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6011(g)-1..............................................    1545-2079
301.6017-1.................................................    1545-0090
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

[[Page 939]]

 
301.6361-1.................................................    1545-0024
                                                               1545-0074
301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074
301.6402-2.................................................    1545-0024
                                                               1545-0073
                                                               1545-0091
301.6402-3.................................................    1545-0055
                                                               1545-0073
                                                               1545-0091
                                                               1545-0132
                                                               1545-1484
301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               1545-1637
301.6501(d)-1..............................................    1545-0074
                                                               1545-0430
301.6511(d)-1..............................................    1545-0024
                                                               1545-0582
301.6511(d)-2..............................................    1545-0024
                                                               1545-0582
301.6511(d)-3..............................................    1545-0024
                                                               1545-0582
301.6652-2.................................................    1545-0092
301.6685-1.................................................    1545-0092
301.6689-1T................................................    1545-1056
301.6707-1T................................................    1545-0865
                                                               1545-0881
301.6708-1T................................................    1545-0865
301.6712-1.................................................    1545-1126
301.6903-1.................................................    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
301.7705-1.................................................    1545-2266
301.7705-2.................................................    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
------------------------------------------------------------------------


[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 941]]



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, 2016 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.

                                  2016

26 CFR
                                                                   81 FR
                                                                    Page
Chapter I
1.954-2 (c)(1)(i), (iv), (2)(ii), (2)(iii)(E), (viii), (d)(1)(i), 
        (ii), (2)(ii), (iii)(E), (v) and (i) revised; 
        (c)(2)(iii)(C), (D), (d)(2)(iii)(C) and (D) amended........76504
    (j) correctly removed..........................................95471
1.954-2T Removed...................................................76505
1.955A-3 (e) heading revised; CFR correction.......................18749
1.956-1 Heading, (a), (b), (e)(2) and (g) revised; (c) and (d) 
        removed....................................................76505
1.956-1T Revised...................................................76507
    Heading, (a)(5) heading and (f) heading correctly revised......95471
1.956-2 (a)(4), (c)(5) and (i) added; (d)(2) revised...............20886
    (a)(3), (c)(1) and (2) revised; (c)(3) Example 4 and (h) added
                                                                   76507
1.956-2T (a)(4), (c)(5), (i) and (j) added; (d)(2) revised.........20886
    (a)(4)(iii) Examples 3 and 4 correctly amended.................40811
    Regulation at 81 FR 40811 removed..............................46832
    (a)(4)(iv) Examples 3 and 4 correctly amended..................46833
1.956-3 Added......................................................76508
1.956-3T Removed...................................................76509
1.956-4 Added......................................................76509
    (b)(2)(ii), (3) introductory text and (c)(3)(i) introductory 
text correctly revised; (c)(4) Example 3 correctly amended.........95471
1.985-5 Revised....................................................88819
1.987-0 Added......................................................88821
    Amended........................................................88867
1.987-1 Revised....................................................88821
    (b)(1)(iii), (6), (c)(1)(ii)(B), (3)(i)(E), (d)(3), (f), 
(g)(2)(i)(B), (C) and (e)(i)(E) through (H) added..................88867
1.987-1T Added.....................................................88868
1.987-2 Revised....................................................88821
    (c)(9) added...................................................88870
1.987-2T Added.....................................................88870
1.987-3 Revised....................................................88821
    (b)(2)(ii), (4), (c)(2)(ii), (v), (d) and (e) Examples 9 
through 14 added...................................................88870
1.987-3T Added.....................................................88870
1.987-4 Revised....................................................88821
    (c)(2) and (f) added...........................................88873
1.987-4T Added.....................................................88873
1.987-5 Revised....................................................88821
1.987-6 Added......................................................88845
    (b)(4) added...................................................88874
1.987-6T Added.....................................................88874
1.987-7 Added......................................................88845
    (b) added......................................................88874
1.987-7T Added.....................................................88874

[[Page 942]]

1.987-8 Added......................................................88845
    (d) added......................................................88875
1.987-8T Added.....................................................88875
1.987-9 Added......................................................88845
1.987-10 Added.....................................................88845
1.987-11 Added.....................................................88845
1.987-12 Added.....................................................88875
1.987-12T Added....................................................88875
1.988-0 Amended.............................................88850, 88879
1.988-1 (a)(4) added; (a)(10)(ii) revised; (i) amended.............88850
    (a)(3) added...................................................88879
1.988-1T Added.....................................................88879
1.988-2 (b)(16) revised; (i) added.................................88879
1.988-2T Added.....................................................88879
1.988-4 (b)(2) revised.............................................88851
1.989(a)-1 (b)(2)(i) revised; (b)(4), (d)(3) and (4) added.........88851
1.989(c)-1 Removed.................................................88851
........................................................................
........................................................................

                                  2017

26 CFR
                                                                   82 FR
                                                                    Page
Chapter I
1.995-4 (d)(2) amended; (f) added...................................6240
........................................................................
........................................................................

                                  2018

26 CFR
                                                                   83 FR
                                                                    Page
Chapter I
1.956-2 (a)(4), (c)(5), and (d)(2) revised; (f) and (h)(3) through 
        (6) added; (i) removed.....................................32536
1.956-2T (a)(4), (c)(5), (d)(2), (i), and (j) removed; (b)(2) 
        through (c)(4) revised.....................................32538
........................................................................
........................................................................

                                  2019

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1.921-3T Removed....................................................9236
1.922-1 Removed.....................................................9236
1.923-1T Removed....................................................9236
1.924(a)-1T Removed.................................................9236
1.924(c)-1 Removed..................................................9236
1.924(d)-1 Removed..................................................9236
1.924(e)-1 Removed..................................................9236
1.925(a)-1 Removed..................................................9236
1.925(a)-1T Removed.................................................9236
1.925(b)-1T Removed.................................................9236
1.926(a)-1 Removed..................................................9236
1.926(a)-1T Removed.................................................9236
1.927(b)-1T Removed.................................................9236
1.927(d)-1 Removed..................................................9236
1.927(e)-1 Removed..................................................9236
1.927(e)-2T Removed.................................................9236
1.927(f)-1 Removed..................................................9236
1.941-1--1.941-3 Undesignated center heading and sections removed 
                                                                    9236
1.943-1 Removed.....................................................9236
1.951-1 (a) introductory text, (b)(1)(ii), (2), (c), (e), and 
        (g)(1) revised; (h) and (i) added..........................29337
1.951-1 Correction: (b)(2)(iv)(B) Table 1, (b)(2)(vi)(B)(2) Table 
        1, and (b)(2)(vi)(B)(1) Table 1 revised....................44223
1.951-1 Correction: (b)(2)(vi)(B)(2) Table 1 amended...............53052
1.951A-0 Added.....................................................29341
1.951A-1 Added.....................................................29341
1.951A-2 Added.....................................................29341
1.951A-2 (c)(4)(iv)(A)(2)(i), (ii), and (C)(2)(iii) amended........44694
1.951A-2 (c)(3) amended............................................69107
1.951A-3 Added.....................................................29341
1.951A-4 Added.....................................................29341
1.951A-5 Added.....................................................29341
1.951A-6 Added.....................................................29341
1.951A-7 Added.....................................................29341
1.951-2 Removed.....................................................9236
1.952-1 (e)(1)(i), (5), and (f)(2)(ii) amended.....................69107
1.954-0 (b) amended................................................63803
1.954-1 (f)(2)(iv) revised; (f)(3) added...........................63803
1.954-1 (c)(1)(iii)(A) introductory text, (d)(3)(i), and (ii) 
        amended; (d)(3)(iii) and (h) added; (g)(4) removed.........69107
1.954-2 (c)(2)(iii)(B), (iv)(A), and (i) heading revised; (i)(2) 
        redesignated as (i)(3); new (i)(2) added...................63804
1.954(c)(6)-1T Added (temporary)...................................28423

[[Page 943]]

1.956-1 (a) and (g) heading revised; (b)(4) introductory text 
        amended; (b)(4) Examples 1 through 8 designated as 
        (b)(4)(i) through (viii); new (b)(4)(i)(i), (ii), (ii)(i), 
        (ii), (iii)(i), (ii), (iv)(i), (ii), (v)(i), (ii), 
        (vi)(i), (ii), (vii)(i), (ii), (viii)(i), and (ii) 
        redesignated as new (b)(4)(i)(A), (B), (ii)(A), (B), 
        (iii)(A), (B), (iv)(A), (B), (v)(A), (B), (vi)(A), (B), 
        (vii)(A), (B), (viii)(A), and (B); new (b)(4)(ii)(A) and 
        (g)(1) amended; (g)(4) and (5) added; authority citation 
        removed....................................................23717
1.956-1 Technical correction.......................................29799
1.958-2 (d)(1) introductory text revised; (e) amended; (h) added 
                                                                   63804
1.960-1 Revised....................................................69107
1.960-2 Revised....................................................69112
1.960-3 Revised....................................................69114
1.960-4 Nomenclature change; (a)(1) and (d) amended; (f) revised 
                                                                   69117
1.960-5 (a)(1) amended; (b) revised................................69119
1.960-6 (a) amended; (b) revised...................................69119
1.960-7 Revised....................................................69120
1.962-1 (b)(1)(i) revised; (b)(2)(iv)(a) and (b) redesignated as 
        (b)(2)(iv)(A) and (B); (d) added............................1874
1.962-1 (a) concluding text redesignated as (a)(3); new (a)(3) 
        amended.....................................................9236
1.962-2 (a) amended; (d) added......................................1875
1.962-2 (b) introductory text and (c)(1) amended....................9236
1.962-4 Removed.....................................................9237
1.963-1 Removed.....................................................9237
1.963-4 Removed.....................................................9237
1.963-5 Removed.....................................................9237
1.963-7 Removed.....................................................9237
1.963-8 Removed.....................................................9237
1.964-4 (e) removed.................................................9237
1.965-0 Added.......................................................1875
1.965-0 Amended....................................................14260
1.965-1 Added.......................................................1875
1.965-1 (f)(13)(ii) revised........................................14260
1.965-2 Added.......................................................1875
1.965-2 (b)(2) and (4) revised.....................................14260
1.965-3 Added.......................................................1875
1.965-4 Added.......................................................1875
1.965-5 Added.......................................................1875
1.965-5 (c)(1)(iii) added..........................................69120
1.965-6 Added.......................................................1875
1.965-7 Added.......................................................1875
1.965-7 (c)(3)(iv)(A)(2) and (B)(4)(viii) revised..................14261
1.965-7 (e)(1)(i) amended; (e)(1)(iv) and (3) added; (e)(2)(ii) 
        revised....................................................29365
1.965-7 (e)(1)(i) amended..........................................69120
1.965-8 Added.......................................................1875
1.965-8 (e) heading, (1), and (g)(1)(ii)(B)(2) revised.............14261
1.965-9 Added.......................................................1875
1.965-9 (a) amended; (c) added.....................................69120
1.985-3 (e)(2)(iv) amended.........................................69120
1.986(a)-1 Added...................................................69120
1.986(c)-1 Added....................................................1915
1.987-0 Amended......................................20794, 20795, 31194
1.987-2 (c)(9) revised; (e) added..................................20795
1.987-2 (c)(9)(iii) amended; (e)(1) revised........................31194
1.987-2T Removed...................................................20795
1.987-4 (c)(2) and (f) revised; (h) added..........................20795
1.987-4 (f)(2) amended.............................................31194
1.987-4T Removed...................................................20796
1.987-7 (b) removed................................................20796
1.987-7T Removed...................................................20796
1.987-12 Revised...................................................20796
1.987-12T Removed..................................................20801
1.988-2 (a)(2)(iii)(A) amended; (a)(2)(iii)(C) added...............69123

                                  2020

26 CFR
                                                                   85 FR
                                                                    Page
Chapter I
1.937-2 (d) amended................................................79853
1.937-3 (d) amended................................................79853
1.951A-0 Removed...................................................44638
1.951A-2 (c)(1)(iii) revised; (c)(3) redesignated as (c)(3)(i); 
        new (c)(3)(i) heading, (ii), (7), and (8) added............44638
1.951A-2 Correction: (c)(7)(viii)(E)(2)(ii) amended................64040
1.951A-2 (c)(6) added..............................................72070
1.951A-2 (c)(5)(iv) and (6)(iv) redesignated as (c)(5)(v) and 
        (6)(v); new (c)(5)(iv) and new (6)(iv) added; new 
        (c)(5)(v)(B)(1), new (C)(1), and new (6)(v)(B)(1) amended 
                                                                   76975

[[Page 944]]

1.951A-2 Correction: (c)(3)(ii)(B), (7)(viii)(A)(4) introductory 
        text, (8)(iii)(D)(6)(i), and (iii) amended; 
        (c)(7)(iii)(B)(2), (viii)(A)(2)(ii), (A)(4)(i) revised; 
        (c)(8)(iii)(C)(2)(vii) redesignated as 
        (b)(8)(iii)(C)(2)(vii).....................................79853
1.951A-7 Existing text designated as (a); new (a) heading and (b) 
        added; new (a) amended.....................................44648
1.951A-7 (d) added.................................................72070
1.954-0 (b) removed................................................44649
1.954-1 (c)(1)(iii)(A)(2)(ii), (d)(1) introductory text, (ii), (2) 
        introductory text, and (i) amended; 
        (c)(1)(iii)(A)(2)(iii), (iv), (d)(3)(ii), and (7) removed; 
        (c)(1)(iii)(A)(3), (iv), and (h)(3) added; (d)(3)(i) and 
        (h)(1) revised.............................................44649
1.954-1 (c)(1)(i)(C) and (d)(3)(iii) amended; (h)(1) revised.......72070
1.954-2 (h)(2)(i)(H) and (i)(3) amended; (h)(2)(i)(I) redesignated 
        as (h)(2)(i)(J); new (h)(2)(i)(I) added....................72071
1.954(c)(6)-1 Added................................................53097
1.954(c)(6)-1T Removed.............................................53097
1.958-2 (d)(2) and authority citation removed; (g) Example 1 
        through Example 6 redesignated as (g)(1) through (6); new 
        (g)(1) and new (g)(2), and (h) amended; new (g)(4) revised
                                                                   59435
1.960-1 (c)(2) amended; (d)(3)(ii)(A) and (B) revised; 
        (d)(3)(ii)(C) removed......................................72071
1.960-2 (b)(3)(iii) amended........................................72071
1.960-3 (e)(2)(i) amended..........................................72071
1.960-4 (f)(1) Table 2 amended.....................................72071
1.960-7 Revised....................................................72072
1.962-1 (a)(2), (b)(2)(i) through (iii), (c), and (d) revised; 
        (b)(1)(i)(A)(2) and (b)(1)(i)(B)(3) added; (b)(1)(ii) 
        removed....................................................43109
1.965-5 (b) redesignated as (b)(1); new (b)(1) heading and (2) 
        added......................................................72072
1.965-9 (c) amended................................................72072

                                  2021

 (No regulations published from January 1, 2021, through April 1, 2021)


                                  [all]